Stock Options

The Doubling Strategy

Richard Croft
August 29, 2016
5 minutes read
The Doubling Strategy

This week, rather than looking at short term trading opportunities, we will examine a longer term strategy that is not dependent on a directional bet for the underlying stock. What it comes down to is positioning. Is this a stock you would be willing to hold longer term, what role will it play in your portfolio (i.e. risk reduction, return enhancement, etc.), what cost is reasonable? Assuming you are comfortable holding the underlying stock and have a rudimentary understanding of the role it will play in your portfolio, options can address acquisition cost.

The acquisition strategy is a covered combination on a volatile stock that is designed to take advantage of dollar cost averaging. A volatile stock has a greater impact on the range of outcomes for the strategy. In much the same way as volatility enhances the outcome when acquiring a position through dollar cost averaging.

To that point we’ll focus on two examples; Goldcorp Inc. (Symbol: G, Fridays close $20.75) and Valeant Pharmaceuticals (VRX, $40.14).

Company specific issues aside, the case for Goldcorp rests almost entirely on your outlook for gold. If that outlook is positive and you want to increase exposure to gold in your portfolio, the covered combination is an excellent way to manage the acquisition of shares.

We’ll assume for example that you are comfortable owning 1,000 shares of Goldcorp in your portfolio. We begin by purchasing 500 shares of Goldcorp at $20.75. We immediately sell five Goldcorp January (2018) 21 calls and five January (2018) 21 puts for a net credit of $8.60. Note these options expire in January 2018, which is seventeen months from now.

At the January 2018 expiration one of three outcomes will occur; the stock will rise above $21, fall or stay the same. If Goldcorp is trading above $21 in January 2018, the Jan 21 puts will expire worthless and the Jan 21 calls will be exercised. Under this scenario you would deliver your initial 500 shares to the call buyer. Your out of pocket cost to buy the initial 500 shares was $12.15 ($20.75 less $8.60 in option premium = $12.15). The seventeen-month return on the initial position would be 72.8%. This assumes of course that you are using margin rather than cash to secure the short puts and does not take into account the seventeen monthly dividends that you would receive while holding the shares.

If the stock stays the same or declines, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 500 shares of Goldcorp at $21.00 per share. At this point you would have acquired your 1,000 share objective at an average cost of $16.575. You should be comfortable holding 1,000 shares of Goldcorp at the average acquisition cost.

Now to Valeant Pharmaceuticals whose options options are trading in the top quartile of implied volatility. The high premiums are reflecting market concerns over management missteps. But, if you believe that past missteps are a sign post and not a hitching post, and believe this is a stock that can enhance longer term performance within a diversified portfolio, the covered combination can play a valuable role.

We’ll assume you are looking to acquire 400 shares of Valeant. We begin by purchasing 200 shares at $40.14. We immediately sell Valeant April 40 calls and April 40 puts for a minimum net credit of $18.50. These are not liquid options so be sure to use limit orders.

At the April 2017 expiration Valeant will be either above or below $40 per share. If Valeant stays the same or rises, the April 40 puts will expire worthless and the April 40 calls will be exercised. Under this scenario you would deliver the initial 200 shares to the call buyer. Your out of pocket cost to buy the initial 200 shares was $21.64 ($40.14 less $18.50 in option premium = $21.64). The eight-month return on the initial position would be 84.8%. Again assuming margin rather than cash is used to secure the short puts.

If the stock declines below $40 per share at the April expiration, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 200 shares of Valeant at $40.00 per share. The average cost for the 400 shares would be $30.82. You need to be comfortable with the average cost base for the 400 shares.

Richard Croft
Richard Croft

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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