Writing Cash-Secured Puts On The Market's Best Values

Includes: MS, NTRI, OVTI
by: Vince Martin

Back in August, amidst the first bout of market volatility caused by the S&P downgrade, the European debt crisis, and American political infighting (among many other causes), I wrote a series of articles detailing the use of cash-secured puts as a hedged bull play amidst a market correction and the corresponding rise in volatility. (See here, here, and here.)

When writing a cash-secured put (an equivalent trade to the more well-known covered call), an investor will write a put option on a stock, then "secure" the option with the cash necessary to cover the option should the stock drop to zero. In other words, if we write a November 10 put on XYZ stock -- giving the buyer the right to sell that stock to us for $10 -- for $100, we will add $900 to our account to secure the option. Should the stock stay above $10, we keep our $100 profit. At $9, our profit disappears, and we own the stock -- which traded at $12 or $13 upon writing the option -- at a net cost of $9 per share.

Like a covered call, the cash-secured put acts as a hedged bull play, trading potential upside for protection against a drop in the stock price. The effectiveness of the play can be seen in one of the stocks I covered back in August: Sirius XM (NASDAQ:SIRI).

At the time of the article, SIRI traded at $1.89; it has since dropped 10.6% to Tuesday's close of $1.69. Yet, cash-secured puts would have limited those losses, as shown by looking at the two conservative strategies I recommended:

1. December 1.5 put, sold for 11 cents. Despite the stock's struggles, this trade still requires no cash, and an investor still has over 17% of downside protection before expiration. An investor now bearish on SIRI could close the trade out for today's ask of 13 cents, a loss of 1.4%, compared to the 10.6% suffered by outright owners. (Please note -- losses are calculated on the net capital risked -- in this case, $139 per option -- since gains are likewise calculated on that cost basis. I am also ignoring commissions, which may be an issue in some accounts, though option trades are often only slightly more expensive that a simple purchase.)

2. January 13 LEAP 1 put, sold for 11 cents. Again, this trade continues to have substantial downside protection -- over 47% from Monday's close, despite the stock's downward drift over the past six weeks. This trade could be closed at 14 cents, for a 3.3% loss compared to the 10.6% loss for SIRI longs.

These examples show the protection that cash-secured puts can provide. The recent spike in the VIX has only aided this strategy, as increased put premiums offer more protection -- and higher returns. As such, I wanted to revisit the idea with option plays on some of my favorite values in the current market.

1. NutriSystem Inc. (NASDAQ:NTRI)
Closing Price 9/27: $11.85

NTRI doesn't stand out at first glance, with one exception: its 5.9% dividend yield. The forward P/E (based on the midpoint of the company's 2011 guidance of 65 to 70 cents) is 17.6, net cash is about $1/share, and revenues -- and earnings -- have been dropping over the past few years.

Add in worries about consumer spending (the company's cheapest plans cost over $250 a month), higher food costs, and competition from not only Weight Watchers (NYSE:WTW) but newer entrants eDiets (OTC:DIET) and Medifast (NYSE:MED), and it's hard to see a compelling reason to invest in NutriSystem. Until you look at the cash flow statement.

Last year, the company generated $47 million in free cash, over 15% of the company's $300 million enterprise value. The company added another $34 million in the first six months, and earnings per share are guided to increase 50% in the second half, which should compensate for possible needed adjustments to working capital.

To its credit, NutriSystem management is putting that cash to work for shareholders. The company announced a $150 million share repurchase program -- some 45% of current market capitalization -- in conjunction with second quarter earnings, which the company expects to be funded from cash flow over the next two years. The share repo program should also gives investors faith in the dividend payout, since the dividend will no doubt take precedence should cash flow fall short of operations, and payouts will be smaller on a total basis as share count is reduced. And though put sellers do not receive dividend payments directly (as a covered call seller would), it's important to remember that a high dividend increases put premiums, as the strike price remains static even when the company goes ex-dividend. (For reference, this applies only to scheduled, announced dividend payments such as NTRI's 17.5 cent quarterly payout; special dividends will cause an adjustment in the strike price.)

Let's look at a few option plays that might be of interest:

Short-Term: Sell December 11 at bid of 90 cents; return is 8.9%, or 40% annualized. Break-even is $10.10, a 14.8% drop from Tuesday's close.

Long-Term Moderate: Sell January 13 LEAP 10 put for $1.85 (use a limit order, as the bid/ask spread is 50 cents); return is 22.7%, or 17.2% annualized. Break-even is $8.15, a 31% drop from Tuesday's close.

Long-Term Conservative: Sell January 13 LEAP 8 put for $1.05; return is 15.1%, or 11.4% annualized. Break-even is $6.95, a 41% drop from Tuesday's close.

2. OmniVision Technologies (NASDAQ:OVTI)
Closing Price 9/27: $16.28

The camera sensor maker has had a rough 2011, capped off a by a 30% plunge after fiscal first quarter earnings, as weak forward guidance led to fears that the company had lost its position as a supplier to Apple (NASDAQ:AAPL)'s iPhone.

The fears have led to a collapse in the stock price that is completely and ridiculously overblown. Backing out the company's $9.57 per share in net cash and investments, OVTI trades at an enterprise value-to-earnings ratio of just 2.7. Using cash-secured puts, we can create assignment prices near the company's tangible book value of $12.50 and even the cash balance of $9.57.

Short-Term: Investors interested in going long the stock should consider strongly simply selling an October 16 put. Bid at $1.10, this trade returns 7.4% in just 27 days, a 100% annualized return. Break-even of 14.90 requires an 8.5% drop in an already depressed share price.

Mid-Term Aggressive: Sell the January 16 put, bid at $2.55; return is 19%, or 59% annualized. Break-even is $13.45, requiring a 17.3% drop from Tuesday's close, and just above the company's tangible book value of $13.45.

Mid-Term Conservative: Sell the January 12.5 put, bid at $1.10; return is 9.6%, or 30% annualized. Break-even is $11.40, requiring a 30% drop in less than 17 weeks. Note that the break-even is not far above the company's cash and investment balance of $9.57, and that a loss here would require a drop in enterprise value of 73 percent.

Long-Term Aggressive: Sell the January 13 LEAP 15 put, bid at $4.10. Return is 37.6%, or 28.5% annualized. Break-even is $10.90, requiring a drop in the stock price of 33%. Again, net assignment price is not far above the company's current cash balance.

Long-Term Conservative: Sell the January 13 LEAP 10 put, bid at $1.75. Return is 21.2%, or 16% on an annualized basis. Break-even is $8.25, well below the company's current cash and investment balance, requiring a nearly 50% drop in the stock price. Such a precipitous fall would seem to require either outright fraud by the company or a massive collapse in the business model, given the company's current balance sheet, and present and future earnings.

3. Morgan Stanley (NYSE:MS)
Closing Price: $14.97

I recommended buying MS stock a little over a week ago, upon which the stock promptly fell 22% (as one helpful commenter was happy to point out). The stock has rebounded, now down only about 9% since my ill-timed article, but I believe the long-term story as outlined there still holds. Simply put, the market seems to be assigning a substantial possibility of outright collapse to Morgan Stanley stock. Given the company's relatively limited net exposure to European debt, and the enshrinement of "too big to fail" in Dodd-Frank (no matter what the regulators and politicians tell you), this seems unlikely. And, if Morgan Stanley does survive the current crisis/recession/end of capitalism intact, the stock seems almost certain to rise, despite regulatory risk and the possible demise of its proprietary trading desk. The company's book value of $30.95 is more than double its stock price, meaning investors are already assigning crisis-level valuations to the company's assets. (Competitiors Goldman Sachs (NYSE:GS) and JP Morgan Chase (NYSE:JPM) are also trading below book, though at higher percentages than the depressed level of Morgan Stanley.)

There is no doubt that MS is a risky stock; the 50% drop since February and the whipsaw volatility over the past six weeks are ample proof. We can cushion the risk with options hedging strategies; here are a few examples:

Short-Term Conservative: Sell October 10 put, bid at 20 cents. Return is 2.0%, a 27.5% annualized return. Break-even is $9.80, requiring a 34% drop in 24 days. (If the stock breaks those levels, rest assured that this trade will be the least of your worries.)

Short-Term Aggressive: Sell November 15 put, bid at $1.74. Return is 13.2%, or 88% annualized. (We do need a 3 cent gain in the underlying stock price for that maximum return.) Break-even is $13.26, an 11.4% fall.

Mid-Term Conservative: Sell April 10 put, bid at $1.12. Return is 12.6%, or 22% annualized. Break-even is $8.88, 40% below Tuesday's close.

Mid-Term Aggressive: Sell April 15 put, bid at $2.97. Return is 24.7%, or 43% annualized. (Again, we require a small, 0.2% gain for maximum return.) Break-even is $12.03, a nearly 20% drop.

Long-Term: Sell January 13 LEAP 13 put, bid at $3.00. Return is 30%, or 22.8% annualized. Break-even is $10.00, a 33% fall.

To conclude, please remember that as good as these numbers look, cash-secured puts are not a foolproof strategy. We are trading potential upside for downside protection. If you are strongly bullish on the broad market, or financial stocks in the case of Morgan Stanley, an outright purchase of the underlying stock or more speculative call options is the way to go. However, with the uncertainty across the market (and Western economies), and the elevated option premiums provided by market volatility, using cash-secured puts is a choice that any investor in the market should consider right now.

Disclosure: I am long OVTI, NTRI.

Additional disclosure: I have initiated hedged bull option strategies on OVTI and NTRI, though I do not own the underlying stock of either compay. I do not have a position in MS, but may initiate a bullish option play in MS this week.

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