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The entire mortgage REIT sector sold off recently, even strong names such as American Agency Capital (NASDAQ:AGNC), Annaly Capital Management (NYSE:NLY), MFA financial Inc (NYSE:MFA), etc. were not immune to this sell-off. In fact, out of the above three, surprisingly MFA financial held up the best. From its high to its low in October, it shed only 9.2%. Annaly Capital management and American Capital Agency, both of which topped out in September, shed 13.2% and 19.3% respectively. One of the main reasons attributed to this decline is the fact that most investors feel that the lower long-term interest rates will lead to tighter interest spreads, which could hurt earnings. Mortgage REITs make money by borrowing money at low short-term interest rates and then using this borrowed money to purchase higher-yielding mortgages or mortgage-backed securities. The spread is where they generate their income and the tighter the spread the less they earn and vice versa.

While the above relationship is true, we feel that the current sell-off probably represents a short-term buying opportunity. Historically, every strong pullback has proven to be a buying opportunity. In the last two years American Capital agency has experienced four rather strong corrections and on each occasion, the stock recovered and trended higher (illustrated in the chart below). The company also recently announced a $500 million buyback program, which it plans to complete by 2014. As shares will only be purchased when they are trading below book value, this should help provide a floor for prices in the short term. Management also appears confident that it will be able to deal with prepayments as a result of QE3. However, there is always the possibility that things might not work out as planned, and this is where the Bull put spread comes into play. With a Bull put spread you simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. The long put serves as a hedge in the event things do not work out as planned. The great benefit of this strategy is that your risk is defined from the onset and there is no guess work in terms of how much you might potentially lose if the trade does not work out. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price.

Benefits of a Bull Put Spread

  1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
  2. The ability to profit even if the stock barely budges in price.
  3. The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put on Annaly Capital Management with a strike at 16, and the stock dropped to Zero, your loss would be $1600 minus the premium you received. Now if you purchased a put with strike at $13.00, your maximum loss would be $300 minus the net premium you received. The difference is rather significant.
  4. The capital requirements are considerably less. With cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $16, you would need to have $1600 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $300. This is significantly less than the $1600 you would have to put up if you sold cash secured put a strike at 16. This strategy should not be abused just because the capital requirements are significantly less. This is a conservative strategy, and by abusing it, you will have converted into a speculative strategy.
  5. In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

Technical outlook

The first thing you will notice is that the stock has always recovered after a strong sell-off in the past two years (illustrated by the blue circles above). In fact, if you go back even further in time you will notice a very similar pattern. The stock has already recovered significantly after selling off on the 15th October. It is currently trading $33 after dropping as low as $29.63 on the 15th of October.

The stock has a strong level of support in the $31.50-$32.00 ranges. This was clearly demonstrated on the 15th when the stock closed at $32.00 well off its lows of $29.63. As the stock and the general markets are in a volatile phase, there is a good chance that the stock could test the $31.50-$32.00 ranges again. We would wait at least until the stock trades down to $32 before putting this strategy into play. As management has stated it plans to purchase the stock when it's trading below book, it would be fair to assume that it would probably step in every time the stock dipped down to the $31.00-$32.00 range. A weekly close above $34.50 will be a bullish development and should result in a test of the highs.

Charts and data of Interest

The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. Based on this relationship, the stock is currently undervalued. Fastgraphs has an estimated earnings growth rate of 2.0% for American Capital Management.

When stocks are trending above the EPS consensus line, they tend to perform better and vice versa. In this case, the stock is trending well above the EPS line and would need to drop below $18.00 for this relationship to take a turn for the worse. Based on this historical relationship the stock should continue to trend upward.

EPS is projected to increase from $3.97 in 2012, to $4.22 in 2013, which would represent a year-over-year gain of 6.3%. This is a decent development as it indicates that EPS would resume its upward trend after possibly pausing in 2012. If the projected EPS for 2012 comes in below $4.93 and there is every reason to believe it will, then the EPS would have pulled back for the first time in three years.

Bull Put Spread

The March 2013, 32 puts are trading in the $1.73-$1.86 ranges. If the stock pulls back to the $31.50-$32.00 ranges, these puts should trade in the $2.30-$2.50 ranges. We will assume that the puts can be sold at $2.30 or better.

The March 2013, 27 puts are trading in the $0.39-$0.44 ranges. If the stock pulls back to the stated ranges the put should trade in the $0.60-$0.75 ranges. We will assume that this put can be purchased at $0.75 or better.

Transaction Details

  1. After the sale and purchase of the respective puts you will have a net credit of $155.00.
  2. Your maximum risk is $345 (the spread of $500 is subtracted from the credit of $155).
  3. Your maximum profit is $155 per spread for a possible return of almost 44.9%.
  4. Your breakeven point is $30.45

Risks associated with this strategy

The main risk is that you over leverage yourself because the capital requirements are so small. There is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. Thus, the biggest risk is that an investor might abuse this strategy. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.

The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Thus, it would be wise to close the short option out or roll the option before your position hits the maximum loss point. You roll the option by buying back the put you sold and selling a new out of the money put.

Suggestion for those looking to boost their returns

You could use the spread, which in this case is $155 to purchase out of the money call options. The benefit of this strategy is that it would provide you with the chance to leverage your position even more without taking on too much extra risk. If the stock should take off, you could lock in strong gains via the calls. The disadvantage is that if the stock does not take off, and remains range bound you could end up sacrificing any gains you would have made with spread instead of adding a call to the position.

Conclusion

American Capital has a tendency to rally after a strong pullback. In the past two years, this has taken place three times (not counting the current recovery) and on each occasion, it went on to trade higher. It has already recovered quite a bit after selling off on October 15, and is trading well of its lows of $29.63. As the markets are in volatile phase, we would wait for the stock to pull back to the stated ranges before putting the suggested strategy into play.

Do not abuse this strategy as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put does not prevent this from taking place. If the stock is trading close to your breakeven point, consider rolling the short put. To do this you would simply buy back the put you sold and a sell a new out of the money put. Once your position is showing a decent profit, consider banking some of the gains. You do not necessarily have to wait to squeeze the maximum profit potential of 44.9% from each spread.

Options tables sourced from yahoofinance.com. EPS Consensus estimates and EPS charts sourced from zacks.com


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

Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware

Source: A Low-Risk, High-Reward Way To Play American Capital Agency Now That It Has Broken Down