Investors can take advantage of low current volatility in the stock market by purchasing deep out of the money put options on stocks to hedge their exposure to financial turmoil. Not to rain on the market's parade, but one must always be ready for a significant drop in stock prices, which does happen occasionally.
Deep out of the money put options have no intrinsic value and will expire worthless unless there is a dramatic price decline in a stock. Thus, they tend to be somewhat inexpensive but are unlikely to provide any return. Put buyers must carefully select stocks which score poorly according to tests of financial health since the vast majority of out-of-the-money puts expire worthless.
The following criteria were used to select the most cost-effective puts:
1) The stocks score as potentially distressed according to the Altman Z-Score.*
2) Insiders were net sellers over the past six months. This bearish sign is consistent with a lack of confidence.
3) The stocks have lower than average volatility. Essentially, the more volatile the stock is, the more likely the possibility of its price moving dramatically. Unfortunately, volatility is a major determinant in the pricing of options, so this metric alone wouldn't help identify bargain puts. In short, buying puts on higher volatility stocks would cost more.
4) Long-dated put options are sold for the stocks. Maturities between one and two years will allow for bad news to surface and be reflected in stock prices and volatility. All the stocks which met the criteria have markets for January 2014 puts.
Generating a List of Deep out of the Money Put Candidates
Here is a list of stocks which met the criteria:
Company | Ticker | Industry | Altman Z-score | Jan-14 Put Strike | Jan-14 Put Ask* | Max Put Payout |
Consolidated Edison | Electric Utilities | 0.88 | 30.00 | 0.25 | 120.0 | |
NextEra Energy | Electric Utilities | 1.04 | 35.00 | 0.45 | 77.8 | |
Verizon | Telecom Services | 1.17 | 20.00 | 0.28 | 71.4 | |
Duke Energy | Electric Utilities | 1.10 | 10.00 | 0.15 | 66.7 | |
General Electric | Diversified | 1.20 | 5.00 | 0.08 | 62.5 | |
American Electric Power | Electric Utilities | 0.93 | 23.00 | 0.40 | 57.5 | |
Comcast | CATV Systems | 1.32 | 15.00 | 0.32 | 46.9 | |
Energy Transfer Equity | Oil & Gas Pipelines | 0.70 | 25.00 | 0.55 | 45.5 | |
CenturyLink | Telecom Services | 0.94 | 20.00 | 0.45 | 44.4 | |
CBS | Broadcasting - TV | 0.39 | 13.00 | 0.30 | 43.3 | |
Time Warner | Entertainment | -0.45 | 18.00 | 0.44 | 40.9 | |
PPL | Electric Utilities | 1.08 | 20.00 | 0.60 | 33.3 | |
Ashland | Chemicals - Major Diversified | 1.52 | 25.00 | 0.80 | 31.3 | |
Virgin Media, | CATV Systems | 1.60 | 18.00 | 0.65 | 27.7 | |
Transocean Ltd. | Oil & Gas Drilling & Exploration | 0.50 | 20.00 | 0.77 | 26.0 | |
Alcoa | Aluminum | 1.40 | 5.00 | 0.20 | 25.0 | |
Owens Corning | General Building Materials | 1.67 | 13.00 | 0.55 | 23.6 | |
Chesapeake Energy | Independent Oil & Gas | 0.86 | 2.00 | 0.09 | 22.2 | |
Dunkin' Brands Group | Restaurants | 1.56 | 17.50 | 0.90 | 19.4 | |
Plains Exploration & Production | Independent Oil & Gas | 0.95 | 15.00 | 0.82 | 18.3 | |
Wyndham Worldwide | Lodging | 1.48 | 25.00 | 1.65 | 15.2 | |
HCA Holdings | Hospitals | 1.73 | 18.00 | 1.20 | 15.0 | |
Boston Scientific | Medical Appliances & Equipment | 1.35 | 4.00 | 0.29 | 13.8 | |
JetBlue Airways | Regional Airlines | 1.08 | 2.00 | 0.15 | 13.3 | |
Atlas Energy | Gas Utilities | 1.07 | 20.00 | 1.70 | 11.8 | |
Liberty Global | CATV Systems | 0.54 | 50.00 | 4.72 | 10.6 | |
Micron Technology | Semiconductor- Memory Chips | 1.77 | 3.00 | 0.33 | 9.1 | |
SandRidge Energy | Oil & Gas Drilling & Exploration | 0.59 | 5.00 | 0.70 | 7.1 |
*The last trade price of an option was used in place of the ask if it was greater than the ask. Substitutions like this were made to avoid stale prices and keep estimates for put costs conservative.
Buying a diversified mix of these January 2014 puts is an attractive way to hedge for your long portfolio. In particular, the puts at the top of this list have very high strike price-to-premium ratios, which afford the most notional value per dollar for put buyers. Stocks near the bottom of the list afford little downside protection per dollar spent on puts. Puts with strike-to-premium ratios over 50 are unusual and worth considering.
It is prudent to note that there is no way to tell the future, and that many of these firms are currently healthy and will remain so in the future. This is a list of put candidates based on a credit scoring model, and by no means is a divination or a guarantee about future events.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
