Chimera Revisited: Selling Puts

| About: Chimera Investment (CIM)
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In our first article about Chimera Investment Corp. (NYSE:CIM) back in March we structured a trade that permitted us to own a high yield REIT while protecting it with a near-the-money (NTM) put option, not due to expire until mid-September. The reasons we did the trade this way are set forth in our March 8 CIM article. Of course, at the time we had no way to know whether the share price of CIM would actually sell off; but now that it has, we are gratified to have had the protection afforded by the options. Now it is time to prepare to sell them.

While the option has not completely protected the position, it is better than watching the unprotected stock price plummet 30% in six months (which is what it has done). Dividends are fine, but when the stock doesn't hold its principal value, the “income” can be a hollow incentive.

As it is, we are only down about 12% net of the cost; and the option cost is something that we may be able to recover through the various trade adjustments that options permit. Meanwhile, we have also collected two dividend payments and are about to collect a third. With two dividend payments, we experience about a 7% loss in the trade, including transaction costs.

Nevertheless, with the option expiring September 17, 2011 we thought it would be a good idea to consider some possible follow-up strategies to take advantage of present circumstances. Recently, we have read and heard suggestions that perhaps it may be a good idea going forward to protect positions in high yielding stocks with put option purchases. That may or may not be advisable, depending upon a key element of option pricing that fluctuates over time. We're talking about option implied volatility (IV).

We have traded options long enough to know that generally, when option IV is low it is preferable to be a buyer of options. Those options with relatively low IV levels are considered “cheap”. On the other hand, options with high IV are “expensive”; and when options have relatively high IV it is better to sell them. So we buy “cheap” and sell “expensive”... makes sense to us.

How can you tell when option IV is relatively low or high? The information is available for free here. Also, any broker's basic option trading platform should have it. Of course, you can invest in proprietary option trading software that furnishes this information. Just keep in mind that the cost effectively adds to the transaction costs of your trading.

There are some other things that can give you a feel for whether option IV is low or high. One is the VIX, sometimes called the “fear index”. VIX is the CBOE SPX Volatility Index, a weighted blend of prices for a range of options on the S&P 500 index.

Generally, we find that when VIX is below 20.00 it is a good time to buy stock options. (Back in March when we bought CIM puts, VIX was at about 20.00.) When VIX is above 40.00 it is a good time to sell stock options. Of course, different traders have different ways of using VIX; and there are certainly differences in risk tolerance among traders. However, these guidelines are helpful to us.

There is also no substitute for having a feel for fear in the marketplace, as measured by investor sentiment, for which there are a number of studies. The media is also a good barometer for fear. When fear is rampant, that is a time to buy stock; but it is a time to sell options.

Presently, option IV levels for CIM (and most of the stocks in this sector) are relatively high, not a good environment for put option purchases. So what can we do?

  1. Stand aside. In the words of Luke Jackson, "sometimes nothing can be a real cool hand". Sell the put options on or before September 16th and at the same time sell the stock. The small percentage loss is very manageable; and we live to fight another day. No need to worry about the financial strength of the company or its management, a possible rise in interest rates, or various political or regulatory moves being considered by government that may further undermine the market value of the stock.

  2. Buy another put. In an environment of “expensive” options, where fear and uncertainty is elevated in the mortgage REIT sector, we do not favor straight put purchases at this time. That may change, but for right now we would not be option buyers.

  3. Sell October 3.00 puts for .30 or better. If this is the bottom for CIM stock, protection is no longer needed. This accomplishes two objectives, albeit with additional risk. First, taking in inflated put premium can help recover the cost of the put protection previously purchased in March. Second, selling puts here is also a way to further average down the price per share of your stock. In the event the October 3.00 puts are assigned, you will own additional CIM stock at 3.00 a share, effectively buying more stock by selling the options.

Timing put sales can be tricky in this situation. For one thing, the next dividend announcement will likely not be made before September options expire. Meanwhile, the time value of October options continues to dribble away. They expire October 22, 2011. If the stock continues to decline into the next week or two, the 3.00 October put will continue to increase in value to that extent.

Therefore, we suggest monitoring the situation day by day, as long as the September puts are sold by the 16th. An additional spike in option IV may imply some additional downward movement in the stock price. This only becomes a problem AFTER the September and October puts are sold because you will have locked in the profit on the Septembers and exposed yourself to additional risk on the Octobers.

Disclosure: I am long CIM.