Long Positions Using In-The-Money Options
Taking a long position in high priced stock by purchasing DITM calls or Selling Deep In-The-Money Puts has many merits. This article will talk about selling DITM puts, the logic and the analysis behind them. Specifically this article will focus on DITM puts expiring in one year.
Selling DITM puts, particularly longer dated requires a bullish fundamental outlook on the company. However, instead of Buying a DITM call (and spending a lot of premium), selling a DITM puts generates a lot of premium and gives the seller a good cost basis should they be assigned on the put.
A chemist friend of mine sold DITM puts on BIIB on January 8, 2015. I’ll use his trade because it has the advantage of a real time thought process. To protect the innocent, my friend will be called the Chemist. But he doesn’t make biochemical weapons or illicit drugs. Instead, this chemist creates smell and tastes. Think vanilla and lavender. He married a Ph.d. twice as smart as him. And yes, they continue to live happily ever after.
But I digress. The Chemist is also an options trader. He has traded options for his personal account for over 40 years. Against this backdrop, I’d say he’s a man worth hearing.
On January 8th BIIB was trading at $350.00. The Chemist sold the January 2016 puts (with 371 days to expiration) with a strike price of $400 @ $78.00.
If the 400 puts are assigned, the seller owns the stock at $322 or $28 lower than the current market price.
In other words, the put has $28.00 of time premium (400 – 78 = 322; 350 – 322 = $28). $28 on a $350 investment for 371 days = 7.87% annualized time premium.
Dividends: The stock pays no dividends so we don’t need to worry about getting assigned on our put after the dividend is paid.
Cost to Carry: .60% for one year; The cost to borrow money for one year.
The Chemist was pleased with the risk-reward, but needed to confirm that the puts were trading at a “fair price”. N.B.: in this sense, “fair price” has nothing to do with volatility, but rather put-call parity.
Put-Call Parity states that the Synthetic Forward Price (using options) must equal the Actual Forward Price. If there is a difference then there’s an arbitrage or miscalculation.
Put-Call Parity Check: We can check parity easily by looking at the price of the 400 call expiring in January 2016 was trading at $30.03 (time premium). The calls have $2.03 have more time premium than the puts. The last thing to check is how much it would cost to carry the stock for 371 days.
Synthetic Forward Stock: The 400 calls trading at $30.03 & the 400 puts trading at $78.00 = a synthetic long forward stock is trading at $352.03. Buy calls @ $30.03 & sell puts @ $78.00 = $352.03
Actual Forward Stock: borrowing $350 at .6% for 371 days means the Actual Forward Stock is trading at $352.03
Put-Call Parity: Synthetic Forward Stock ($352.03) = Actual Forward Stock ($352.03)
Matching Options Expiration with Your Objective
The transaction my friend put on, with more than a year to expiration must include his fundamental view. The option captures 4 more earnings cycles so some homework on projections might not hurt.
On the other hand if your goal is to capture the current earnings season then the trade will be evaluated from a technical point of view and a shorter dated option may be used. That’s a story for another blog.
The Fundamental Story
On January 30, 2015 Biogen (BIIB – NASD) announced stellar earnings last week and closed the day at 389.16. Biogen’s profits doubled on strong sales of its MS drug Tecfiderai. Revenues grew by 40% since 2013 largely due to Tecfidera which launched in 2013. In just one year, Biogen captured 20% of the MS drug market. Biogen is testing an Alzheimer’s drug known as BIIB037, but t’s too early to estimate the cost-revenue impact of BIIB037. The company also currently has good financials, with miniscule debt and good liquidity in the common stock.
You can read more details about Biogens 4Q14 earnings here.
The chemist could have covered the 400 puts for around $56 on January 30. A $22 profit in 12 days is nothing to sneeze at. The chemist has to decide if he wants to remain short the put for another 350 days or take his profits today.
But…That’s a story for another day. After all The Chemist deserves to keep some secrets.
Happy trading, Everyone!