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Mourad Zarouri
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Investment background: Private investor focused on income and biotech stocks. Over 30 years experience investing is stocks, options, and bonds. I design my own structured products to maximize income while limiting risks. Education: BS, MS in Engineering Awards: 10+patents in disk drives and... More
  • Is There A Safe But Potentially Rewarding Play With Annaly Capital And MREITs? 7 comments
    Jun 13, 2013 11:54 AM | about stocks: NLY, REM, AGNC

    Is there a safe but potentially rewarding play with Annaly Capital and mREITs?

    The short answer is yes. NLY and all mREITs have been hammered lately and multiple articles here on Seeking Alpha have documented the real and perceived problems with mREITs, so using mREITs and safe in the same sentence seems counter intuitive, but hear me out. NLY and other mREITs are designed for high yield (yields significantly above 10-year treasury notes and other benchmarks) and should be held for that purpose and not capital appreciation. However given the recent rundown in share value, buying the stock for capital appreciation could be rewarding.

    The Play

    I favor using a structured product approach and hedging the position with options. Essentially using the dividend money to buy puts and protect the principal. Table 1 below illustrates the trades using REM (mREIT ETF), NLY, and AGNC as examples, but of course other mREITs can be used.

    (click to enlarge)

    Table 1: Based on closing prices from 6/7/2013.

    To best explain the table let's go over the first row in order from left to right: Share purchase price, put purchase price, put strike price, call sale price, call strike price, # of dividends, dividend, max. loss in $ and % if shares are below put strike price at maturity, gain if there is no change in share price in $, %, and % annualized, gain in $,%, and % annualized if share prices increases ½ way to 52 week high.

    The last three columns in green show the potential returns if the stock price were to retrace ½ of its drop from the 52 week high. Using this approach, REM, NLY, AGNC could return significant gains with limited risk assuming the share price recovers some between now and Jan 18, 2014.

    WHY

    Last year NLY and other mREITs suffered an even bigger drop driven mainly by QE3 tightening the spread between long and short term rate (See figure 1).

    (click to enlarge)

    Figure 1 from Yahoo finance charts.

    The chatter around that time was that mREIT business model was not sustainable, everyone should sell their mREITs, etc. NLY in response lowered the dividend and adjusted its business model to address the tightening spread by acquiring CXS. The share price recovered to $16 or roughly half of the drop. The drop this time is due to the tapering of QE3 and the projected increase in interest rates decreasing the book value of mREITs. I expect the price per share to similarly recover as the interest rate picture becomes clearer and the spread between the short and long term interest increases with the tapering of QE3.

    I hold similarly structured positions in NLY and REM. I recommend selling the calls on any share price spikes to maximize return. I also might or might not hold the positions until maturity to maximize returns, and example would be selling the puts once the interest picture become clearer and the outlook for the mREIT sector improves

    Disclosure: I am long NLY, REM.

    Themes: mREIT Stocks: NLY, REM, AGNC
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Comments (7)
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  • ephort
    , contributor
    Comments (16) | Send Message
     
    Hi Zino, good to see a fellow option junky's recommended trades. I looked only at the AGNC numbers and here are my comments:

     

    1. I think you are talking about January 2014 options, right?

     

    2. You say "I recommend selling the calls on any share price spikes" but your table assumes selling the calls at 50 cents. It's not clear if this is a rough estimate of what you expect to get for the 31 call on a spike. 50 cents is roughly the bid on the 29 Jan 2014 call right now, and if you sold that your upside would be clipped at 29 (not that bad, but lower than at 31).

     

    3. Your calculations assume a stable dividend, right? Many people expect this, but when you present a "max loss" shouldn't you mention the possibility of a significant dividend cut? If you allow for a $.80 dividend, the numbers get less appealing.

     

    So I would say that this is a reasonable trade for a trader with bullish sentiment who wants to limit possible downside, but how good the trade is depends on how bullish you are. And the breakeven will be lower than you suggest if the dividend is cut.

     

    An AGNC trade I would suggest is staying out of the shares and just selling the January 2015 strike 32 put. That brings in almost $12 (right away) and your principal is protected for share price all the way down to 20. With $20 capital at risk, your maximum potential profit (for PPS>32) is 12, or 60% of capital at risk. Your breakeven is 20, and you collect the $12 up-front. And you don't care if the dividend is cut (as long as PPS stays above 20).
    18 Jun 2013, 02:46 AM Reply Like
  • ephort
    , contributor
    Comments (16) | Send Message
     
    Of course that 60% best-case profit (in the case of the short put) is for 18 months -- so 40% annualized.

     

    If PPS is at current levels in January 2015, profit is about $5.50, or 27% for the 18 months (18% annualized).
    18 Jun 2013, 03:00 AM Reply Like
  • ephort
    , contributor
    Comments (16) | Send Message
     
    Correction -- if PPS is at 25.50 in January 2015, profit is about $6.50, or 32% for the 18 months (22% annualized).

     

    Of course, with the short put maximum loss is $20 -- which still is better than being long the shares.
    18 Jun 2013, 03:05 AM Reply Like
  • Mourad Zarouri
    , contributor
    Comments (202) | Send Message
     
    Author’s reply » ephort...I don't know about junky, how about we say connoisseur, lol...

     

    1. yes Jan 2014
    2. The table shows the call premium that day. Not what you would get if there is a PPS increase
    3. Table assumes stable dividend equal to the last reported one. It goes without saying if there is a dividend cut the loss would be greater. However if there is an increase the loss would be less. In this environment with long term rate increasing, I suspect we are more likely to see a dividend increase than decrease

     

    Agree, the trade only works if you are bullish and expect the shares to recover some over the next 7 months.
    18 Jun 2013, 11:38 AM Reply Like
  • ephort
    , contributor
    Comments (16) | Send Message
     
    OK -- I just thought it would be a good idea to maket the assumptions (constant dividend) explicit.

     

    As for the Jan 2014 31 call, it seems strange that the bid on it would drop from .50 to .24 in just 5 days while the PPS dropped just about .26. The 29 strike seems closer to that 50 cents in the table. Not a big deal though, it doesn't change the big picture much.
    18 Jun 2013, 01:27 PM Reply Like
  • Mourad Zarouri
    , contributor
    Comments (202) | Send Message
     
    Author’s reply » That does seem like a huge drop. For my sanity I went back and looked at the call prices for May 31st.. The price that I quoted might've been for the 30's not the 31... I didn't look at all exchanges so could've been higher in others... Looked at a lot of numbers that day....

     

    May 31, 2013Open 0.40High 0.40Low 0.35Close 0.35
    AGNC JAN-14 31.00 CALL (AGNC Jan 18 '14 $31 Call)

     

    May 31, 2013Open 0.55High 0.55Low 0.51Close 0.51
    AGNC JAN-14 30.00 CALL (AGNC Jan 18 '14 $30 Call)
    18 Jun 2013, 02:04 PM Reply Like
  • Mourad Zarouri
    , contributor
    Comments (202) | Send Message
     
    Author’s reply » Also, thanks for all the feedback ephort.
    18 Jun 2013, 02:05 PM Reply Like
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