Cisco (NYSE: CSCO) has been showing some weakness as it trades near multi-year highs. After hitting a high of $31.95 in September, the stock has moved in small ranges completing four months of sideways action. Although in a strong multi-year uptrend (highlighted below), there is always this possibility that the stock consolidates or flat-lines for an extended period of time. Can the investor benefit from it? This article says 'yes' and discusses the required strategy in detail.
An investor can almost triple his income from Cisco using a very simple, neutral options strategy called Short Strangle. I had recently recommended this strategy for General Electric (NYSE: GE) as well. My best effort will be to discuss all the aspects involved in the strategy, including the risks, in the simplest manner to appeal to both the classes of option traders - beginner and seasoned.
From the monthly Cisco price chart below, it is clear that the networking giant has been sloping higher in a broad range entrenched since 2011. The basic assumption that we consider at the beginning is that the stock follows this trend for the next year as well. This gives us a wide range of $26-$39 until January 2018.
Assuming that the range holds until next January, an investor can benefit from trading this range using deep out of the money options. Short Strangle involves selling of an out-of-money (OTM) call option and an OTM put option, both expiring on the same day. The basic premise behind this strategy is that since the stock is not expected to close beyond this range on expiration date, an investor can make income from the premium received by selling these options.
According to the latest options data, the call strike price closest to the higher end of the range i.e. $39 is $40. Therefore, selling this option would bring an investor an income of $0.21, which is the last traded price. The bid-ask is closely tied as $0.20-$0.21. The market currently believes that there is a significant 92% probability that this option expires worthless, which strongly complements our thesis. Since we are talking about the next one year, the expiration date is January 19, 2018.
Similarly, selling the $27 strike put option could reasonably bring in an income of $1.78. This is in tune with the last known bid-ask of $1.77-$1.80. The market currently sees a 68 percent probability of this option going to 0 until January 19, 2018.
The important point to note here is that since the strike price of the put option is closer to the current market price, it is understandable that the market sees a greater probability of the stock touching the lower end even though it is in an uptrend. After all, the $26 level has been achieved by extrapolating the current trend one year into the future. The current level of support trendline is $24.
Now, if an investor is able to sell these two options at the discussed prices, he will receive a total income of $0.21 + $1.78 = $1.99. For simpler calculations, let us take it to be $2.
This $2 will be received by an investor in the next 380 days if the stock closes at or within the range on the expiration date. If an investor shorts these two options now, he can lock in this income at the current price of $30.10, which translates into a return of 6.64 percent. This annualizes to 6.38 percent.
This return is 192 percent more than the current dividend income of $1.04 or 3.44 percent in dividend yield. In total, an investor can almost triple his annual income even if the stock continues to consolidate or fails to head higher.
But, there are some important points and risks to this strategy which need to be put out.
The major risk here is that if the stock breaks the uptrend on the downside, which currently looks highly unlikely, the returns from the strategy will not be able to cover the losses arising out of price depreciation. Cisco has a beta of 1.26 which indicates that the price move will be more pronounced than the broader market.
The point of maximum pay-off is the higher strike price i.e. $40. If the stock closes at $40 on the expiration date, the investor will receive double benefit of strong appreciation in the underlying as well as receive significant income from the shorted options. As per the current price, a level of $40 on the expiration date would equate to 40 percent returns.
Total return on expiration date = $10 (price appreciation) + $2 (premiums)
At $30, this is a return of 40 percent.
If the stock were to surprise on the upside and breach the resistance, the investor would incur no loss as the shares held by the investor will offset the losses arising out of the shorted call option. So basically, the return potential of this strategy becomes horizontal beyond $40.
Commissions and fees have been deliberately omitted from the calculations for easier presentation and simpler understanding. However, the importance of consulting the broker before implementing this strategy cannot be stressed enough. If the transaction costs are too high, do not implement this strategy.
Since the strategy involves selling of two deep out of the money options, a significant amount of capital will be locked for the next one year. Therefore, it is imperative to consult the broker regarding margin requirements and conditions as well. This could also be the reason why an investor would simply choose to wait for lower levels to increase his stake in the company.
An investor is free to choose different expiration dates and strike prices which better suit his risk-appetite. It was from a conservative standpoint that I chose what I did.
Cisco is currently in the middle of a multi-year uptrend which makes it a suitable candidate for a neutral options strategy called short strangle. This strategy will benefit the investor if the stock consolidates in the next one year or fails to head higher. Using two deep OTM options, an investor can almost triple his income in a very simple manner.
There are some important points which an investor must consider before implementing this strategy such as the commissions and the fees involved. The risk of downside action in the stock price still exists, like always, but the strategy can provide partial protection with its phenomenal returns. The point of maximum return is the strike price of the shorted call option.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.