How To Earn 9.9% On Ford While Hedging Against A Potential Share Price Collapse

| About: Ford Motor (F)
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Despite massive fundamental improvements that have sent earnings soaring, Ford's shares have massively underperformed the market in the last five years.

And with the US auto market seemingly peaking now, a lot of Ford investors are worried what might happen if a recession hits, and sends US auto sales plummeting.

Bull Put Spreads are a good way to potentially earn solid income, or buying discounted shares BUT with a hedge against a potential collapse of the share price.

Learn about one particular spread that is a great mix of zero leverage, low risk and is currently paying a 9.9% annual yield.

BUT also don't forget about the one risk that no option strategy can entirely eliminate.

Ford (NYSE:F) has done a remarkable turnaround since the great recession, renegotiating UAW contracts, strengthening its balance sheet immensely, and rolling out a fleet of new models that have proven big winners with consumers.

F Revenue (<a href= F Revenue (NYSE:TTM) data by YCharts

And thanks to still ongoing cost cutting, and efficiency efforts, profits have soared, allowing management to start paying out some of the most generous dividends in corporate America.

F Total Return Price Chart F Total Return Price data by YCharts

But as you can see, the market hasn't been all that impressed with Ford's amazing turnaround.

And with US auto sales potentially peaking, and worries over a potential US recession growing, naturally some Ford shareholders are worried that if the market is willing to undervalue its shares this much during the best of times, then just how ridiculously cheap might shares get if auto sales end up in the toilet?

US Light Vehicle Sales Chart US Light Vehicle Sales data by YCharts

So for those long-term Ford bulls who are potentially interested in generating some extra income from Ford's super cheap shares, BUT also want a bit of downside protection, here's a low risk strategy to earn up to 9.9% annual income, while potentially buying even more discounted shares.

Best of all, in the event that Ford's shares do end up going over a cliff, learn why this particular bull put spread can not just limit your downside, but potentially let you walk away with shares so cheap that they are likely to generate market-smashing returns for decades to come.

Ford's potential downside risk

With the majority of refreshed models behind it at least for the next few years, Ford's sales as of late have been pretty weak. For example, September saw sales fall 7.7%, and the company just announced it was going to idle four factories in North America to fend off rising inventories.

Of course, it's no secret that the auto industry is cyclical, and Ford has been working tirelessly in recent years to cut costs, and labor contract liabilities so that it can break even if auto sales fall drastically, such as during the next recession.

In fact, Ford management believes that it can remain profitable as long as industry sales stay above 10.5 million units on a seasonally adjusted basis. Better yet for dividend investors is the fact that CEO Mark Fields is confident the company's hybrid, variable pay dividend policy means that the core $0.60/share payout should survive the next recession and industry downturn.

BUT as you can see from the auto sales chart above, in the event of a serious recession there is no guarantee that auto sales will stay above the 10.5 million unit magic number that Ford, and its investors, are counting on. So just how bad could things potentially get should the US fall into a recession?

F Chart F data by YCharts

Well, that's a tough question to answer. On one hand you could look at the March 2009 lows of the great recession, when Ford dropped to under $2.50 for a brief time.

However, keep in mind that 2008-2009 wasn't just a generic recession, it was a full blown credit and banking crisis. One in which many feared that the entire global financial system was collapsing.

In other words, a worst case scenario, one not likely to be repeated every bear market.

Sources: Morningstar, Gurufocus, Fastgraphs
TTM FCF/Share Projected 10 Year Growth Intrinsic Value Estimate Growth Baked Into Current Price Margin Of Safety
$3.38 15% $97.78 -40.6% 88%
10% $71.54 84%
5% $53.12 78%

In addition, we need to keep in mind that Ford is already one of the most undervalued stocks in the US market. The above discounted cash flow analysis uses a range of growth targets, from the latest 15% analyst consensus, which I view as massively optimistic, and a best case scenario, to a conservative 5%. This lower figure is one that should easily be beaten by the company's strong cost cutting efforts, and continuing strong growth in China.

But no matter what growth forecast you think is reasonable, one thing is clear. Currently the market is pricing Ford as if its growth is not just about to stall, but fall off a cliff.

In other words, Ford need not actually grow at all to beat market expectations, but merely survive over the next 10 years and, at today's prices long-term investors are likely to make a killing.

So we have great long-term profit prospects, but high near-term uncertainty, and rising concerns that slowing US growth might signal a potential coming recession.

Combining the two countervailing factors, I think that a reasonable "worst case scenario" for Ford over the next year or so is a fall to $6 per share; nearly a 50% crash.

Keep in mind that's a worst-case scenario not a prediction of imminent doom. I don't expect such a crash to happen, but it's my best estimate of how bad things could get if the US does experience a recession that brings car sales crashing down around Ford's head.

Using $6 as a worst-case scenario here is a great hedging-based income strategy that can help those worried about a potential Ford short-term crash: Earn some nice income returns, OR buy discounted shares, while also limiting downside risk.

Why this bull put spread is a potentially great option strategy

In my last Ford option article I explained how selling cash-secured puts was a potentially low-risk way to generate some good income yield if Ford stayed flat, or rose, OR buy shares at an even more outrageous discount.

One of the risks with that strategy, however, is that in the event of a crash you can be left holding cheaper shares that are still far underwater.

That is where bull put spreads come in. This is the lowest-risk income-generating option strategy I know of. One that minimizes both event risk, and financial risk, while allowing for maximum flexibility.

Source: Yahoo Finance
Put Spread Net Credit/Share Effective Cost Basis Yield On Cost Premium Yield Annualized Premium Yield
Jan 2018 $11.75/$7.75 $1.31 $10.44 5.7% 12.6% 9.9%

A bull put spread is when you sell one cash-secured put and buy a lower strike price put that acts as a hedge in case the share price falls substantially.

In this case, because we're worried that Ford might decline over a longer term we're looking at the Jan 19th, 2018 LEAPs.

As you can see, the result is a net credit of $1.31/share, or $131 per contract, which equals a 12.6% potential income yield over 15 months, or a 9.9% annualized premium yield.

If Ford is trading above $11.75 on Jan 19th, 2018, then the spread is maximally profitable and you've just earned a very nice return. If it's under $11.75 but above $7.75 then your effective cost basis becomes $10.44 ($11.75-net credit), for a yield on cost of the regular dividend of 5.7%.

For long-term Ford bulls this is a pretty nice outcome.

Now if the price falls under $7.75 that is where the benefit of hedging comes in. The spread basically limits your downside to a maximum of the difference in strike price ($11.75-$7.75 =$4/share) minus the net credit, to $2.69/share or $269 per contract.

Source: Yahoo Finance
Max Loss/Share Effective Value of Long Put At $6/share Potential Effective Cost Basis Unrealized Loss With Hedging Unrealized Loss Without Hedging
$2.69 $3.06 $8.69 31.0% 49.0%

This is because the spread obligates you to buy 100 shares of Ford at $11.75 per share, BUT gives you a chance to get out of the trade by selling those same shares to someone else at $7.75. In other words, a $4/share loss minus the $1.31/share in up front premium you got from setting up the spread.

That's an option in case Ford goes into free fall and you become afraid that shares might continue downward, potentially far below $6.

BUT thanks to the flexibility of a bull put spread you also have another choice, one that I personally find much more appealing.

Because the put you own is an insurance policy that appreciates in value as Ford falls, you now have two options. First, you can sell the put early, and close out the spread entirely, via buying back the $11.75 put you sold.

This will likely mean converting the net credit per share into a debit, or taking a loss. BUT because this stock crash scenario is likely to result in implied volatility going through the roof (meaning premiums will fatten), you can roll the spread downwards by writing a new spread --one for a higher net credit/share that results in an overall higher credit/spread than you initially started with.

Or, as shown in the above table, you can always simply accept the shares assigned to you, sell the long put, and use that lower put sale to generate a new cost basis of $6 + maximum loss or $8.69 per share.

And while that would still result in a nasty unrealized loss of 31.0% compared to the current share price of $11.76, it's a heck of a lot better than just buying today and facing a potential 49% short-term unrealized loss.

The risks you can't hedge against

In my previous article I explained that writing cash-secured puts involved 3 forms of risk: event risk, financial risk and opportunity risk.

The benefit of a put spread is that it greatly reduces event and financial risk. That's because the flexibility of the strategy, specifically being able to profitably roll the put downwards (by selling the long put, buying back the short put, and writing a lower strike spread), means you have more control over whether or not you will be assigned shares, and at what price.

And of course, because this is a hedging strategy, your risk of financial loss is also lowered. BUT opportunity risk is simply something that no investing strategy can do away with.

Specifically this is the risk of "option sellers' remorse" such as might occur if you wrote this spread, and thus tied up $1,044 per contract in cash to cover the net cost of buying the shares if assigned.

For example, say you go ahead and write the spread and Ford ends up shooting higher to $15, or even $20. Sure, technically your spread will achieve maximum profitability and generate 9.9% annual income over the next 15 months. But you'll end up regretting not simply having bought the shares outright, because you've left a lot of profit on the table.

On the other hand, compared to the cash-secured put strategy, the opportunity risk is lowered because in the event that the price does collapse you still have the option of managing the trade via roll down or accepting the shares with a cost basis of $8.69, with a yield on cost of 6.9%.

In other words, you have eliminated one direction (downwards) worth of opportunity risk, and most of the event, and financial risk. That is why I consider the cash-secured, bull put spread the lowest risk income generating option strategy you can use.

Some more details to keep in mind

Finally before trying this strategy be aware of a few key details.

First, the precise put I've highlighted, selling a $11.75 Jan 19th, 2018 put and buying a $7.75 Jan 19th, 2018 put, is one that I consider a good mix of high income-generating capacity, and a decent amount of downside protection.

BUT every investor is different and the great thing about options is the flexibility they allow. For instance, say you are more conservative and think that a $2.69/share max loss is too high.

Then you can always try a narrower spread. For example, if you write a $11.75 Jan 2018 put, and buy a $9.75 Jan 2018 put, then you get the following bull put spread:

Source: Yahoo Finance
Put Spread Net Credit/Share Effective Buy Price Yield On Cost Premium Yield Annualized Yield
Jan 2018 $11.75/$9.75 $0.87 $10.88 5.5% 8.0% 6.4%

Because the $9.75 strike price is much more likely to get hit than $7.74, it will cost more, and thus result in a smaller net credit for this spread. That results in a lower potential 6.4% annualized premium yield in the event that the spread expires worthless (Ford above $11.75 on Jan 19th, 2018).

BUT take a look at how the hedging profile changes in the event that Ford crashes to $6.

Source: Yahoo Finance
Max Loss/Share Effective Value of Long Put At $6/Share Potential Effective Cost Basis Unrealized Loss With Hedge Unrealized Loss Without Hedge
$1.13 $5.06 $7.13 15.8% 49.0%

As you can see, in the event of a collapse, the higher strike of the long put means that its value will increase far more than the $7.75 put in my first example. This creates a lower maximum loss in case you decide you would rather back out of the trade altogether and wait to see how things shake out.

BUT it also means that your second and third choices, of rolling the spread downwards, or simply gaining ludicrously low-priced Ford shares also improves. Again, that's due to the higher intrinsic value of the long put, which you can sell to ensure a cost basis of $6+ max loss, or $7.13.

As for other key details to keep in mind, they are much the same as in my first article, mainly: commission costs, and taxes.

Specifically, remember that all option premiums are taxed as short-term capital gains, even LEAPS such as the examples I'm using. That means if you don't do this in a tax sheltered account such as an IRA your premiums (if the spread expires worthless) will be taxed at your top marginal tax rate.

Now a quick note regarding commissions. For this strategy in particular I would recommend using Interactive Brokers (NASDAQ:IBKR) or eOptions

For Interactive Brokers the commission costs are extremely low, $0.70 per contract with a $1 minimum. So even if you can only afford a single spread, the trading fees will come to $1 /$131 = 0.76%. This is well within the rule of thumb of keeping costs to under 1% of capital.

eOptions charges $3 +$0.15/contract, meaning that if you can afford to, and are comfortable buying several hundred shares of Ford, then you can reduce your cost even more.

For example, a trade of 10 spreads has a commission of $4.5 or 0.34%. eOptions is also a good choice if you don't have the minimum $10,000 to open an account with Interactive Brokers.

Bottom line: markets can always get crazier, so consider this bull put spread to generate strong income, lower your risk, and leave you with maximum flexibility for managing the trade

While options certainly aren't for everyone, and aren't necessary to make profit-crushing returns over the long term, nonetheless they can be a powerful income-generating tool if used correctly.

If you are a long-term believer in Ford's turnaround story, as I am, but worried about what the next year might bring, then this might be one option strategy worthy of your consideration -- especially if you are already comfortable with writing cash-secured puts.

Disclosure: I am/we are long F.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.