The ability to be patient and stick to a trade thesis can be paramount so long as the fundamental assessment is still valid. It is important to stick to remember this you pick an unloved and undervalued stock that is not favored by Wall Street.
When I wrote about Cisco Systems Inc. (CSCO) back in May 2011, I thought that at $16.27 and a 9.40 P/E (earnings estimates of 1.72) it warranted a second tier entry. Part of this included the willingness to be patient in the trade, and part was due to the trade structure.
The second tier entry I wrote about had discussed selling January 2012 $16 strike puts for $1.31 each and buying January 2012 $19 strike calls for $0.45 each at a 2:1 ratio or a net credit of $2.17 for the whole package.
The reasoning behind this was to collect a strong net credit via the puts; if the stock merely remained flat, then an investor would have $2.17 in net profits per spread versus a flat investment via just long the stock. The assignment of the shares in the trade would have put the investor long shares at $14.91.
However, the time has come to close out most of the trade. I still view the company and its potential favorably, but I am concerned with the broader market and economy and the trade has already been stellar one.
The updated trade recommendation is to buy back the short January 2012 $16 puts at $0.23 per contract and to sell January 2012 $20 strike calls for $0.50. Essentially the sale of the calls pays for the buy back of the puts with a net credit of $0.04.
This also means that an investor books $2.16 in profits while having having another $0.59 of potential upside profits via the January 2012 $19-$20 call spread with no original capital in the trade. Worst case is that Cisco trades below $19 and the value in the call spreads settles worthless and the investor only books the $2.16 in net profits.
The return on the trade work out as follows:
- $2.16 / $29.82 MVAR (14.91*2=29.82) = 7.24% (14.48% annualized)
- $2.16 / $13.00 margin = 16.62% (33.24% annualized)
Potential return (if CSCO > $20):
- $2.75 / $29.82 = 9.22% (18.44% annualized)
- $2.75 / $13.00 = 21.15% (42.30% annualized).
The margin versus MVAR (maximum value at risk) is important as more often than not MVAR will not come into play if the investor was correct in his underlying fundamental analysis.
One additional thing to take away from the trade is that at minimum the January 2012 $16 strike puts should be closed out as there is over two months worth of unknown market risk versus the potential gains of $0.23.
Usually when a long-term trade has short options embedded into the trade, and the remaining value is less than $0.25 and has over a month left, I choose to close them out the vast majority of the time. The risk versus remaining reward usually just does not make sense and frees up capital for future trades that should hopefully generate more than the remaining $0.25.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.