It's More Than A Feeling To Go Long Aflac, July Options Review

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 |  Includes: OCN, RIO, WDC
by: Dark Horse Traders' Hedge

I woke up this morning and the sun was gone

Turned on some music to start my day

I lost myself in a familiar song

I closed my eyes and I slipped away

It's more than a feeling

More than a feeling

When I heard that old song that they used to play

So many people have come and gone

Their faces fade as the years go by

Yet I still recall as I wander on

As clear as the sun in the summer sky

It's more than a feeling

-- Boston

Aflac (NYSE:AFL) easily meets all my criteria for long exposure in Dark Horse Traders' Hedge. I prefer to look at levered free cash flow, and AFL's $3.69 billion has gotten my attention. Its operating cash flow of $12.2 billion keeps me wanting to look deeper. Out of the 20 analysts following the company, seven have upgraded 2012 estimates in the last 30 days and expect it to earn $6.56 for this year with a five-year growth rate of 11.13%. I then looked for the forward P/E, hoping to pay less than the 11% growth rate in earnings. AFL closed yesterday at a forward P/E of 6.33 based on the 2013 consensus estimate of $6.87.

"As clear as the sun in the summer sky," AFL has everything I hope to find. That leads me to recommending a long position, and with "more than a feeling" we want to add AFL to our portfolio. As you will see in the options review for positions closing on Friday, July 21, we will free up some cash to add to our positions and recommend buying half the shares you are willing to own at the market ($43.90 at the close Wednesday). The option premiums are attractive, and I recommend selling the November $45 call ($2.07) and put ($3.65) for a net price on our first 1/2 shares of $38.08. We obligate ourselves to sell the shares for $45 if AFL is above $45 on Nov. 16, 2012, or buy the other half shares we are willing to own at $45 if AFL is below $45 on Nov. 16, 2012. As you will see in the options review, and for any who have followed Dark Horse Traders' Hedge over the last two years (first published July 1, 2010), we will likely roll the options to a future strike and month if AFL trades close to $45 on expiration date.

Western Digital (NASDAQ:WDC) was added on March 19, 2012, at $38.41. On April 26, 2012, WDC had moved to a high of $44.44, and I felt good that WDC would reward us with both the July $40 call and July $40 put premiums for a tidy profit. With WDC closing at $33.40 on Wednesday, it appears that we will be able to earn the entire $2.85 sold on the July $40 call. That brings our cost basis on the half shares purchased for $38.41 down to $35.56. The July $40 puts obligate us to purchase the other half shares on Friday, July 12, for a net $35.86 ($40-$4.14 put premium).

While I was much happier when WDC traded at $44.44, I am still happy to have a full position worked into with a cost basis of $35.71, less than what it would have cost to purchase the full amount of shares for $38.41 on March 19, 2012, when we decided to take long exposure in WDC. All the items in my thesis in March still exist, and technically, I see a nice amount of upside from today's prices with the RSI 5 trading at 51.75 and moving north. I don't consider a stock overbought technically until the RSI 5 crosses 70 going south. Therefore, I recommend accepting additional shares from the put, earning the profit from the call and holding the full position for a few months to look for a higher selling price.

On April 16, 2012, we tried to better our current position in Rio Tinto (NYSE:RIO) by rolling options and avoiding putting more cash into the position. I still like the conditions in our original thesis from Feb. 14, 2012, when we rolled to the July $57.50 call and put for a combined premium of $8.30. Unfortunately, "I lost myself in a familiar song" as RIO closed Wednesday at $45.75. Obviously, the premium collected for selling a July $57.5 call is money in the bag. The $4.30 earned for selling the July $57.50 put is the one that "is a familiar song" for anyone who has spent 25-plus years in this business.

The sum of all parts reveals that, again, we have a much better cost basis than had we charged in, purchasing the full number of shares we were willing to own on Feb. 14, 2012. I am recommending earning the call premium and accepting delivery of the put shares. This will give us a full long position in RIO, a stock that I believe has the earnings power to trade back up into the low $60s in 2012, for a cost basis of $50.

Ocwen Financial (NYSE:OCN) performed as expected following our first recommendation to buy on Jan. 29, 2012, at $13.66, followed by April $15 and July $15 covered calls. The endgame on this position will come Friday when the stock is called away for $15, while it closed on Wednesday at $19.66. I can't complain about trades that return a profit of 20.4% in five months, but "I still recall as I wander on" how much happier I would be selling OCN for $19.66 on Friday. My recommendation is to allow OCN to be called away and be happy with the 20.4% profit.

Overall, I maintain my midterm feeling that the market has more upside than downside. The RSI 5 indicator that I like to use shows a market building strength, but just crossing the 50 mark. There is no doubt that it could reverse and head south rather than continue to trend north above the 70 line. Many of the "worst-case scenarios" are priced into the risk on trades, but to date they have resolved themselves much better. We have a good balance of long and short positions, and I will continue to look to add to the longs as we become more convinced of this three- to six-month trend upward. The mass volumes of data we review lead me to believe this is "more than a feeling."

Recommendations:

  • Buy AFL at the market, Thursday, July 20, 2012
  • Sell to open, AFL November $45 call (AFL121117C00045000) for approximately $2.07
  • Sell to open, AFL November $45 put (AFL121117p00045000) for approximately ($3.65)
  • Allow WDC July $40 call to expire
  • Allow WDC July $40 put to expire and take possession of second half shares
  • Allow RIO July $57.50 call to expire
  • Allow RIO July $57.50 put to expire and take possession of second half shares
  • Allow OCN call to expire and OCN shares to be called at $15

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.