Expecting Realty Income's Price To Drop? Explore Some 'Options'

| About: Realty Income (O)

Summary

Realty Income's price continues unfettered into nose-bleed valuation territory.

Some thoughts on shorting the stock, shorting in general, and short squeezes.

A look at May and June Realty Income options expirations.

An out-of-the money example and an in-the-money example.

Investors continue to have a lot to chew on with regard to widely held REIT, Realty Income (NYSE:O). Clearly most analysts today see the company as expensive relative to its intrinsic value as a real estate landlord. Fellow REIT writer Dane Bowler, in a recent article, even suggested that near-term opportunistic investors short the stock due to current excessive price.

While I agree with much of Dane's value-inspired sentiment and analysis, pure income investors -- the company's bread and butter shareholder -- won't likely be acting on the advice. It could also prove dangerous, as any short can, depending on how things work out near-term. Although, in defense of the idea, I would agree that elevated downside risk as opposed to upside price potential appears to be a logical conclusion in this instance.

My recent analysis on Realty Income focused on the stock's seeming symmetry with activity in the bond market. I opined that unless bond rates embark on a clear uptrend, O's valuation is likely to hold. Though I see the economy holding its own, I do not see a 3% 10-year Treasury anytime soon, although a rebound to 2% would be an easy target depending on economic development and Fedspeak. Central bankers seem to be waffling a lot these days, given the sensitivity of investors and generally murky global economic conditions.

On the other hand, 1.5% seems to be a strong level of support for the 10-year, but if a meaningful black swan or otherwise negative growth event were to occur, a break of support could occur. In that scenario, investors would likely push O's price even higher. That would represent the biggest risk to a short position.

Just as an observation, short interest has been ramping on the stock over the past month, which means traders are starting to smell price decline blood in the air. As always, this brings the possibility of a short squeeze into play, if unexpected momentum continues.

As Dane suggested in his short article, a transformative acquisition could also juice O's stock price, as typical granular acquisitions may have trouble moving the growth needle. Given its currency, I can't fathom that management is not looking for an accretive acquisition. But a perfect, suitable counterparty may be difficult to find, given O's very conservative, and somewhat unique, tenant profile.

Of further general caveat to those betting against O is that a short position generally requires the borrower to pony up any dividend payments that occur until the trade is covered (right now 30 basis points a month). Also, in terms of a short, loss potential is infinite, assuming the stock continues a stratospheric climb.

In the seemingly unlikely scenario that a black swan event roils the market and investors decide to place a 3% yield on Realty income, the stock could hit $80. That would represent 27% downside if a short is executed at $63 a share.

Other Options

For income investors that are reluctant to outright buy the stock at a 3.8% yield point, or can't shoulder the unlimited risk potential of an outright short, there are other "options." We'll briefly discuss two actionable income generating ideas in two scenarios, one where we assume the stock stays between $60-$65 by May and June, and another where you think the stock drops below $60 a share by June.

If you currently own the stock, you could sell "out of the money" call options against shares that you already own. You could also execute a covered call transaction on newly purchased shares. This is a solid trade if you think the stock sits between $60 and $65 prior to either a May or June options expiration. Here were the premiums relative to Realty Income options on Friday, April 8, 2016 at about 2:30 PM:

Source: Ameritrade

Focusing in on the $65 strikes for both May and June, and considering the midpoint, you could get 65 cents on the May call and maybe a dollar on the June call. Understand that if O's price dribbles higher than $65 after you sell the call and even prior to expiration, you might be forced to part ways with pledged shares at $65, assuming assignment (counterparty exercise) occurs.

If the stock flat lines or sells off, you get to keep the premium with no disturbance to your position, which amounts to about 1% for the May call and a little better than 1.5% for the June call (commissions excluded).

Considering that a monthly dividend from Realty Income equates to a yield of a little better than 30 basis points (.3%) at current price, this is an opportunity to generate additional income on an expensive stock. The downside, assuming the stock goes above $65, is you leave open the possibility that it will be called away from you. If you already had $65 in mind as an exit point, this could be a strategy to exit and pocket a little extra in the process.

Rollout is also an option if assignment appears likely. A rollout transaction includes a simultaneous cover of a near-term position and write of a longer-term call.

If the stock flat lines or goes down and the option expires worthless, you could re-initiate the process, although the premium and expiration will obviously be different. Premium pricing is generally predicated on three inputs: strike price, days to expiration, and volatility.

Another Option

If you are convinced that O's price will fall to the $60 "area," you could look at "in the money" options with higher premiums. Looking at the June $60 calls, you could sell contracts for $3.85, which represents a 6% immediate yield payback at current market. The risk you run if the stock doesn't drop, is that you will be forced to sell pledged shares at $60. And since shares are already in the money, the possibility exists that a counterparty exercises immediately, causing immediate forced sale

All is not lost, however. With the stock at about $63, a $3.85 premium means you make out to the tune of about 85 cents per contract ($3.85 premium - the $3 spread on price/strike per contract -- not factoring in commission) on an immediate call. If that happens, you could conceivably turn around and place another covered call transaction, and reap more immediate premium.

If the stock drops to right around $60, and assignment does not occur, the position is preserved, and the price drop has been effectively avoided. If the stock drops considerably further, you still pocket the premium, but you also see paper loss as opposed to just having sold the stock. But you will see $3.85 per share less paper loss compared to someone who simply sat on a naked position.

In many cases, there may be more wisdom in simply selling the stock, as opposed to playing with an in-the-money call. Personal considerations may create impetus to execute in the money call strategies or protective put strategies that don't involve immediate release of shares on positions deemed vulnerable.

Summary

Since Realty Income has grown to become one of THE income stocks for income investors to own, it would only be natural to consider it as a prime candidate for an option-income overlay strategy. Covered calls are particularly effective when price downside is deemed probable or simply when you believe price will stagnate. However, it may or may not be worth the effort for the average DIYer to add such a strategy to an income repertoire.

Call writing generally requires one to make a price prediction prior to an expiration. The average income investor may be apathetic to such prognostications, especially if a current strategy or investment program is deemed sufficient, or if near-term prognostication is simply not up the investor's alley.

For those with a bit of disposable time and inclination to augment passive income, covered calls sit relatively low in terms of the options risk pyramid. Still, in the sometimes quickly moving markets of today, you could find yourself stuck if your attitude towards a position changes mid-stream. You could also find yourself churning your account much more than you expected or need be.

Simple options are not particularly complicated, but you need to know what you are doing, how to enter orders properly, and how to unwind a trade. It also requires more portfolio attention than the typical passively managed income portfolio. In short, while covered calls may be a good "option" for today's Realty Income investor, they are not for everyone.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in O over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.