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MGM (NYSE:MGM) is one of the premier casino gaming companies. While geographically diversified, it still generates a significant fraction of its revenues from the Las Vegas strip. This article is not intended to provide a comprehensive review of valuing MGM as a business. Rather, I will summarize my thesis on MGM and present an options and equity strategy and subsequent outcomes analysis.

Since the 2008 crash, Las Vegas tourism volume has increased once again nearing peak levels. Gaming revenue continues to lag expectations, but revenue on the Vegas strip up 3.2% year over year (to date). Additionally, recent renovations to the MGM stable of luxury hotels is aimed at maintaining high average daily room rates at core properties. And, importantly, MGM appears to be taking business from smaller strip hotels. With MGM Grand, Aria at City Center, Bellagio, Mirage, NYNY, and others - MGM to Vegas tourists has a classic network effect. If you stay at Bellagio, you can room charge from any hotel. You can get cross comps from the hotels. You can use a players card at any of the hotels, gaining you additional free perks. This group effect encourages repeat visitors to MGM properties, and fosters customer loyalty.

MGM also continues in its attempt to stabilize and refinance debt; the low interest rate environment continues to help in this regard. As an added bonus, its Macau and Asian presence is expanding.

In short, the company is cheaply (or at least fairly) valued. I think the company is worth $14 to $16 per share. But, that is unimportant here! In order to execute this trade, you only need to believe that downside to the equity is limited to 7-10% from current levels.

Consider: every time in the past 2 years MGM has dropped to the $9 level or less it has bounced back quickly and strongly. The one sharp drop below $9, was to $7.50 on 10/4/2011, but the stock rebounded to $12 by 10/31/2011. That was less then a month later!

For calculation purposes, I'll assume that the total position we want to accumulate in MGM is 1000 shares. This makes the numbers easy. In reality, I consider 5% to 10% of my total account value a good total allocation parameter. This is a larger single stock allocation than some investors like, but as you can see from the trade, we have nearly 10% downside protection.

So, if 1000 shares is our maximum position, we will start the trade by purchasing 500 shares, since we are going to sell 5 puts as well which places us at risk to be assigned an additional 500 shares.

Proposed Trade (prices as of 9/11/2012 midday):

  • BUY 500 shares @ $10.78 ($5390)
  • SELL 5 Jan 2013 $11 CALLS @ 0.95, Net $475 (credited into your account)
  • SELL 5 Jan 2013 $10 PUTS @ 0.71, Net $350 (credited into your account). Note that depending on your broker you must have some cash or margin in your account to "secure" these puts.

Your net outlay for the trade is thus $5390 - $475 - $350 = $4565

Potential outcomes in January:

MGM Below $10: In this setting, the CALL will expire worthless, while the PUT will be exercised assigning you an additional 500 shares, for a total of 1000 shares. We paid $4565 for the first 500 shares, and $5000 for the second 500 (based on the put sale at $10 strike (10 x 500). So, your total outlay of cash is $9565 (4565+5000), for an adjusted basis of $9.565 per share. In this situation, we would re-evaluate what we thought of the stock in January. Assuming nothing had meaningfully changed in the business model or 1-2 year outlook, we would simply sell 10 upside call contracts to cover our 1000 shares (probably at the March 2013 $10 Strike). In this way, we could drop our cost basis again (from 9.565 to probably near $9). Doesn't sound like a get rich quick scheme? Well, if called away in March 2013, we would still be up over 10% in 7 months, which is more than 15% annualized. We would not sell the put again, unless we were willing to risk doubling the position again (you could plan for this by starting out with a quarter total allocation).

MGM between $10 and $11: In this setting, both the CALL and the PUT expire worthless. So, our cost basis for the shares of MGM is 4565/500, which is 9.13. So, our minimum gain is 9.5% (at $10), and the maximum gain in this bracket is 20.4% (at $11). Also, we keep the shares! This allows you to hold on and resell a LEAP option against them (at the $11 strike). You should be able to easily add 10% for the 2014 LEAP and you can hold the stock gain for a long term capital gains rather then sell it in the short term, gaining more favorable tax status.

MGM above $11: In this setting, the PUT expires worthless, while the CALL is exercised, and the shares are taken from you. You get $5500 for the 500 shares of MGM at $11. Since the net outlay was 4565, you gain 935, which is 20.4% in less than 5 months (more than 45% annualized return).

Look what we've done here: We identified a stock that had some key parameters (a decent volatility, leading to fat option prices as well as a perceived price floor is backed by long term fundamentals). Then, we structured a trade that nets us nearly 20% in 5 months if MGM barely moves (inching up from $10.78 to $11). That's what I consider a good risk reward play.

It's the kind of strategy even a casino could love.

Disclosure: I am long MGM. 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.

Source: Earn 20% In 5 Months With Little Risk