Position Theta's  Instablog

Summary: Today I sold four True Religion Apparel, Inc. (Ticker Symbol: TRLG) July 2010 25 puts for a credit of $3,080.00, less commissions. Because the puts were sold "naked," my brokerage has reserved $4,602.40 of cash in my account. The net result of the transaction is a decline in my purchasing power of $1522.40.

Break-Even Point: Break-Even point on the transaction is around $17.3 per share, or about 5.5% downside protection from the stock's price at the time of sale.

Max Profit: Maximum profit is the credit of $3,080.00, less commissions, which will be achieved if the stock is at or above $25 per share at expiration.

Potential Downside: My maximum potential loss on the position is $6920.00, plus commissions, which will occur if the stock goes to $0.

Greeks: Given that these are deep in-the-money puts, the position's delta shows what is roughly a 1 to 1 ratio with the stock's price. Theta is moderately positive because of the roughly $1.00 in extrinsic value and will increase closer to expiration or with a rise in the stock (due to an increase in extrinsic value).

Rationale: Following a recent quarterly earnings miss, True Religion (a high-end jean manufacturer and retailer) has seen its stock price decline substantially to a six-month low, and is now trading at a very compelling multiple of trailing and forward earnings - about 9.6x and 8.6x respectively, less on an enterprise value basis (due to a net cash position of roughly $80M). The company has exhibited tremendous growth during its short existence, has built a great brand (albeit an expensive one) and has a loyal following which has largely continued purchasing the company's products during this long recession. While there is certainly an abundance of competition in the high-end denim market and the continued recession will no doubt dampen TRLG's earnings, I believe the company's current valuation offers a compelling risk-reward ratio over the coming years. To capture a significant amount of this upside, while providing a moderate amount of downside protection, I've sold the July 25 puts. In the event the stock continues to decline and the puts are eventually exercised, I will have purchased the stock at an even more compelling valuation (assuming no serious and permanent decline in the company's business). In the event the stock rises, I will look to exit the position after a significant decline in extrinsic value.

Summary: On Tuesday, I sold 10 March 2010 $10 puts on A-Power Energy Generations Systems, Ltd. (APWR), for a net credit of $1,700 less commissions. A-Power closed Tuesday afternoon at $11.39 per share. Because I have sold the puts "naked," cash collateral of $2,700 as of Tuesday's close was required (this collateral will increase or decrease depending on the underlying stock's price movement).

Rationale: A-Power's core business is building onsite power generations systems in China, but it also has a rapidly growing wind turbine design and manufacturing business. This year it has won several contracts to build turbines for various partners in China, entered into a joint venture to build turbines with General Electric, and this week announced its participation in a $1.5 billion wind farm project in west Texas. The stock is a true growth story - revenue was $152M in FY 2007, $264M in FY 2008, and analysts estimate revenue to be $324M in FY 2009 and $574M in FY 2010. Earnings have followed a similar upward path. Nevertheless, the stock trades at less than 9x projected forward earnings and less than 15x trailing earnings. The company's balance sheet is pristine with roughly $40M cash and no debt.

That being said, the stock is tremendously volatile and its future is tied to the continued demand for a rather speculative product in a developing market. By selling out of the money puts, I can target a much more conservative purchase price, in this case effectively $8.3 ($10 strike price less $1.70 in premiums), which is around 26.5% below its current price, and would be less than 10x trailing and 7x forward earnings. In the event the puts are not exercised and the puts expire worthless, I will have generated a real return of 20.4% on my reserved cash (less the option premium) over a five month period (IRR of roughly 65%). Note that because this stock is very volatile, the options hold the level of premium necessary to generate this sort of return. Because I'd be glad to purchase the stock at $8.3 per share and go long, I can use high volatility to my advantage as a value-driven investor. Note the difference between this approach and merely selling high vega to generate higher returns.

Disclosure: Long APWR

Summary: On 10/28, following a severe decline in the price of Rick's stock (RICK), I sold 10 December 2009 7.50 puts, for a net credit of $1,100. At the time, the puts were slightly in the money. Because these are "naked" puts, a brokerage will require cash collateral in the event of exercise, which as of 10/30 was $2,537.

Rationale: Rick's, the owner of several "adult nightclubs" (strip clubs) is a stock I follow and have long thought to be a good investment if purchased at an appropriate price. It trades at a low multiple of earnings (which as of 10/30 was roughly 7.5x predicted forward earnings) and generates strong free cash flow. Rick's is a consolidation story - it acquires clubs generally at low multiples of earnings (likely possible given the lack of buyers and general unsophistication within the industry), which are, in most cases, immediately accretive to earnings (there are exceptions - the company acquired the old Las Vegas Scores at a hefty price and which has since been a losing investment). In the event the puts are exercised, my effective purchase price would be $6.4 per share ($7.50 less the $1.10 premium). This price would value Rick's equity at less than 7x forward earnings, a multiple I believe more than prices in the past year's lackluster earnings and liquidity scare (which has since abated) and the current economic environment, and would present a favorable risk/reward scenario to go long the stock. After purchasing the stock, I will look to sell calls against my holdings so long as I can capture favorable premium at an appropriate price. If the puts are not exercised, and Rick's stock closes above $7.50 per share as of the December closing, the captured put premium would represent a roughly 17% real return on the cash required to purchase Rick stock, less the put premium, over a two month period, and obviously an even higher return on my actual reserved cash. Note that given the possibility of exercise, I do not find it appropriate to calculate return on this investment using merely a brokerage's margin requirements as the amount invested.

Disclosure: Long RICK