Investors Fret over SNC–Lavalin

SNC-Lavalin has once again made headlines as scandals with the Montreal’s new megahospital remain unresolved. The news certainly has contributed to SNC-Lavalin’s recent price weakness. Investors fear that if the plot to rig the megahospital contract in SNC’s favor is true, the company would face penalties and material reputation risk to compound on a troubled past. If you would like to read the article, visit: http://business.financialpost.com/2013/03/01/will-mcgill-health-centre-deal-ever-come-back-to-haunt-snc-lavalin/

On a balance sheet basis, the company remains attractive, but the uncertainty of management behavior puts a shadow of mistrust around the stock. Under normal circumstances buying a stock in the midst of a controversy usually represents an opportunity, but having the courage to act is an entirely different issue. Maintaining a disciplined composure is far easier said than done. This is why I am a huge advocate of utilizing options as an alternative to stock ownership.

I have heard many argue to me that effective risk management of positions can be done with utilizing stop losses, but I think that there are numerous advantages of utilizing a call option over conventional stop orders. Over the last few years SNC-Lavalin has had a number of news driven gaps. These large gaps are dangerous for traders utilizing stop loses as there can be considerable slippage in your fill price. There is also vulnerability to short term volatility if stop losses are placed too close.

When utilizing call options, we can participate in the stocks upside potential but have a much better defined risk proposition. If you are brand new to options, view this short educational video. http://www.m-x.tv/media/buying-call-options

Here is my rationale:
SNC-Lavalin (TSX:SNC): $43.26.

Immediate Downside Risk: The 52 week low at $34.36 (-$8.90 or -20.57% lower).

Reasonable Upside Targets: The $50.00 and $55.00 highs from 2012 ($6.74-$11.74 upside).

A stock investor has a pretty mixed risk reward proposition from an investment perspective.

In this example I will look at the June $42.00 call option, which is in-the-money by $1.26 ($43.26-$1.26). The option is currently trading at $2.50. Because I have elected to buy the in-the-money option, it gives me higher delta participation on the upside. The current delta was 0.60. If you are new to the option Greeks such as the delta, watch this short video http://www.m-x.tv/media/greeks-option-sensitivities.

So here is breakdown on the option:

Let me expand the risk component further. If a sudden news driven event was to occur and the stock was to gap lower by $4.00 a share to $39.26, the call option would drop to the $0.50-$0.75 level. If the investor decided to sell the call, the loss incurred would have been limited to a few dollars. On the other hand, a stock investor could freeze and helplessly watch the stock precipitously drop to a new valuation, the investor has an undefined risk and more importantly an undefined holding period.

The bottom line: The call gives the investor a more controlled way to participate on the upside of the stock, while being able to sleep at night not overly concerned about company specific risk.