New Buy/Write Options Welcomed With Arms Wide Open

by: Dark Horse Traders' Hedge

Well I just heard the news today
It seems my life is going to change
I closed my eyes, begin to pray
Then tears of joy stream down my face

With arms wide open
Under the sunlight
Welcome to this place
I'll show you everything
With arms wide open

If I had just one wish
Only one demand
I hope he's not like me
I hope he understands
That he can take this life
And hold it by the hand
And he can greet the world
With arms wide open…


For those of you with a odd sense of humor (like me), check out Tim Hawkins' rendition.

All of the positions we discussed last Friday closed and/or rolled as expected. Agilent Technologies (A), Gannet Communications (GCI) and China Petroleum & Chemical Co. (SNP) have all moved on ("I hope (they) understand") while Radware (RDWR), Xyratex (XRTX), LDK Solar (LDK), and Jabil Circuits (JBL) rolled or added options as we continued to "hold (them) by the hand." I promised to recommend replacements to the portfolio, and so I am.

Please note my comment that Rockwood Holdings (ROC) was mistakenly commented on in my last article as a January option, but it actually expires on February 17, 2011. I still feel "rock" solid about the position, with ROC closing today at $9.86 and our buy/write strikes being at $40. Earnings will be released on February 21, 2012 which is after our expiration, so the option shouldn't be affected by any disappointing earnings news.

The closing of 2 covered calls (GCI and SNP) and 1 buy/write (Agilent) allows us to welcome 3 new positions "with arms wide open." "If I had just one wish, only one demand" (besides hoping the stocks aren't just like me) it is that the stocks we choose be GARP - Growth at a Reasonable Price/Value - stocks. As always, we hope to find stocks with expected high growth in earnings AND acquire exposure to them at a reasonable price. Once we identify the 3 stocks, we will utilize the Phil Davis Buy/Write Strategy "and hold it by the hand," adding income from options to gain exposure at a 15-20% discount to the current price. So without further ado, let's review the replacements "with arms wide open."

Western Refining Inc. (WNR) is my choice to replace SNP in the Dark Horse Traders' Hedge portfolio. The first point to notice on WNR is that analysts are expecting $2.77/share for 2012 and 20% growth in those earnings over the next 5 years. Secondly, we want to note that we can acquire exposure today at 5.92 times forward earnings. Thirdly, and possibly most importantly, we have a quality of earnings that is showing up in cash flow of $350M and a balance sheet with $4.51/share in cash.

My recommendation is to add exposure to WNR by purchasing ½ the amount of shares you are willing to own in the open market today at approximately $16.38. For example, let's use 100 shares. Sell 1 contract (equivalent to 100 shares) of the Mar $16 call WNR120317C00016000 at approximately $1.35 and 1 contract of the Mar $16 put WNR120317P00016000 at approximately $1.00. This is the same buy/write strategy we used so effectively with GCI and Agilent to earn time premium while holding a stock we believed to be undervalued when considering its cash flow and earnings growth.

Our net position after these 3 trades is that we own ½ position of WNR for $16.38 but have sold call and put premiums for $2.35 lowering our cost of the second ½ to $13.65 if WNR is below $16 on the third Friday in March. Don't forget that as in the past we always have the option to roll the option premium left just before expiration date to earn more time premium and delay owning the second ½ shares.

I want to recommend replacing Agilent Technologies with Seagate Technology (STK), the #1 ranked stock in the Sabrient Baker's Dozen 2012. This time we are getting long exposure to a company projected by analysts to grow earnings 30.15% over the next 5 years for a forward P/E of only 4.35. Free cash flow checks in positively at $376M and the balance sheet shows $6.91/share in CASH.

Once again, we will want to recommend acquiring ½ the number of shares desired for exposure in the open market, at approximately $20.79 today. Assuming 100 shares as an example, we would want to sell 1 call contract and 1 put contract (each representing 100 shares). The Mar $21 call STX120317C00021000 will yield approximately $0.86 and the Mar $21 put STX120317P00021000will net us an additional $1.29. As with WNR, above, we are earning $2.14 in premium while being exposed to purchase the second ½ shares of STX at $21 if the stock is below the strike on March 16, 2012.

Lastly (on the long exposure), I would like to recommend exposure to Ocwen Financial Corp (OCN), which through its subsidiaries, is a provider of residential and commercial mortgage loan servicing, special servicing, and asset management services. In September 2010, OCN acquired the U.S. non-prime mortgage servicing business of Barclays Bank PLC. In September 2011, it acquired Litton Loan Servicing from Goldman Sachs Group, Inc.

From my perspective, there will be sub-prime mortgages to service for years into the foreseeable future. Analysts apparently agree with me on this point. OCN has also performed quite well in a punishing year for most financial stocks, with shares rising 49% in 2011. OCN is expected to grow earnings by 200% this year and 40% per year over the next five years, and yet it sports a projected P/E of less than 8.0. Sabrient gives OCN an overall Outlook score of 91 and a Value score of 78, and the company carries over $400 million in cash on its balance sheet and earns $4/share in cash flow.

I am only recommending the covered call option for OCN, as the put option market is trading very thinly. We can acquire OCN for $13.89 and sell the Apr $15 call OCN120421C00015000 between the bid of $0.30 and ask of $0.55. My recommendation is to get the stock purchased and put an order in at $0.45 or higher on the call, and only sell if the market maker accepts your price. There is no rush to cover OCN as the stock is a good value at $13.89 and we won't mind just holding the stock for a while.

One final idea I would like to leave you with is to short Rockwell Collins (COL) based on earnings quality concerns. The company recently reported a mild earnings beat, but upon closer analysis it would appear that this was accomplished through tactics that diminish the sustainability or quality of those earnings. Without going into great detail I would point out that some the of EPS were the result of pension income and reversals of prior period warranty reserves, which could be a sign of deteriorating quality earnings of the company going forward.

In summary, I welcome long exposure to WNR, STX and OCN "with arms wide open" and, using our options strategies mentioned above, will enter at a discount to the current price. I also think it is a good idea to add short exposure to COL.


Buy to open WNR at the market

Sell to open WNR Mar $16 call at the market

Sell to open WNR Mar $16 put at the market

Buy to open STX at the market

Sell to open STX Mar $21 call at the market

Sell to open STX Mar $21 put at the market

Buy to open OCN at the market

Sell to open Apr $15 call at or above $.45

Sell to open (Short position) COL at the market

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.