Getting Long GoPro For The Risk Averse

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Includes: GPRO
by: Andrew Dudar

Summary

GoPro's future is uncertain.

Getting long demands a risk-averse approach.

An appropriate options strategy can yield a far better risk-reward opportunity than owning shares outright.

Intro:

There are numerous well-written articles on Seeking Alpha supporting the bull and bear cases for GoPro (NASDAQ:GPRO), and the goal of this article is not to alter your conclusion about the future of the company, but rather to help you manage risk effectively. This article assumes two things from the start:

  • You are bullish on GoPro's prospects over the next two years, and believe it can deliver excellent results if management executes successfully.
  • You acknowledge that if GPRO's management cannot reel in its growing expenses or fails to deliver on another product, the stock will be punished.

This article is all about risk management, and I will use price points I believe are achievable, but please feel free to utilize the approach with price points derived from your own analysis.

The Approach and Analysis:

The approach is to use a bullish call spread instead of owning shares directly to mitigate risk and capture upside and while its a simple options trade, the numbers below will emphasize why it's so well suited to this situation. I will use a position I recently initiated as an example.

I purchased the Jan 2019 $15 call option and simultaneously sold the Jan 2019 $25 call for a total cost of $75, which translates to:

  • Max risk: $75 - if the stock is at or below $15 at expiration
  • Max gain: $925 - if the stock is at or above $25 at expiration
  • Break even: If the stock is at exactly $15.75 at expiration

In percentage terms, max profit: (925/75 - 1) * 100% = 1133%

Now let's compare that to purchasing shares directly by assuming you want to buy enough shares at current prices such that you will realize the same dollar amount gain should the stock rise to $25. Using Jan 6th closing price of ~$9, one would need to purchase:

$925 / ($25-$9) = approximately 58 shares for a cost of $9 * 58 shares = $522

This brings us to two important implications, 1) risk and 2) potential earning capacity, specifically it's affect on risk.

With the option contract, the max loss is $75. To lose $75 on the 58 shares the stock price would need to drop to only $7.70. If you believe the stock will be somewhere between $7.70 and $25 in Jan 2019, you are better off owning the shares, but be warned, you take on $522 - $75 = $447 or 496% more risk for that belief. This is the primary motivation to utilize bullish call spread(s) rather than owning shares directly.

This brings us to the potential earning capacity of the money saved going with the options route because over those next two years that $447 spent on shares cannot be invested elsewhere.

Assuming an annual interest rate of 6%, the future value of $447 is: $447 * (1 + (0.06 / 1))^(1*2) = $502 or 12.3% or a gain of $55.

To incorporate this you simply need to add $55 to your original max gain and repeat the calculations for the number of shares required to earn $925 + $55 = $980. I won't repeat the details, and instead will skip straight to the punch line.

You need 61 shares purchased for $549. You risk 532% more to be better off owning shares. Technically, $549 - $75 = $474, and this is the new number you need to repeat the potential earning capacity calculation on. You are done when this number converges, and while the results don't change much, for the sake of completeness, you end up risking ~540% more owning the shares.

Why GoPro:

I believe GoPro is a good candidate for this strategy because it is the exact opposite of a safe, stable, diversified, dividend paying, blue-chip company. If GPRO succeeds in delivering its drone and deploying their subscription services while getting costs under control and returning to profitability, I expect this small-cap company with no debt and so much negativity baked in would have very little holding its shares down. However, if GoPro's drone efforts fail, or they fall behind in delivering the best action camera experience, their dwindling cash pile will provide little support as expenses climb. This options strategy allows the user to hope for the best case scenario while preparing for the worst, and in the case of GoPro both are entirely possible.

The Risks:

The primary risk is that in Jan 2019, GPRO is above ~$7.80, but not significantly above $15. One method to think about this would be to state: at what point does your reward from owning the shares equal your risk. We've already determined that the total risk is 540% more by owning shares. Let's assume GPRO reaches $16.50 at the Jan2019 expiration. The gain from the call option would be $75, while the gain from an equivalent amount of shares would be ~$460 which equates to ~515% more owning the shares, compared to a 540% risk. In other words, if you believe GPRO will be above $16.50 by Jan2019, the call spread was better from a risk/reward perspective.

Here's a different, more intuitive way to think about risk/reward. Let's modify the scenario and assume you spent the same amount on shares as you would on the options, in this case $75. If GPRO reached $16.5/share, the gain from the options would again by $75 while the gain from the shares would be ~$65. In this instance it again turns out that if you believe GPRO will be above $16.50, the options are the better choice.

There is a scenario that could really destroy the thesis of using options over shares for these particular price points. If you believe there is a high probability of a buyout in the near term, it seems unlikely that a potential buyer would pay more than $15/share. If your analysis leads you to the conclusion that a buyout is likely, I have to recommend either purchasing the shares or adjusting the options' price points to reflect that.

Conclusion:

With carefully chosen price points, purchasing a bullish call spread instead of shares can greatly improve your risk/reward potential. The underlying assumption is that over the next two years you believe GPRO stock will have a relatively large move in either direction. You want to take advantage of an upswing but limit your risk should the company fail to execute. If the approach is suitable to your needs, but you find the price points don't align with your analysis, I encourage you to repeat the process to find the investment that works best for you.

Disclosure: I am/we are long GPRO.

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.

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