Sometimes choosing the right bullish strategy can be a really difficult decision. For the most part we will sell the put as we are income orientated investors as opposed to strict capital gain investors. However there may be times where buying the stock may be a better risk/reward set-up especially if strict stop loss management is used. For example when a stock gets badly beaten up, has sentiment on the floor but still has a strong balance sheet, then the risk reward setup may tilt towards buying stock. Why? Well you have limited profit potential which is something we cant say of the naked put option. For example, look at how Apple (NYSE:AAPL) and DIS (NYSE:DIS) rallied out of their lows last year. If one had sold puts near the lows, the maximum amount of profit that one would have gained would have been the price of the put option. In fact, as both stocks rallied aggressively out of their lows last year, neither one really suffered a down-tick since which would have made it difficult for a re-entry.
However we have all witnessed stocks that were potential value plays but never gained traction for one reason or another. Furthermore we have to admit that both Apple and Disney were helped by the strong tailwind of rising US equities. Therefore selling put options definitely have their place because straight off the bat, the investor is lowering their cost basis on the trade and improving their probability of success. Yes one may capping their gains but income investors would prefer to have multiple setups like the ones mentioned instead of going all in on a stock based trade.
Selling options take advantage of theta decay. Theta essentially is a measure on the speed at which an option loses its time value over the duration of the option contract. This is really the crux of the issue and why astute investors sell options aggressively to have the probabilities work out in their favor. Think of it as leverage. Selling options definitely gives us leverage by default as those options lose value very day. Yes you have to defend positions when strike prices get breached for example but theta decay definitely works in favor of the option sellers and not the option buyers.
High implied volatility is usually the tipping factor whether an investor/trader ends up selling option premium or buying the stock. Why? Well as discussed in a previous post, volatility is mean reverting which means it invariably reverts back to its averages. Therefore selling premium when IV is high is a smart play especially on stocks that are trading on the cheap and have strong competitive advantages. One stock I have been eyeing up lately is L Brands Inc (NYSE:LB) which is trading with unusual high implied volatility at present. The company doesn’t announce earnings until the 17th of May so IV should not be this high this early (see below).
As the chart illustrates, the present implied volatility of L Brands is well over 40% whereas the average is well under 30%. This screams opportunity straight away to option sellers because we are dealing with a quality company that has had its stock badly beaten down here. Before we get into the fundamentals, let’s go through the valuation. Presently the company has the following valuation multiples ( see below) which are much lower than L Brands historic averages.
Earnings per share came in at $3.98 when the company closed out its full year in January last. This was down from $4.22 the previous year (January 2016) which was the company’s highest year with regard to earnings. The dip in earnings has meant the stock has practically been cut in half over the past 12 months. Let that sink in for a moment. Although it may take a few years for annual earnings to surpass the 2016 number, analysts are expecting earnings to keep grinding higher as can be seen from the forecast chart below.
Furthermore the two metrics to watch closely in the apparel sector are operating margins and top line revenues. Well sales are expected to reach $12.6 billion this year and $13 billion the following year due to rising eCommerce sales and stabilization in international markets. Operating margins continue to hold strong around the 16% level and with good reason due to an array of strong brands such as Victoria’s Secrets and Bath & Body Works. Stores may be struggling of late compared to recent years but gross margins continue to hold above 40% which illustrates to me we are not dealing with brand impairment issues here.
Value investors may be dissuaded by the company’s long term debt load of $5.7 billion which currently dwarfs the amount of equity on the balance sheet. However personally I would be taking a bullish stance by either being long stock or selling bullish option trades such as naked puts , put spreads and jade lizards. On long stock positions, one could also sell covered calls to avail of the high implied volatility. By selling puts for example, this is the type of set-up that if one was assigned shares or elected to roll, the assignment would be at an attractive price.
Going forward the company will continue to ditch low margin channels and focus on higher margin opportunities such as eCommerce and international franchise opportunities. Remember this stock currently pays out a large dividend yield of 4.82%. The pay-out ratio stands currently at around the 60% level and the dividend has doubled in dollar value over the past three years (Currently $2.40 annual payout). Concentrate on the big picture here. This stock should go north. As always, the timing of this pending move is always the hardest metric to predict. That is why selling premium and taking advantage of the stock’s high implied volatility seems like a low risk set up here.