When Good Stocks Do Bad Things

Jason Ayres
October 31, 2016
6 minutes read
When Good Stocks Do Bad Things

Time and time again we see good stocks fall victim to the emotional roller coaster ride that is the market. Whether it’s a rumour that may be circulating around a certain company or a surprise earnings miss, often times we will see good, fundamentally strong stocks do bad things as panicked investors run for the exit. From time to time, you may also find that you’ve missed your entry point on an opportunity and are averse to “chasing” the market.

If you have your eye on a certain security that falls into one of the above mentioned categories, this is where knowing a little bit about the options market opens up a whole new world of possibilities.

As an options trader, one thing that we know is that when the direction of a stocks share price becomes uncertain, option premiums become expensive.

Think of it like your car insurance. You could have a clean driving record, but run one red light, or get pulled over for speeding and all of the sudden your insurance broker is jacking up your premiums. Even though you didn’t get into an accident, or do any damage what so ever, your behavior has put you into a higher risk category and your insurance underwriter needs to get paid for that added risk.

Take Agnico Eagle Mines (TSE:AEM). Without getting into a debate about the direction of gold or the company fundamentals for that matter, fact is, the stock has had a huge run this year hitting $77.50/share but giving back almost 25% over the last few months to a recent low of $57.00

Applying our understanding of the options market, as AEM shares sold off, the implied volatility priced in to the option premiums sky rocketed. Implied volatility is the term given to the risk premium that is added to an option contract when things are looking risky and unpredictable.

As an investor looking for an opportunity to purchase shares of AEM at a “discount” this becomes an interesting opportunity.

With the shares hovering around $60.00 on October 14th, 2016 the November, 60 strike put was trading at $3.25 per share.

As a put writer, we are getting paid to take on the obligation of buying AEM shares at the price specified by the contract. In this case, we would write (sell) the contract and get paid $3.25 per share to take on the obligation of buying the shares at $60.00 up until the expiration of the contract (November 18th, 2016). Note that we are obligated to purchase 100 shares for every put option contract sold.

Here’s what we know

If the shares of AEM are trading above $60.00 on expiration, the $60.00 strike put will expire worthless and we keep the premium. In addition, we no longer have an obligation to buy the shares. This is a return of 5.41% in just over a month.

If the shares are trading at or below $60.00 on expiration, we will be assigned to fulfill our obligation to purchase the shares at $60.00, regardless of how low the shares are trading. But remember we have been paid to take on that obligation and get to keep the $3.25 premium if assignment takes place.

When considering the purchase of the shares at $60.00 and collecting the $3.25 premium, our average purchase price of the shares is reduced to $56.75. This is just over 5% lower than if we simply purchased the shares at $60.00.

Getting Paid to Wait

Once the put option has been written, the objective is to sit back and wait until expiration. If the options expire, we can sell another put at a different strike and apply the strategy all over again if we are still comfortable owning the shares at the new adjusted price.

The objective of this strategy is to enhance cash flow in the portfolio while attempting to acquire the shares at a reduced price. If assigned and the shares are purchased, the focus will turn to benefiting from a rally in the share price and enhanced cash flow through strategic call option writing (Covered Calls)

Follow Up

At the time of writing (October 26) AEM is trading at $64.50. The puts written are now worth $0.99 per contract.

Actions could be taken as follows:

  • Contracts could be bought back at a profit and we could wait for another pull back to write again
  • Contracts bought back and new position written based on current market conditions and expectations
  • Position could be held until expiration and allowed to expire worthless
  • Shares may drop back down to $60.00 and we get assigned to own them at expiration

Put writing to purchase shares is just one of the many ways you can use options as an investor. While this strategy may not work for every opportunity, it sure is great to have a few choices when considering a new position for your portfolio.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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