How To Play Lorillard With A Put Option
In this previous article, I talked about the investment opportunity in the stock, Lorillard, which is a tobacco company based in the U.S. If you are trading the stock, you only have a few options to take your position. You could buy the stock, or sell the stock short (this entails ‘borrowing’ the shares, selling them, then at some future point buying back the shares at a lower price to cover your borrowing).
Another way to play this company is to use options. Options are new for me, so the strategy that I will use is to consider simple one position options. Conceptually, it should be evident enough about what we are trying to do with the option (as I’ll explain), but as I’ve found sometimes the terminology about the transactions gets confusing. So, I will give it my best shot to describe this trade (as I am learning it as well).
The uncertainty in the Lorillard stock manifests itself as higher volatility in the options. Volatility is a typical expected large change in the stock price, or perhaps even the expectation that there could be a big change even if the stock price doesn’t typically have high volatility.
The risk for Lorillard is that the FDA could rule that menthol is to be banned as an additive to cigarettes. As I’ve talked about before, I think this is unlikely, but not out of the realm of possibility. So, the question is, if you are a big shareholder, how do you protect yourself from such a risk? One answer is to buy what’s called a Put Option. A Put Option enables the buyer to sell the stock at a set price (the ‘strike’ price) when the underlying stock price trades below the strike price.
As an example, let’s say Lorillard trades for $80/share. The shareholder wants to protect himself from potential downside by buying a Put Option with a strike price of $65. This means that if Lorillard trades below $65 during the life of the option he can always get $65. If catastrophe strikes he will always be able to sell for $65.
This is where we come in. Wherever there is a seller there must be a buyer. We are that buyer who will pay $65, if it ever came to that point. Here’s where the terminology gets tricky. Since the shareholder bought a Put, we will then become a Put Seller. If the Put goes ‘in the money’ at any point (the underlying stock price is below the strike price) we would be obligated to then buy the shares at the strike price. Yes, that’s right we sold a Put to become a buyer of the stock.
This trade has both downsides and upsides. Let’s consider them.
Downside And Risks
- By far the biggest risk is that the FDA rules that menthol should be banned, probably phased out over a time period. The advisory committee will offer a non binding recommendation in March 2011, which the FDA could then use or ignore. I would quantify this risk as 30-40 a share, given that any ruling (if it occurred during the life of the option) wouldn’t wipe out profits immediately but over time. So, we would be out perhaps as much as $20/share since we would be obligated to buy the shares.
- Another risk of this trade is opportunity cost of missed dividends. Let’s say nothing happens to impact the company, we would have lost dividend income (which is quite substantial for this company, almost 7%) because we don’t own any shares, just the option. A more complicated option strategy, a covered call, could accomplish the same thing while still collecting dividends.
- Finally, there is upside risk. Let’s say that the FDA rules that menthol is OK and no changes are required. The stock may go up $10-15, which we would not participate in since we don’t own any shares by taking this option position.
Upside And Profit
- The biggest upside to this trade is that we can earn a substantial option premium that we get to keep no matter what happens. If the likely scenario occurs (the ruling causes no big impact to profitablilty), then the option expires worthless and we keep the money. Because the Put Option buyer is paying a premium to get this protection, we earn money on the option by entering into the transaction. Because of the implied volatility of the option, this premium is substantial.
- Another possibility is that the market itself causes a sell off in the stock price unrelated to the issues facing this company. This is the best of all possibilities, because we can then own a great company for less money since the shares would be ‘put’ to us. Income investors get ahead buying cheaper, because investment yields go up.
Take This Put Position
This is the trade that I will be establishing, if I can get it at this price:
Sell Lorillard June 2011 Put, Strike Price: $65, Premium: $4.
This means that for each contract (100 shares), I will collect $400 in premium.