Writing Uncovered Put Options On Reinsurance Stocks

| About: Aspen Insurance (AHL)

I recently wrote an introduction to investing in reinsurance companies. I mentioned in that article that I often acquire shares by writing uncovered put contracts. In this article, I will tell you how and why I use that approach, with examples at the end. I write puts on reinsurance stocks primarily to generate income, and secondarily to acquire shares of a targeted company at a desirable price. What I like about put writing is that you are a seller of a wasting asset; in other words, the option seller benefits from the passage of time, all other things being equal.

Theory behind the strategy

I like writing puts on reinsurance companies for several reasons:

1. Reinsurance companies have an ongoing random risk of loss due to catastrophes they insure, which in theory should lead to permanently higher implied volatilities.

2. The majority of companies in this space trade below book value. Writing an out of the money put contract on a company that is already trading below book value contains two built-in margins of safety.

3. Reinsurance equities themselves are basically a put option against catastrophe losses, and this makes writing puts against those stocks a second-order derivative. Because the underlying insurance contracts also have a time-decay quality to them, selling put options benefits from time decay in two ways.

4. Reinsurance companies are relatively uncorrelated to this rest of the market (less than 0.50 correlation co-efficient versus S&P500 for all companies I have analyzed), so this fits in well as a diversifier in a portfolio-approach to put writing.

Risks and alternative approaches

As outlined above, the theory of writing out-of-the-money puts on reinsurers trading below book value has a lot of theoretical appeal to me. There are some problems with this approach however. The options market is thin for these companies. While I can typically sell a contract by positioning one third of up from the bid, in the lower third of the bid/ask spread, that is typically limited to 5 contracts per trade. Larger positions would typically have to "hit the bid", which reduces returns. Another concern is often that the put options can have wide spreads due to illiquidity. (I happen to think the illiquidity further underscores how un-loved this sector tends to be).

Due to this problem of thinly traded reinsurer option markets, another strategy to explore would be a paired trade, such as going long companies trading below book value and shorting one or more equities trading above book value (or a company with unprofitable underwriting, or your other favorite metrics). Obviously I prefer writing puts when possible, because it generates income, and doesn't carry the risks of shorting a stock nor does it require paying out dividends on the short positions. I list it mainly as another strategy that might be more feasible for people trading in large size.

Managing the positions

There are three choices available once a position is initiated:

1. Buy back the option (buy to cover). I typically do this when the underlying has a rapid move upward early in the life of the put contract, resulting in a rapid gain of 50%. I often will close those out at a profit to free up capital. Otherwise, you tie up the margin for a lot more time just to get the other half of the gain - and of course it can still turn into a loss.

2. Let option expire worthless (out of the money). This is the sweet spot. This frees up margin capital and results in the maximum profit potential for the position.

3. Let option exercise (in the money) - this is the part of the strategy that can keep you awake at night; make no mistake, this is where the losses can and do happen. This is not a necessarily a bad outcome, since the positions were chosen by company valuation as being desirable investments. And I generally only sell out-of-the-money puts, which implies the stock would have fallen further - presumably making it a better valuation as long as the fundamentals of the company hadn't changed. I typically will turn around and sell covered calls on this new long stock position.

A real life example

As I write this during expiration week of December 2012, I have a large position in Aspen Insurance Holdings (NYSE:AHL) stock that is about to be assigned via covered call. A look back through the history of this position shows that I have acquired the stock in numerous batches of assigned uncovered puts the past 3 years, due to the inherent nature of periodic catastrophe-related dips. Typically I will write the put option one strike price down from the current stock price.

As the long stock position grew over the years, I have continually written covered calls that were one strike price out of the money, expiring every 6 months. Now the bill has come due, so to speak, because of a large ramp up in the price of AHL, which even Hurricane Sandy itself couldn't stop. (The stock did dip about 8% following the hurricane and recovered half of that, but even the peak drawdown from that storm didn't take this stock price back out of the money).

So, the total return I have earned in AHL has been: put option premium in numerous tranches over the past 3 years, a 2+% dividend yield in the growing stock price, covered call option premium the past 3 years, and a capital gain that now equates to about 15% of the current stock price. Because the buys were spread out over 3 years, it had the effect of being a form of dollar cost averaging, and I would also note that much of the capital was invested in other things much of these 3 years since I acquired the position gradually (for those that think the 15% long-term capital gain isn't impressive for a 3 year position). Had I simply bought the stock, two of these sources of gains (capital gains and dividend) would still have been present, but I estimate that I have added another total return of 15-20% to this via the put and call selling.

Remember, the key is to do this on a stock that you want to own anyway. Other reinsurance stocks that I have currently have similar strategies with include Alterra Capital (NASDAQ:ALTE), Validus Holdings (NYSE:VR), Endurance Specialty Holdings (NYSE:ENH), PartnerRe (NYSE:PRE), Everest Re (NYSE:RE), and Platinum Underwriter Holdings (NYSE:PTP). Thanks for reading, and good luck!

Disclosure: I am long AHL, ENH, RE, VR, PRE, PTP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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