05 Apr Understanding Cash-Secured Puts
At T&T Capital Management, our primary focus of course is on deep value investing. That means we are only interested in buying securities that trade at large discounts to intrinsic value, thereby ensuring us a significant margin of safety. By doing this, we both protect the portfolio and position it for maximum potential long-term returns. In today’s newsletter, I’d like to provide a refresher on some of our other strategies to provide a better understanding for how they work.
Firstly, the only options strategies that we use are cash-secured put options and covered calls. We employ these strategies for the purposes of generating income and reducing risk. We don’t engage in any speculative activities such as buying options, where one must be correct on both the direction and the timing, with the odds generally stacked against them. These strategies when combined with the deep value focus, help us to minimize the risk of permanent losses of capital, reduce interest rate risk, and allows us to take advantage of market declines to secure cheaper entry-prices into value stocks.
“We employ these strategies for the purposes of generating income and reducing risk.”
Our most popular strategy is selling cash-secured puts on stocks we would want to own anyways at cheaper prices. One stock that we like in today’s market is ALLY Financial (ALLY). The stock closed today at $26.74 and has an adjusted tangible book value per share of $28.10, as of the end of the 4th quarter 2017. It is very hard to find nicely profitable and financially strong companies trading at discounts to tangible book value in today’s market, but ALLY is still really cheap and attractive. This is a business that is rapidly growing earnings and has a clear path to grow earnings per share by at least 12-15% a year from a 2017 base of $2.41. The stock was a big winner for us in 2017 where we both bought the stock and sold a great deal of puts.
We still see very good value so one way to play it is by selling a January 2019 $27 put for $2.80. We believe ALLY is worth about $35 per share, but because we have concerns about the overall market, selling puts is a safer way to play it. Two things can happen assuming we hold the put option till expiration.
- If ALLY closes above $27 at expiration in January of 2019, you will have made $280 ($2.80 per share on 100 shares) on a maximum risk of $2,420 ($2,700-$280) for a return of 11.57% in 289 days, or 14.6% annualized. Obviously, that is a tremendous return in an environment where junk bonds only yield around 5.5% and have considerable interest rate and credit risk.
- If ALLY closes below $27 at expiration in January of 2019, you will have your option exercised, and will end up owning 100 shares of ALLY at a breakeven price of $24.20 per share. This entitles you to all future benefits and risks of owning the stock, but you’ve secured a 10.3% discount to the current market price on a stock we believe is worth at least $35. Imagine a scenario where the stock market declines by 20% and let’s assume ALLY declines 20% too just to be fair. You would only be down 9.7% on your position and you’d have a great long-term holding, which is why this is a safer strategy than just owning stocks outright.
We can go over covered calls in a future email, but cash-secured puts are our most common strategy, in addition to just buying securities outright. One thing that is important to understand is that you will only see the full benefit of the options as we get closer and ultimately get to expiration. Most of our sold options expire in January of 2019. Between now and then, the option prices will move based on a variety of factors, including volatility. However, once we get to expiration, the only thing that matters is where the stocks are relative to our sold options. This is why we often see a 5-8% boost to our accounts as we get closer our major expiration dates.
“One thing that is important to understand is that you will only see the full benefit of the options as we get closer and ultimately get to expiration.”
To get a feel for the amount of unearned option premium in your account, you look at your short option value. This number shows up as a negative, which is just part of the confusing way that brokerages account for sold options.
Let’s say for example your account value is $500,000 and you have -$100,000 in short option value. In the hypothetical scenario that 100% of your options expired worthless, meaning you keep 100% of the premium and not accounting for any other changes in stocks prices, your account value would grow to $600,000 ($500,000 plus $100,000).
Many of our positions are cash-secured puts and the vast majority of them are looking very good despite recent market volatility. Our accounts have generally held up a lot better than the overall market during this recent downturn, which is what we would expect based on the strategies that we have employed. The benefits of these options should show up far more substantially as time continues to elapse and as we get closer to January. To be clear, we don’t always hold options until expiration. If we make the majority of the profit in a shorter amount of time, we can close out the options to allocate capital to a higher return investment. We like to look at the short option value just to provide a glimpse of the unearned option premium embedded in the portfolio, as only looking at the account value on a day to day basis can be very misleading given the strategies we employ.
“Only looking at the account value on a day to day basis can be very misleading given the strategies we employ.”
The last week or so has seen a lot of hysteria about the potential for trade wars. Our accounts have very little exposure to companies that would be severely impacted by any tariffs. I’d encourage investors to focus on what policies are actually implemented, as opposed to the barking that goes back and forth between politicians, as that is all part of the negotiating process.
Developments in Puerto Rico continue to improve as exemplified by economic data that is dramatically outperforming projections. The government of PR and the Oversight Board continue to flout the law and were recently chastised by the chairman of the House and Natural Resources Committee, which created Promesa for doing so. Ultimately, we are confident that the rule of law will prevail, and we think that our major investments in that area should provide exceptional returns.
Lastly, this recent volatility has halted the acceleration in interest rates, which we believe to be good for the overall market if it continues. This is especially good for our real estate investments, which we acquired at very cheap prices and that offer very high dividend yields. We should see quite a few solid dividend checks coming into our accounts this month and in subsequent quarters, as a result of these investments. If rates don’t break too much higher, these stocks have 40-60% upside potential conservatively. We view these high-yield real estate stocks as a far better option than fixed income due to the low interest rate environment that still exists. It might entail a little more volatility at times, but the dividends and upside potential are very real.
“We view these high-yield real estate stocks as a far better option than fixed income due to the low interest rate environment that still exists.”
As always, please let me know if you have any questions at all or if I can assist with anything. I can be reached directly at 805-886-8140 and Peter’s number is 949-734-4290.
Thank you very much!