Options Strategy: Diagonal Call Spread On J&J

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 |  About: Johnson & Johnson (JNJ)
by: Tom Armistead

Johnson & Johnson (NYSE:JNJ), like many of the largest and strongest US companies, is trading at a discount to its historical valuation, creating an investment opportunity that has drawn ample comment. For investors who are comfortable with the increased risk of options, and have a favorable opinion of the ultimate trajectory of present macro concerns, a diagonal call spread on JNJ offers an attractive risk/reward profile.

Diagonal spreads take many forms. This article is about using long-dated, deep in-the-money calls as a substitute for share ownership, and writing short-term, out of the money calls against them. (I wrote up the strategy up at some length several years ago.)

LEAPS (Long-term Equity Anticipation Securities) are equity options that expire as much as 3 years in the future, with January expiration dates. While they aren't available for all stocks, there are LEAPS on JNJ, with the longest dated expiring in January 2014.

Johnson & Johnson

The company is well-known. I've been avoiding it for over a year, out of concern for the FDA action and product recalls, as well as issues arising from off-label marketing of Risperdal. After reviewing the available material, I've become comfortable with investing in it again, at today's prices.

Reputational Damage

I'm working on an article on the topic. Briefly, the risk of serious injury to consumers from the recalled products was remote, and the company has complied with FDA required corrective action. The loss of market share is reflected in current earnings, and can be recovered over time with judicious advertising and promotional efforts.

The Risperdal case involves off-label marketing of an anti-psychotic drug, something for which other drug companies have been prosecuted, with the cost running in the $1 to $2 billion range. That can quantified as less than 1% of market cap, or 2% of shareholders' equity. I see an ethical issue in shades of gray.

Meanwhile, publicly available surveys on reputation show JNJ retaining its position as one of the most admired companies in the United States.

Valuation

Using earnings of $4.97 (mid guidance) for 2011, and a consensus estimate of $5.26 for 2012, projected 5-year average EPS at year end 2012 is $4.73. JNJ has historically traded at an average multiple of 17.9 on that metric, suggesting a target price of $85. At a recent price of $62.64, shares are undervalued by 26%.

FINVIZ.com reports a target price of $71.73. The options strategy discussed earns its maximum profit at $67.50

The Trade

Buy to open 10 JNJ Jan 19 2013 50.0 Calls @ 14.60

Sell to open 10 JNJ Apr 21 2011 67.5 Calls @ 1.52

Here's an analysis of several potential outcomes of the trade (click to enlarge):

Click to enlarge

In the static case, if JNJ is unchanged as of the 4/21/2012 expiration, the investor will have an annualized yield of 18.6%, and can sell another covered call, since the Jan 2013 50.0 call will still have nine months to expiration.

The maximum possible profit of $4,595 is about the same as the maximum probable loss, $4,095 if JNJ is at $57.50 (its current 52-week closing low) as of the April expiration.

Intrinsic vs. Time Value

If an option is in the money, the difference between the strike and the share price is referred to as the intrinsic value. With JNJ at 63.78, the intrinsic value of the Jan 2013 50.0 call is $13.78. The JNJ Apr 67.5 call is out of the money, and has no intrinsic value.

The difference between the price of an option and its intrinsic value is its time value. The time value for the JNJ Jan 2013 50.0 call is $14.60 minus $13.78, or 82 cents. The entire premium of the JNJ Apr 2011 37.5 call is time value.

Trade-offs

There are trade-offs in selecting the specific strikes and expirations to implement this strategy. I prefer that the time value on the call sold be greater than the time value on the call bought, resulting in a positive return in the static case. At the same time, I like to have the call sold far enough out of the money that there will be a decent profit if the shares make an upward move. Finally, I prefer having the strike on the deep in the money call low enough that it unlikely that the underlying will go under it.

These preferences create positions that will perform extremely well in a sideways or moderately upward market, while underperforming at the extremes.

Low-Cost Leverage

A primary benefit of this trade is that it provides low-cost leverage. If an investor were to borrow $50,000 to invest in 1,000 shares of JNJ, he would pay interest at the rate his broker gives him in a margin account, which varies substantially. At 7%, the loan would cost $3,500 per year. $2,280 worth of dividends would reduce the cost to $1,220.

The 82 cents time cost for the JNJ Jan 2013 50.0 call annualizes to 66 cents. The cost of maintaining the options position to control 1,000 shares for a year is $660, a meaningful saving from the cost of using margin. Plus, the inconvenience and embarrassment of margin calls is avoided.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JNJ over the next 72 hours. I plan to execute the trade outlined, in an appropriate size, during the coming week, market conditions permitting.