Sunday, July 31, 2011

Generating Income - Anybody?

I last wrote about HP in the June 19 article that can be accessed here. In that I argued that HP seems to be trading at a cheap price compared to its inherent value. The big unknown of course is whether the new CEO will focus on growing the company organically or doing expensive acquisitions. At the time of the article, HP was trading around 35$. When I looked at the price again recently the price was back at 35$ after having gone through some ups and downs!

As I was thinking about ideas of investment, I realized that the market has been more volatile recently with the US Debt debate. While this will definitely have impact on various companies, its impact on some of the technology companies (including HPQ) should be quite limited. Besides, the volatility has meant that the option prices should have gone up. With that here is my new idea.

Sell Put Options

There are a few put options for HPQ that seem interesting and below I lay them out along with approximate returns.

Approach 1

Sell HPQ Put Option maturing Aug 19, 2011 with Exercise Price of 35$
Premium= 1.10 – 0.05 (Transaction Cost) = 1.05
Return  = 1.05 (Premium) *12 (# of Months) / (35 (Exercise Price) * .5 (Maturity in Months))
            = 72% Annualized
Risk      = You may be forced to buy the stock at 35$. So only use the strategy if you are comfortable owning the stock at 35$. Since the price of the stock is 35.17$ it stands to reason that the fair price judged by the market is slightly above the exercise price.

Approach 2

Sell HPQ Put Option maturing Sept 16, 2011 with Exercise Price of 34$
Premium= 1.15 – 0.05 (Transaction Cost) = 1.10
Return  = 1.10 (Premium) *12 (# of Months) / (34 (Exercise Price) * 1.5 (Maturity in Months))
            = 25.9% Annualized
Risk      = You may be forced to buy the stock at 34$. So only use the strategy if you are comfortable owning the stock at 34$. This approach provides the added comfort that HPQ price has not touched 34$ over the last 2 years.


I would recommend that the above strategy minimally requires the following:
  • Cash hoard by the investor so that you can buy the stock at the above prices if the buyer of the option chooses to exercise.
  • Investor's fair price of the stock is around the exercise price level so that (s)he is comfortable buying the stock at those prices.
  • Investor could also potentially short the stock but I am not sure the funding cost for that and hence I am not suggesting that here.

Apart from the above, Option prices by definition are quite volatile. Hence one should only invest in them if they are comfortable with the volatility. If you are likely to be forced out of your position at the wrong time then options are not good for you.

Disclosure: I don’t have position in either of the options mentioned above.
Disclaimer: All views expressed in this article are the author’s own views. They don’t represent the views of any company or organization that the author may be affiliated with. This is not a recommendation to buy or sell. You need to do your own diligence before buying or selling.

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