January 2010 Performance Summary

The Position Theta portfolio had a very good month on an absolute-return basis, and an even better month when compared to the performance of the S&P 500 (the benchmark I believe provides the closest comparison). The portfolio returned 3.49% in January, compared to -3.7% for the S&P 500.

At month end the portfolio consists of $98,925.12 in cash ($23,927.60 of which is reserved in connection with naked puts sales) and $11,480 in investments.

Since inception (10/13/2009), the portfolio has returned 10.4% vs. .06% for the S&P500, for a net difference of 9.8%. Note that this performance has been achieved through exclusively delta positive investments, or those that increase with an increase in the price of the underlying security (I have not entered into short-like investments).

Underlying security selection has been key thus far, with sizable gains in diagonal calendar call spreads on BKE, BRK.B and LMT, and short-term naked put sales on APP and APWR. The BRK.B spread benefited this week from S&P's inclusion of the stock in its index, while my willingness to "double down" on BKE and LMT spreads following large price decreases proved profitable. The jury is still out on my LO spread, but I am confident that the position will turn solidly profitable as we near March expiration. I sold high implied volatility puts on APP and APWR at strike prices I was willing to purchase the underlying stock. Each was repurchased for a marginal amount before expiration resulting in high IRR's on these positions. As might be expected from a down month, my long term (January 2012) put sales (CHL, V, NKE, USO) performed the worst, and have lost money thus far in the aggregate. With the exception of USO, which is a more speculative investment than I will normally enter, each of the underlying stocks I've sold long term naked puts on is an enviable business trading at a reasonable valuation. I believe that these positions will add substantial value to the account over the next couple of years.

I note that one of the benefits of selling puts while at the same time entering into diagonal calendar call spreads is that the two positions hedge volatility nicely (one is short vega, the other long). While I'd rather be a net buyer of volatility now, over time I'd generally like to be vega-neutral. With a few exceptions, the account will be built around trades designed to profit from directional movement and time decay, not volatility trades.

BRK.B Diagonal Call Spread

On Friday (1/22), following the 50-1 stock split. I entered into a calendar call spread on BRK.B consisting of buying ten June 66s and selling eight March 70s, for a net debit of $4,660 less commissions. I entered the position believing that Berkshire is undervalued, largely a result of the market's apprehension about Buffett's well publicized purchase of Burlington Northern for a full price (BRK now trades at a ten-year low price to book multiple), but more in anticipation of increased buying pressure as a result of BRK.B's likely addition to the S&P 500, which I think will result in BRK.B trading at or slightly above $70 per share for the foreseeable future. Yesterday, S&P announced the addition and the stock traded up roughly 5% today. The position has been successful thus far, but I believe there is far more upside due to time decay over the next several months. Max profit is unlimited because of the additional 2 June 66s. The position will be solidly profitable if BRK.B trades at or above $70.00 at expiration.

APP Put Repurchase and ATVI Put Sale

APP Put Repurchase:

Yesterday, I closed out a position I've held for a couple of months, repurchasing the forty Feb 2.5 puts on American Apparel, Inc. (APP) I had sold on 11/11 for $5 per put, or $200 plus commissions. In November, I had sold the puts for a net credit of $1,600, less commissions. My thesis in selling the puts was first that APP's price would likely stay above $2.50 (which turned out to be correct), but I nevertheless entered the position ready and willing to purchase 4000 shares of APP at $2.50 if exercised. I'm content with the $1,400 profit (less commissions). Note that factoring in the entire amount of reserved cash necessary to exercise ($10,000), IRR on the position turned out to be around 100% (less if I had held until expiration).

ATVI Put Sale:

After repurchasing the APP puts, I sold ten March 10 puts on Activision Blizzard, Inc. (ATVI) for a net credit of $500, less commissions. This market leading video game publisher has seen its stock drop substantially over the last several months as the market's come down from lofty holiday season expectations and a Call of Duty MW2 high. ATVI is an excellent business, with tremendously valuable video game franchises, and more than $3B excess cash on its balance sheet. Before subtracting its excess cash, the stock trades at a little more than 13x analyst expectations for 2010 earnings. I think ATVI is a compelling medium to long term investment at its current price, and even more so at an effective purchase price of $9.5 per share ($10 strike price less $.5 put premium). As such, exercise may not be a worst case scenario.

Lorillard, Inc. Diagonal Call Spread (Update)

On 12/20, following a several-week stock price decline, I increased my exposure to LO by entering into an additional diagonal call spread, by selling 5 March 75 calls, and purchasing 5 Jan 2011 70s, for a net debit of $2,800 less commissions. Max profit on this second spread is $75 per share, but because of my prior spread, my max profit on LO is between $75 and $80 at expiration.

My current LO exposure consists of long 10 Jan 2011 75s, and 5 Jan 2011 70s, and short 10 March 80s and 5 March 75s. The position in the aggregate has a substantial amount of theta (roughly 20 increasing as we near March expiration) and delta (roughly 240).

In the event LO increases to $80 per share at or above before March expiration, I will likely take some delta gains, and decrease my exposure.

Two Unrelated LEAP Put Sales (CHL and V)

Summary: On 12/28, and 1/5, I sold long-dated puts on Visa Inc. (ticker symbol: V) and China Mobile Ltd. (ticker symbol: CHL), respectively. The positions consist of the following: (i) sell 3 January 2012 50s on CHL for a net credit of $3,630, and (ii) sell 2 January 2012 80s on V for a net debit of $2,250. In connection with the sales, the brokerage account reserved $6,330.60 and $4,367.60 respectively, which will increase or decrease depending on the underlying price movement of the stocks. Note that for simplicity's sake I record my return on investment (or IRR) assuming that the amount of reserved cash for each position stays static from the moment of sale. I'll also report IRR using the entire amount of cash required upon exercise as opposed to just reserved cash.

CHL Rationale: Similar to my Nike put sale which I wrote about on 12/27, the CHL puts were in-the-money at the time of sale, but are now at-the-money. As of today, the price of the puts will decrease at close to a .5 to 1 ratio with an increase in the price of the stock. The puts carry a substantial amount of time value (around $9.6 per share) - resulting in time decay which will expand nearing expiration. Instead of purchasing the stock directly, I've chosen to maintain a good amount of downside protection over the next two years (break-even at about $40.4 per share as of today, or 19% below today's closing price - note that this calculation ignores CHL's dividend), free up capital through the use of zero-cost leverage while maintaining a substantial amount of upside on CHL in the event the stock price increases substantially in a short period of time. As the largest telecom provider in China with the government's backing, CHL is a terrific business and has grown substantially and consistently over time. It generates an enormous amount of cash, which increases each year as China's population becomes wealthier and adopts modern technologies, and trades at a very reasonable multiple of its earnings (about 12x trailing earnings). Fortunately, given general market discomfort with China, the puts carry a substantial premium. The worst-case scenario for the position - an effective purchase price of CHL of $40.4 per share in two years - would most likely represent an opportunity for a solid investment going forward.

Visa Rationale: Note that unlike the CHL and NKE puts, the V puts are out-of-the money. Due to a substantial increase in the price of the stock, the stock's volatility, and the overhang of some large litigation, V puts also carry substantial premium. Nevertheless, V is an exception business - a capital light, "toll-road" model, with enormous international growth potential as credit and debit cards become more ubiquitous globally. By selling the long-term puts, I can target a much cheaper effective purchase in two years (roughly $69.5 per share, or about 19% below today's price), or capture time decay in the event V continues to increase or stays flat. I have little doubt that V will continue to be a market leader in a growing industry over the medium to long-term.

Lorillard, Inc. Diagonal Call Spread

On 12/9 I entered into a diagonal call spread on tobacco company Lorillard, Inc. (ticker symbol: LO), manufacturer of the Newport menthol cigarettes, which consisted of selling 10 March 80s for $3,200, and purchasing 10 Jan 2011 75s for 8,000, or a net debit of $4,800, less commissions.

While I've failed to discuss the position on the blog for more than a month, its pricing has stayed largely flat so its ultimate success or failure is largely yet to be determined. Lorillard, like most major tobacco companies, is a terrific business - it operates with very high gross and operating margins and generates enviable (and sustainable) returns on assets and equity, due to the scale and pricing power of a successful cigarette operation and its loyal customer following. While LO doesn't have a growing international operation like several of its competitors, and the US domestic cigarette market faces significant headwinds, LO's current price more than reflects these weaknesses. With excess cash on its balance sheet, LO trades at an enterprise value of roughly 7x trailing EBITDA. In short, I consider LO at its current price to be a compelling long-term investment.

Similar to the rationale for my LMT diagonal call discussed yesterday, because of the headwinds facing US tobacco sales and the general lack of excitement regarding the tobacco business I don't believe LO has the potential for short term pops in price, but will likely increase gradually over a long period of time due to stock buybacks and dividend increases. This position will allow me to profit from time decay if the stock stays relatively flat towards expiration, at which point I will roll over the March calls to a later month. In the event LO does increase substantially, the position won't make much money if any, but will not lose money. In the event LO decreases substantially, and the business fundamentals remain intact, I will look to increase exposure.

Lockheed Martin Corporation Diagonal Call Spread

Summary: On Tuesday, following a several week decline in the price of Lockheed Martin stock (ticker symbol: LMT) to the $75 range, a price at which I think LMT is a compelling medium to long term investment because of its historically low multiple of earnings, conservative capitalization and long term market advantage (see my original LMT post dated 10/17), I took the opportunity to establish a new diagonal call spread by selling ten Feb 75 Calls for $2,950, and purchasing ten June 70s for $7,900 (or a net debit of $4,950 ($4.95 per spread), less commissions). This represents a second bite at the apple - see my 12/24 post where I discuss closing out a previous LMT diagonal call spread for a net profit of $1,148.22. The profit and loss chart on the position looks something like the following:




Break-Even Price: Break-even price is likely around $72.5 per share depending on implied volatility at the February expiration.

Maximum Profit Price: Max-profit is at $75 per share. Note that the options I am short are in-the-money. Because I don't think LMT has much upside potential over the next couple of months, I've chosen a position that will profit if the stock largely stays flat or moderately declines. Nevertheless, because my net debit for each spread was below $5.00 (the difference in strike prices), the position won't lose money on the upside, it just won't be profitable.

Potential Downside: Downside is limited to the net debit, or $4,950.

Greeks: As of today, position delta was around 100, which will rapidly decline to 0 if the stock price increases (as discussed above, max profit is at $75, below today's stock price of $76.84). Position theta is substantial at around 20 (theoretical $20 per day due to time decay assuming static price and IV) and will increase as we near expiration assuming a relatively flat stock price. Like any calendar or diagonal call where the investor buys the long dated option and sells the short dated option, the position has positive exposure to vega, or implied volatility.

Follow-Up: In the event LMT stock declines drastically before expiration, I will look to add exposure so long as LMT's fundamental strength remains intact. Like my original LMT diagonal call spread, the optimal turn of events would be for LMT to stay in the mid 70s prior to expiration, allowing me to roll the February 75s to a later month while keeping the June 70s.

Rick's Cabaret International, Inc. Puts (Repurchase)

Today, I repurchased the ten RICK February 2010 7.50 puts I had sold on 10/28, for $5.00 per put, or $50.00 total, less commissions. Instead of waiting until expiration and in all likelihood collecting the additional $50.00 of premium, I chose to lock in profit of $1,013.09 and free up the reserved cash more than a month prior to expiration.

Following strong quarterly earnings, two new acquisition announcements and an analyst upgrade, the market has become much more optimistic about the strip club operator's future, and is beginning to price the company at a multiple of earnings closer to what I believe is fair value. While I continue to like the stock's medium to long-term potential, I likely won't sell additional puts unless the stock declines substantially over the coming months.

IRR on this position, taking into account just the amount of reserved cash in the brokerage account, was 1,100%+. IRR on the position when taking into account the full amount of cash required to exercise ($7,500) was 100%+.

True Religion Apparel, Inc. Puts (Repurchase)

Today I repurchased the four July 2010 True Religion puts I had sold naked on 12/7, for a net debit of $2,160, plus commissions. Following a string of better than expected retail numbers and general market optimism, True Religion's stock price has increased substantially over the last month. While I continue to like the stock's long term potential, I've decided to take the opportunity to lock in a substantial gain over a short time period, while decreasing my reserved cash balance. In the event the stock's price declines over the coming weeks, I may look to sell additional puts.

Net profit on the position was $896.30, and the position's IRR (including taking into account reserved cash) is the unhelpful 18,000%+.