Bullish Outlook
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Why pay more when you can PEY less?

Christopher Thom
January 5, 2017
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4 minutes read
Why pay more when you can PEY less?

Peyto (TSE: PEY) shares did well in 2016, rising 33.5%, as natural gas prices rose almost 64%. Natural gas accounts for 90% of Peyto’s total production volume. In my view, the shares are undervalued and could be purchased outright at this level. However, two issues arise with that idea. First, we are here to talk about options and that wouldn’t involve any. Second, many investors are hesitant to buy a stock after it has risen this much in a year and want to wait for a pullback. A great way to “get over” the resistance is to sell a Cash Covered Put instead of buying the stock. Using this option, we collect the premium; it is ours to keep no matter what happens. If the stock stays above that strike price we don’t buy the stock and our gain is the amount of the premium we sold. If the share price declines below that strike, we buy the shares but the net purchase price is the strike price, minus the premium collected.

Peyto shares are currently trading at $31.50. We can sell a February $30 Cash Covered Put Options for $0.55. This means we will collect just over 1.8% of the strike price ($0.55/30) with expiry day only 44 days from today. That is an annualized yield of 16% (see calculation below). As long as the shares stay above $30 at expiry on February 17, 2017 these options will expire worthless and we capture the gain of 1.8% (transaction costs not included).

If the share price is below $30 at expiry then we will be buying them at that level, but our net purchase price will be $29.45 ($30-0.55). That net purchase price is 6.5% below the current market price. Using this strategy with a stock that has rallied allows us to take a position and have our money working for us, while we wait for a pullback. The alternative is to sit on the sideline with cash while we wait for a pullback that may, or may not, ever happen.

On the housekeeping side, this trade needs to be executed in a non-registered account. Puts cannot be sold in a registered account. We also need to make sure we have the cash available to buy the stock in the event we are assigned. For each contract we sell we need to have $2,945 in cash or money market in order to ensure we are Cash Covered. This is important to remember when selling a put option because any equity can experience a sharp and unexpected pullback. If we don’t have the cash at the ready then we are using leverage and may find ourselves in a debit if we are assigned.

 

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The information contained herein is for general information purposes only and is not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Many factors unknown to Christopher Thom may affect the applicability of any matter discussed herein to your particular circumstances. You should consult directly with your financial advisor before acting on any matter discussed herein. Individual situations may vary.

Happy Trading!

Chris Thom

Christopher Thom
Christopher Thom https://www.odlumbrown.com/cthom/

Portfolio Manager

Odlum Brown Limited

Christopher’s investment philosophy is based on the principles of value investing. Following an investment style consistent with that of Odlum Brown’s Research Department, he focuses on good companies with solid balance sheets trading below their fundamental valuations. As a Portfolio Manager, Christopher works with clients to build portfolios based on their individual needs. A large part of his business includes using options. By incorporating various options strategies in client portfolios, Christopher aims to increase investment income, reduce portfolio volatility and hedge against large moves in the market or currency fluctuations. Christopher has completed numerous industry courses and achieved the Canadian Investment Manager (CIM), Derivatives Market Specialist (DMS) and Fellow of the Canadian Securities Institute (FCSI®) designations. In addition, he has made several guest appearances on Business News Network (BNN) segments, such as Business Day and The Close, on the topic of options and equities. Investing in the equity markets often consists of following a buy low, sell high strategy. For suitable investors, the use of options strategies can help investors protect their portfolio from downside risk, align their cash flows, improve returns, and achieve their objectives given their comfort with risk. By incorporating the use of options, Christopher helps his clients achieve their long-term financial goals. Many clients have come to Christopher after trading options on their own for years, looking for professional advice, and he enjoys the relationships he has built with them over the years.

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