Goldman Options Trading Strategy

The below chart shows Goldman Sachs (GS) stock for the last six months. As you can see, the stock bottomed in March, and has had some volatility associated with it, as the entire financial sector has been quite active. Stochastic lines are turning positive, and we think the timing is right for a call spread on this name.

Our February 2008 recommendation came in two formats: the "low risk" call spread, which was an at-the-money spread for all intents and purposes, and a "higher-risk" spread, which was an out-of-the-money spread. Please bear in mind that the terms “low risk” and “high risk” are subjective and relative. The Low risk call spread was a long April $165 strike price call and sell the April $185 call, for a net cost of $10.00. At Friday's close of GS $179.93, the $165's would have had a value of nearly $15.00, and the $185's expired worthless, giving a profit of nearly 50% over the holding period to expiration.

February's "higher risk" play was a long April $180 calls, short the $200 strike price for a net cost of $5.40. Both of those options would have expired worthless, causing a loss of the entire investment, unless it was unwound prior to expiration.

Both of these trades were designed around the GS Group's first quarter earnings release that was expected in Mid-March. Quite a bit of concern existed around that time that Goldman would make huge, unexpected multi-billion dollar reserves for losses, much like Merrill Lynch and the rest of the investment banking / brokerage company complex did in early '08. While GS did make a minor level of reserves against mortgage-paper related losses ($ billion) they did not in fact have any negative surprises inside their latest numbers. Estimates for earnings were at $2.58 per share, and analysts were quite surprised with the actual results of $3.23 per share in EPS. While GS has a history of surprising to the upside, this 25% over-performance in the current market environment was quite a feat.

Future estimates look for GS's May 2008 quarter to improve to $3.82 per share (an average of 19 analyst estimates) on their way to a full November 2008-ending fiscal year EPS of $16.50 per share. Not too shabby, in our opinion. Next year's estimates (November 2009's) are already above $20 per share. We like this company's top and bottom-line growth curves and with any surprise to the upside, these numbers could be significant.

Balance sheet concerns appear to be managed very well at this company - of the entire fleet of I-Banks on Wall Street, GS is presently "The Teflon Company", if you will allow us a little poetic license. Throughout the entire financial meltdown on the street, nothing has stuck to them - nothing bad anyway. This bank, in our opinion, will be amazingly well-positioned when the time comes for investment banking to emerge on the other side of this recession.

Goldman's Fundamental Data:

• Shares Outstanding 394.2 Million
• Market Cap $71 Billion
• Forward Price / Earnings (avg. Est) 8.7x
• PEG Ratio (5 Year Expected) 0.9x
• Price / Book 1.8x

That's the history; Here's the new Springtime '08 GS Call Spreads:

Investment Recommendation: On the ”low risk” side, we recommend that investors purchase an May 2008 $175 call on GS and sell the May $195 strike price call. Current prices indicate that buying the $175 ($10.15 at present) and selling the $195 GS calls ($2.05 at present) would result in a net cost to investors of approximately $8.10, or $810 per spread. With GS presently trading at $179, this will give investors a break-even point of approximately $183.10 on the stock (calculated as the strike price of the lower priced calls ($175) plus the net cost of $8.10 for the spread).

Investors will have one month (until expiration on May 17th, 2008) to realize these levels if purchase of the spread occurs on Monday, April 21, 2008. We would look to exit this call spread at a price point of $18.00 or greater. This means that if you can sell the $175 call and buy back the $195 call in the near future for a total price of $18.00, or $1,800 per spread, we would exit the trade. This ‘trigger’ order can be entered with your broker. Return target: 120%.

On the “higher risk” side, we recommend that investors purchase a May 2008 $180 call on GS and sell the May $200 strike price call. Current prices indicate that buying the $180 ($7.40 at present) and selling the $200 GS calls ($1.25 at present) would result in a net cost to investors of approximately $6.15, or $615 per spread. With GS presently trading at $180, this will give investors a break-even point of approximately $186.15 on the stock ($180 plus the net cost of $6.15 for the spread).

Investors will have one month (until expiration on May 17th, 2008) to realize these levels if purchase of the spread occurs on Monday, April 21, 2008. We would also look to exit this call spread at a price point of $18.00 or greater. This means that if you can sell the $180 call and buy back the $200 call in the near future for a total price of $18.00, or $1,800 per spread, we would exit the trade. This ‘trigger’ order can be entered with your broker. Return target: 190%.

Disclosure: Analyst has no position in GS options.

Comments

[montag]

Why doesn't anyone who posts option spreads ever mention, Oh and by the way options are wasting assets and you have the potential to lose 100% of your investment. Ridiculous, low risk vs high risk...100% risk. Too funny

[Daniel Jones]

In my newsletter, from which this was excerpted, the comment that "Options investments have the potential to lose all of their value" and the usual disclaimers are present. Seeking Alpha edits the posting down to what they can use. Your comment is accurate. Options are wasting assets. The use of spreads, collars and writing options like buy/write strategies are some of the things investors can do to take advantage of that. It's why we use spreads vs. just going long calls or puts. Good trading to you.

Daniel Jones