Selling Apollo Investment Puts For Income Investors

| About: Apollo Investment (AINV)

Summary

There are many ways of earning investment income.

Stock options can be traded conservatively as well as speculatively.

Selling cash covered put option is a viable means of earning income.

If you are a retired investor like me, chances are that you would like to protect your nest egg while earning regular income generated by your retirement savings. I used to be quite a bold investor; my portfolio was 80% in stocks before the financial tsunami in 2008. The market downturn tamed me, and taught me to respect the unforeseen ups and downs in life. Having discovered that I was not able to withstand the pressure of losing, I tuned down my portfolio to 50% stocks and 50% fixed income. I became very inactive, and with hindsight, my assets were still poorly allocated, missing the market rally that started from 2009.

Fast-forward seven years. I finally recovered from my fear of market crashes, and decided to do something to revamp my investment portfolio. Income had become my number one objective. There was quite a bit of cash in the portfolio, so to warm myself up, I started by buying two CDs — yes, CDs — to earn the pitiful 0.5% annual interest. To make a long story short, in the span of the last 9 months, I have stirred my finger in the corporate ETF bond fund, preferred securities, baby bond, municipal bond, and OTC traded corporate bond pies.

Motivation

In April, SA author Richard Lejeune inspired me with his article "Acquire Prospect Capital Cheaply By Writing Puts". Even though I had taken a course in stock options way back in 1997, my only experience in options trading was a couple of times in that same year. In those days, options trading was not meant for Main Street investors. I gave up after getting a taste of options buying and selling. It was Richard's article that got me interested again, but I had to refresh my memory of options basics and strategies.

You probably already know that options can be used for hedging, but if not used properly, options can be very risky because of their multiplying effects. I can't remember if the options course had taught me this, but I came up with the idea of using cash to cover writing naked put options, which effectively turns the trade into a pseudo-fixed-income deposit.

In the following paragraphs, I will illustrate how I evaluate and intitate a put option contract to generate income. I will use the Apollo Investment Corporation (NASDAQ:AINV) as example, partially due to my knowing that Richard would be writing a new article on AINV. However, I had actually written the put contract on AINV before he mentioned his intention. How I came to a conclusion similar to Richard's could be the subject of another article; before then, please feel free to be skeptical of my claim. The reader is highly recommended to read Richard's article as a review, for understanding or refreshing his analysis of a trade's outcome scenarios.

Dissection of a Put Option Transaction

Apollo Investment Corporation is a closed-end, externally managed, non-diversified management investment company that has elected to be treated as a business development company ("BDC"). AINV hosted a conference call on 19th May morning to discuss Q4 16 earnings results, and on that day the stock dove to close at $5.35, 5.8% below the previous day's price. In the four weeks that followed, the price bottomed at $5.15, and has now drifted back to $5.44 today. I use this little piece of information as introduction to my analysis. For the fundamental analysis which is perhaps even more important, I highly encourage you to read Richard's new article "Apollo Investment And Its 14.4% Yield".

Click to enlarge

Let us consider writing a put contract for the Sep 16 $5.00 option, which, at the time of writing, is trading at midpoint price of 15 cents (10 cents on bid and 20 cents on ask). We will assume that 15 cents is a fair price at the time.

  • Underlying Symbol: AINV
  • Trade Date: 6/20/2016
  • Underlying Share Price: $5.44
  • Expiration Date: 9/16/2016
  • Days to Expiration: Expiration Date - Trade Date +1 = 89
  • Strike Price: $5.00

If we sell a $5 put for 15 cents we are putting $4.85 of capital at risk. We are giving the put buyer the option to sell us AINV for $5 until the put expires on 9/16/2016.

  • Option Premium Price: $0.15 per option unit
  • Capital at Risk: Strike Price - Option Premium = $4.85 per option unit

At least for me, options trading incurs a higher brokerage overhead than trading common and preferred shares and bonds, therefore I am going to factor it in to reflect my real life situation. The amount of overhead differs from one broker to another, so you can make adjustment to suit your case, or assume it to be zero if you want to simplify your calculation. Brokerage is dependent on the number of option units traded, so I will set the size of trade in the example.

  • Size of Trade: 20 units
  • Underlying Shares: Size of Trade * 100 / unit = 2,000
  • Option Premium Amount: Option Premium Price * Underlying Shares = $300
  • Brokerage Fee: $8.95 + Size of Trade * $0.50 + Estimated Exchange Fee = $8.95 + 20 * $0.50 + $0.47 = $19.42
  • Brokerage Ratio: Brokerage Fee / Option Premium Amount = 6.5%
  • Net Premium Received: Option Premium Amount - Brokerage Fee = $280.58

If AINV share price drops to or below $5.00 and buyer puts the shares, then:

  • Amount Payable at Strike: Strike Price * Underlying Shares = $10,000
  • Net Amount Payable at Strike: Amount Payable at Strike - Net premium Received = $9,719.42
  • Premium Interest Rate: Net Premium Received / Net Amount Payable at Strike = 2.89%

Annual Interest Rate: Premium Interest Rate * 365 / Days to Expiration = 11.8%

I said that 15 cents was a fair market price for the put option premium. This entails that both the buyer and seller had negotiated the price such that the option game would become a draw should the stock price close at the strike price ($5.00) on expiration date (9/16/2016); in other words, the strike price less the prepaid premium would be the break even price. However, since options trading involves brokerage fees, the actual break even price for the seller needs to be adjusted upward. This is calculated on a per share basis.

Break Even Price: Strike Price - Option Premium Price + Brokerage Fee / Underlying Shares = $4.86

Another way to look at it is, if AINV closed at $5.00 on expiration date, then the seller would be making a profit of 14 cents per share, which is equal to the premium less the per share brokerage fee. And if AINV closed at $4.86, then the option seller would be buying the AINV shares at no gain or loss. However, just as Richard indicated in his article, the seller would be acquiring AINV at a much lower price than buying it at the spot price of $5.44 today (20th June). We can measure the "advantage" of selling the option.

Discount to Spot Price: Spot Price - Break Even Price = $0.58

Discount Rate: Discount to Spot Price / Spot price = 10.7%

Some other metrics, notably the stock dividend rate and risk free rate, are omitted in the analysis. Dividends are payable quarterly, and the next dividend amount of AINV is $0.20 per share. This projects to $0.80, or 14.7% dividend rate per annum. The risk free interest rate is 3-month treasury bill rate, currently at 0.27%. I believe we should have these numbers at the back of our minds when evaluating a put option transaction, but need not bring the parameters into the formulas.

I have just given a step by step approach of analyzing a put option sell transaction. What is the relevance? Well, it is my hope that investors who are overwhelmed by the name "options" will get an appreciation of the implications of selling a put option. I used to be overwhelmed, but having thought through the process, and now that I have recounted by writing it down, I am much more comfortable, and hope you are too!

Risks

What are the risks involved in writing a put contract for AINV? To start off, the maximum loss of a short put transaction is the entire money at risk, assuming the company goes bankrupt and the share price plunges to zero, in which case the loss would be $9,719.42.

In reality, I think the risk for this transaction is quite low, as is indicated by the discounted price if the stock was eventually put. However, we cannot rule out the possibility of a market crash, which would be causing a loss to the investment, but we are at least protected by the discount cushion before losing money.

Moreover, Business Development Companies are quite safe by virtue of Investment Company Act of 1940, BDCs are required by law to maintain an asset coverage of at least 200% of debt. In other words, the debt to equity ratio must be less than 1. From the latest AINV quarterly earnings presentation, the debt-to-equity ratio is at 81%, which is a fairly safe level.

Conclusion

Notice I highlighted two terms above. The takeaway of this article is indeed these two terms:

Discount Rate - This is a proxy of the inverse of the risk level that an options seller is willing to take. The higher the Discount Rate, the lower the risk level.

Annual Interest Rate - This is a measure of the return rate the option seller is seeking by bearing the option put risk, normalized to annual basis.

Note that I have crafted the risk and reward in ratios, meaning that units of measurements are removed. This method may serve as the basis for my possible future articles. Ratios allow easier comparison across options, which could vary in the relative size of the prices of the underlying stocks, the depth of in-the-money or out-of-the money options, and the expiration periods.

By using the same method, I have calculated the metric values for Richard's PSEC sell put transaction to be: Discount Rate = 14.2%, Annual Interest Rate = 30.6%. Well, that is history. Should you consider selling put contract for AINV now? I would say that since AINV and PSEC are both similar businesses in the same market sector, the metrics are highly comparable, and judging from Richard's example, I think the current risk and award metrics for selling a Sep 16 AINV put option at market price is much poorer, therefore I would not be selling the Put option at this moment.

Lastly, I would like to emphasize that as an income investor, when I sell a put option, a cash amount equivalent to the capital at risk plus the net premium is set aside to prepare for the possibility of buying the underlying securities at the strike price.

Disclosure: I am/we are long AINV, and short AINV December 16 put options.

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.

I am not a investment advisor. I wrote this article based on my limited knowledge which could be incomplete or erroneous. The reader should do his/her due diligence in research before making investment decisions.

Note: The author is a member of the Panick Value Research Report. Members received an advance look at this article.

Disclosure: I am/we are long AINV, SHORT AINV DEC 16 PUT.

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.