by Lawrence Meyers | February 13, 2013 2:30 pm
I’ve had my eye on several high-price stocks this year, trying to decide how much capital (if any) to invest in them. The candidates were Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Priceline (NASDAQ:PCLN), with the latter two being the primary candidates. All of these are great businesses and arguably undervalued.
Selling naked puts against any of these stocks would accomplish two things: It would net really large absolute dollar premiums, and it would provide ample downside protection should the stock fall. And since these are all great businesses I’d be happy to own, it makes for a happy medium.
Still, a put means I could get the stock put to me at the strike price, so I’d still face some risk of having to buy expensive shares. With such huge premiums, however, I would get large downside protection.
I had considered selling an Apple put back in early December. At the time, it was trading in the mid-$550 range, and the January 2014 $500 Puts were selling for around $50, and still have downside protection to $450. With $119 per share in cash on hand, Apple traded at an effective price of $456 per share, or nine times earnings on 20% long-term growth. That was a bargain.
Instead, I purchased 25 shares of Apple and got stopped out for a 7% loss. Since then, Apple delivered a good quarter that the media still hated. The stock fell to $450, and I would have been a pretty nervous guy, even with that huge cash hedge that Apple has. Although I’m not big on technical analysis, I do use it a supplement to my fundamental analysis, and Apple looked like it might be executing a head-and-shoulders pattern that could take it to $350.
Enough uncertainty exists in Apple in the near term that, while it may be a bargain here, that doesn’t stop the market from possibly discounting it further. Earlier, I could sell a put a year out for a 9% return and give myself 100 points of downside protection, but Apple’s premiums aren’t so great now. The January 2014 $400 Puts now go for $22, as the underlying stock trades at $480. That’s a 5.5% return, on the same hundred points of downside protection.
Now, this isn’t a bad trade. I’m glad to take Apple at an effective price of $378, plus the $123 in cash. I think it would have to be in serious trouble fundamentally to hit that price, or it would do so strictly as a result of misplaced investor psychology. Yet somehow I felt that at that price, I’d rather just buy an odd lot of shares and set a stop loss, rather than give up the flexibility by using an option.
So, was there a better trade? Yes. Priceline was at $680. It had $74 in net cash, giving it an effective price of $606. The travel industry has more visibility than Apple over the next year, Priceline continues to execute, it had $1.5 billion in free cash flow over the trailing 12 months, and was trading at 20x earnings backing out its cash while growing at 20%.
January 2014 $585 puts were going for $43. Worst-case scenario was that I’d have the stock put to me at an effective price of $542, some 12% below fair value, barring any disaster.
Yet even more interesting was the same strike price but with a July 2013 expiration going for $21. Why be greedy? Plus, the economy and, therefore, the travel industry had even more visibility just six months out. If I called this correctly, I could sell another put at expiration. So I went with that.
Priceline is a cash-flow machine with tons of cash on its balance sheet. Apple is, too, and I may regret not just buying it outright here. But trading is different from investing. It’s about preservation of capital. I felt my capital was safer in this trade than with Apple, and in this case, it has more to do with medium-term business visibility than the overall business itself.
Lawrence Meyers has sold a Priceline July $585 naked put.
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