Position Theta

January 2010 Performance Summary

2010-01-30T12:41:00.000-08:00

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

2010-01-27T21:47:00.000-08:00

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

2010-01-27T21:20:00.000-08:00

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)

2010-01-26T10:12:00.000-08:00

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)

2010-01-15T13:38:00.000-08:00

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

2010-01-15T10:29:00.000-08:00

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

2010-01-14T17:42:00.000-08:00

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)

2010-01-11T11:28:00.000-08:00

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)

2010-01-08T15:32:00.000-08:00

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%+.

Nike In-the-Money Naked Put Sale

2009-12-27T11:08:00.000-08:00

Summary: On 12/17, I sold 2 Nike $70 Puts, expiring January 2012, for a credit of $3,040, less commissions. In connection with the sale, my brokerage account reserved $5,573. If exercised, I will be required to make a $14,000 purchase.

Max Profit: Max profit on this in-the-money naked put sale is the amount of premium collected, $3,040, less commissions, which will occur if Nike (ticker symbol: NKE) is at or above $70 per share at expiration.

Max Loss: Max loss on the position is $14,000 less the $3,040 premium collected, or $10,960, which would occur if Nike stock went to $0.

Break-Even Point: Break-even point, ignoring the time value of money (I've collected the premium in advance), is $54.80 per share at expiration, which is roughly 13% below Nike's price on 12/17.

Rationale: Nike, one of the great American brands and companies, has delivered terrific revenue and income growth rates as well as returns on assets and equity over the last twenty years, and shows few signs of slowing down. The company has great international opportunities, is conservatively capitalized with very little debt and excess cash, and spits off a tremendous amount of cash which can be used for acquisitions, stock buybacks and dividends. Trading at around 21x trailing earnings and 16x forward earnings, Nike isn't unreasonably expensive, but above a price at which I'd consider the stock for an outright investment. By selling long dated in-the-money puts with a good amount of extrinsic value (13%), I can target a much cheaper purchase price in the distant future for a stock I'd like to own, while taking part in a substantial amount of upside in the event Nike's stock continues to rise. (Note, however, that this 13% figure should be discounted by dividend payments, which are currently 1.08 per share.) If, as predicted by analyst and management, Nike experiences continued revenue and earnings growth, an effective purchase price of $54.80 in two years would be substantially cheaper than $54.80 today. Analyst are predicting diluted EPS for the fiscal year ending May 2011 of $4.10, which would make an effective purchase price of $54.8 13.7x earnings, far below Nike's historical multiple of trailing earnings, and a multiple at which I'd be glad to purchase the stock. In addition, this position requires little investment on my part - reserved cash of around $5,573 less the put premium of $3,040, or $2,533. If Nike were to simply stay at its current price until expiration, my investment return would be roughly 68%. (Note that for simplicity's sake, in calculating returns I am assuming that reserved cash stays stagnant over the life of the call. In reality reserved cash increases with a decline in the price of the stock and decreases with an increase in the price of the stock. If Nike stock declines substantially prior to expiration, this position would effectively require more investment in the form of reserved cash.)

In the event Nike stock continues to rise prior to expiration, I will repurchase the put and take gains on the position when I believe risk outweighs any additional reward. In the event Nike stock declines substantially prior to expiration, I will likely sell additional puts for more premium. Note that fundamentally this position reflects a long investment in a stock and company I feel strongly about over the medium to long term.

Some House Cleaning

2009-12-24T16:56:00.000-08:00

Over the past several weeks I've made a number of trades in the account but haven't had a chance to post. Below summarizes a few trades I've made to close positions, and the returns for each of these positions. I also summarize a rolling trade made for a net credit last week. Later posts will summarize two new positions.

A-Power Generations Systems, Ltd. Naked Puts

On 11/3, I sold 10 March $10 APWR puts for a net credit of $1700. I entered the trade with the idea that if exercised, I would purchase the stock at an effective purchase price of $8.30 per share less commissions, a price at which I considered the stock to be a compelling investment. Alternatively, if the puts expired worthless, I was happy to collect the $1700 of premium. Since selling the puts, the stock ran away from me. On 12/17, I took the opportunity to repurchase the puts at $.30 per share, substantially before expiration. My net gain on the position was $1,349.95.

Including commissions, and taking into account the amount of cash necessary to purchase the shares upon expiration ($10,000), my real return on this investment was 16.22%, or an IRR of 247.85%. My return on the position taking into account just the reserved cash required by the brokerage borders on the absurd and isn't a particularly helpful number (this number will however be taken into account in determining my aggregate returns because it will presumably be offset by losing positions overtime).

Lockheed Martin Diagonal Call Spread

On 12/17, I closed out my diagonal call spread on LMT. I had originally opened this position on 10/15, before their Q3 earnings report by purchasing March 70 calls, and selling December 75 and December 80s. Following management remarks regarding a poor outlook, the stock dropped substantially, and I decided to ratchet down the position by buying back the December 80 calls and selling additional December 75s, for a net credit. In late November I then rolled the December 75s to January for a net credit. Subsequently, the stock steadily drifted upwards and on 12/17 I ultimately repurchased the January 75s and sold the March 70s. Ultimately, the position (actually multiple positions) resulted in a profit of $1,184.22, and an IRR of 142.3%.

Over the next several months, I will look to reestablish a Lockheed Martin diagonal call spread when an opportunity presents itself.

Buckle Diagonal Call Ratio Spread

On 10/23 I entered a diagonal call ratio spread by purchasing 6 June 25s and selling 4 December 30s. On 11/20, I added to the position by purchasing 6 more June 25s, and selling 5 more December 30s. Finally, on 12/18, I rolled the December 30s to March for a net credit of $1,627.91. This position is currently outstanding.

True Religion Apparel, Inc. Puts

2009-12-08T17:22:00.001-08:00

Summary: Today I sold four True Religion Apparel, Inc. (Ticker Symbol: TRLG) July 2010 25 puts for a credit of $3,080.00, less commissions. Because the puts were sold "naked," my brokerage has reserved $4,602.40 of cash in my account. The net result of the transaction is a decline in my purchasing power of $1522.40.

Break-Even Point: Break-Even point on the transaction is around $17.3 per share, or about 5.5% downside protection from the stock's price at the time of sale.

Max Profit: Maximum profit is the credit of $3,080.00, less commissions, which will be achieved if the stock is at or above $25 per share at expiration.

Potential Downside: My maximum potential loss on the position is $6920.00, plus commissions, which will occur if the stock goes to $0.

Greeks: Given that these are deep in-the-money puts, the position's delta shows what is roughly a 1 to 1 ratio with the stock's price. Theta is moderately positive because of the roughly $1.00 in extrinsic value and will increase closer to expiration or with a rise in the stock (due to an increase in extrinsic value).

Rationale: Following a recent quarterly earnings miss, True Religion (a high-end jean manufacturer and retailer) has seen its stock price decline substantially to a six-month low, and is now trading at a very compelling multiple of trailing and forward earnings - about 9.6x and 8.6x respectively, less on an enterprise value basis (due to a net cash position of roughly $80M). The company has exhibited tremendous growth during its short existence, has built a great brand (albeit an expensive one) and has a loyal following which has largely continued purchasing the company's products during this long recession. While there is certainly an abundance of competition in the high-end denim market and the continued recession will no doubt dampen TRLG's earnings, I believe the company's current valuation offers a compelling risk-reward ratio over the coming years. To capture a significant amount of this upside, while providing a moderate amount of downside protection, I've sold the July 25 puts. In the event the stock continues to decline and the puts are eventually exercised, I will have purchased the stock at an even more compelling valuation (assuming no serious and permanent decline in the company's business). In the event the stock rises, I will look to exit the position after a significant decline in extrinsic value.

Lockheed Martin Diagonal Call Spread (Update)

2009-11-24T16:17:00.000-08:00

Yesterday, following several weeks of upward movement in LMT, I rolled the 15 December 75s I had sold to January, for a net credit of $1,350, less commissions. This trade raises cash, increases my downside protection after the recent rise in stock price, and and will allow for more time decay provided that LMT stays within the 75-80 range prior to expiration.

Buckle Inc. Diagonal Call Spread (Update)

2009-11-20T12:55:00.000-08:00

Today, I added to my existing Buckle diagonal call spread by selling 5 December 2009 30s, and purchasing 6 June 30s, for a net debit of $2,300 less commissions. This week Buckle reported strong earnings while its stock price continued to drift lower - I continue to like Buckle's medium to long term potential.

American Apparel Inc. Naked Puts

2009-11-20T11:13:00.000-08:00

Summary: On 11/11, I sold 40 February 2010 $2.50 puts on American Apparel Inc. (APP), at $.40 each, for a net credit of $1,600 less commissions. APP closed at 2.58, and has since risen substantially to above $3.00. The puts are worth about $.25 each today.

Rationale: The controversial American Apparel's stock price has drifted aimlessly for the last several months following a liquidity and potential bankruptcy scare earlier in the year. The company is a unique participant in the retail marketplace with a loyal following and a growing international market. However, management has struggled to convert revenue growth into bottom line growth, and has dealt with several legal issues, and the current price reflects the market's well-deserved apprehension about the company's long term viability. Because of this apprehension and the stock's volatility, the February $2.50 puts offered substantial premium on 11/11. If exercised, my effective purchase price would be $2.10 per share, less commissions, which is 18% below the 11/11 closing price, and roughly 31% below today's price. At $2.10, I believe the stock's upside more than compensates for risk incurred. In the event the puts are not exercised, I will have generated a real return of roughly 19% on the amount in cash required to exercise the puts (not the amount of my margin requirement) over about a 4 month period.

A-Power Energy Generations Systems, Ltd. Naked Puts

2009-11-03T20:05:00.000-08:00

Summary: On Tuesday, I sold 10 March 2010 $10 puts on A-Power Energy Generations Systems, Ltd. (APWR), for a net credit of $1,700 less commissions. A-Power closed Tuesday afternoon at $11.39 per share. Because I have sold the puts "naked," cash collateral of $2,700 as of Tuesday's close was required (this collateral will increase or decrease depending on the underlying stock's price movement).

Rationale: A-Power's core business is building onsite power generations systems in China, but it also has a rapidly growing wind turbine design and manufacturing business. This year it has won several contracts to build turbines for various partners in China, entered into a joint venture to build turbines with General Electric, and this week announced its participation in a $1.5 billion wind farm project in west Texas. The stock is a true growth story - revenue was $152M in FY 2007, $264M in FY 2008, and analysts estimate revenue to be $324M in FY 2009 and $574M in FY 2010. Earnings have followed a similar upward path. Nevertheless, the stock trades at less than 9x projected forward earnings and less than 15x trailing earnings. The company's balance sheet is pristine with roughly $40M cash and no debt.

That being said, the stock is tremendously volatile and its future is tied to the continued demand for a rather speculative product in a developing market. By selling out of the money puts, I can target a much more conservative purchase price, in this case effectively $8.3 ($10 strike price less $1.70 in premiums), which is around 26.5% below its current price, and would be less than 10x trailing and 7x forward earnings. In the event the puts are not exercised and the puts expire worthless, I will have generated a real return of 20.4% on my reserved cash (less the option premium) over a five month period (IRR of roughly 65%). Note that because this stock is very volatile, the options hold the level of premium necessary to generate this sort of return. Because I'd be glad to purchase the stock at $8.3 per share and go long, I can use high volatility to my advantage as a value-driven investor. Note the difference between this approach and merely selling high vega to generate higher returns.

Rick's Cabaret International Puts

2009-11-01T20:59:00.000-08:00

Summary: On 10/28, following a severe decline in the price of Rick's stock (RICK), I sold 10 December 2009 7.50 puts, for a net credit of $1,100. At the time, the puts were slightly in the money. Because these are "naked" puts, a brokerage will require cash collateral in the event of exercise, which as of 10/30 was $2,537.

Rationale: Rick's, the owner of several "adult nightclubs" (strip clubs) is a stock I follow and have long thought to be a good investment if purchased at an appropriate price. It trades at a low multiple of earnings (which as of 10/30 was roughly 7.5x predicted forward earnings) and generates strong free cash flow. Rick's is a consolidation story - it acquires clubs generally at low multiples of earnings (likely possible given the lack of buyers and general unsophistication within the industry), which are, in most cases, immediately accretive to earnings (there are exceptions - the company acquired the old Las Vegas Scores at a hefty price and which has since been a losing investment). In the event the puts are exercised, my effective purchase price would be $6.4 per share ($7.50 less the $1.10 premium). This price would value Rick's equity at less than 7x forward earnings, a multiple I believe more than prices in the past year's lackluster earnings and liquidity scare (which has since abated) and the current economic environment, and would present a favorable risk/reward scenario to go long the stock. After purchasing the stock, I will look to sell calls against my holdings so long as I can capture favorable premium at an appropriate price. If the puts are not exercised, and Rick's stock closes above $7.50 per share as of the December closing, the captured put premium would represent a roughly 17% real return on the cash required to purchase Rick stock, less the put premium, over a two month period, and obviously an even higher return on my actual reserved cash. Note that given the possibility of exercise, I do not find it appropriate to calculate return on this investment using merely a brokerage's margin requirements as the amount invested.

Buckle Inc. Diagonal Ratio Spread

2009-11-01T15:01:00.000-08:00

Summary: On 10/23, I purchased a diagonal ratio call spread on Buckle Inc. (BKE), which consists of purchasing 6 in the money June 2010 25s, and selling 4 in the money December 2009 30s, for a net debit of $2900.

Break-Even Point: Break-even point is likely around 28 to 29, depending on the IV of the June calls at December expiration.

Max Profit: Maximum profit is theoretically unlimited because I am long two more June 25s, then I am short December 30s.

Potential Downside: Downside is limited to my net debit of $2900.

Greeks: Similar to my three other diagonal call spreads, delta and vega are substantial, and theta is positive, and will increase nearing expiration. See the portfolio screenshot for periodic updates as to this position's greek metrics.

Rationale: Buckle is a well managed, casual apparel, mall-based retailer. Buckle has been and is currently growing rapidly, but doing so in a principled manner and without the use of debt. EPS has grown from .86 in 2005 to 2.24 in 2009. Throughout this period, Buckle has generated substantial cash and has been a net buyer of its stock. Its five-year average revenue growth rate is 13.4%, while its five-year average EPS growth rate is 26.4%, a result of both share repurchases and margin expansion. Buckle generates terrific and peer-beating returns on assets and equity (without the use of debt). Nevertheless, the market is currently valuing Buckle's equity at historically low multiples of earnings due to the tough retail market - it's trading at around 6x EV/trailing EBITDA or 12x trailing earnings. Given management's track record and the current valuation, I am bullish on Buckle's near-term, and even more so, its long-term prospects, but appreciate the potential challenges both to its stock price and its business. This position provides some near-term downside protection and profits from time decay, while preserving upside. In the event Buckle's stock slides substantially in the near-term, I will look to gain further upside exposure.

Note that Buckle reports earnings November 17th, which will likely cause a substantial move in the stock price.

Lockheed Martin Diagnal Call Spread (Update)

2009-10-22T14:47:00.000-07:00

Following a poor outlook for FY 2010 earnings provided by management on the recent earnings conference call, LMT's stock price fell considerably on 10/20. In light of this price movement, I defensively repositioned the LMT spread by (i) buying back the 10 December 80s, and (ii) selling 10 December 75s, for a net credit of $1100 less commissions. The position's max profit point is now $75 as opposed to $80.

Lockheed Martin Diagonal Call Spread

2009-10-17T11:49:00.000-07:00

Summary: On 10/15 PT entered into a second diagonal call spread, this time using Lockheed Martin Corporation (LMT) stock, which consists of (i) buying 15 March 70 calls, (ii) selling 5 December 75 calls, and (iii) selling 10 December 80 calls, for a net debit of $8615.16. As of 10/16, OptionsXpress expresses the profit/loss profile of this position in the blow chart (which, as discussed in the prior post, should be taken with a grain of salt b/c of an unrealistic IV assumption).

Break-Even Price: Likely around 73 depending on IV at December expiration.

Maximum Profit Price: $80 per share. Note that unlike the McDonald's (MCD) spread, this spread doesn't include additional long calls to capture upside - which sacrifices downside protection and time decay on the MCD spread.

Potential Downside: Downside is limited to the net debit, or $8615.16.

Greeks: As of 10/16, position delta was 468, and gamma -26. Position theta was around 10.7, and will increase as we near December expiration subject to a changing stock price. Vega was substantial at 93.3. For more information regarding the "greeks" please see the McDonald's post.

Rationale: Similar to MCD, I believe LMT is a compelling diagonal call spread candidate. IV on the March calls (and all LMT calls) has declined drastically in recent months. Given concerns regarding the current administration and the federal government's budgetary restrains, the stock trades at a historically low multiple of both trailing and projected forward earnings, and offers a substantial dividend yield. LMT stock has shown strong support in the 70-75 range (which makes sense fundamentally), and has come down modestly over the last few weeks after flirting with the $80 mark. Look for LMT stock to move relatively substantially next week upon the 10/20 earnings announcement. Following the announcement, the position will be reevaluated.

In the event LMT stock declines drastically over the next three months, I will look to add exposure so long as LMT's fundamental strength remains intact. I don't, however, believe LMT has break-out potential given the above mentioned concerns and believe it will likely stay range bound into the forseeable future. The optimal turn of events would be for LMT to stay in the mid to high 70s until December expiration (or at least end there), allowing me to roll the December 75 and 80s into January or February 80s while keeping the March calls.

Note that I've chosen to stagger the expiration of the near month calls in my two diagonal spread positions between November and December, a helpful hedge against market volatility.

McDonald's Modified Diagonal Call Spread

2009-10-14T19:58:00.000-07:00

Summary: On 8/13 PT entered into a modified diagonal call spread on Mcdonald's Corp. (MCD), which consists of: (i) selling 10 November 57.5 calls (which were at time of sale, slightly "in the money"), (ii) buying 10 March 2010 52.5 calls, and (iii) buying 3 March 60 calls (hence the "modified" in modified diagonal call spread). The cost of the position, including commissions, is a net debit of $5,173.99. The following chart depicts the profit/loss profile (albeit inflated because of a quirk in the OptionsXpress software which assumes a higher than realistic implied volatility (IV) at expiration).

Break-Even Price: Break-even price at expiration, which will depend on implied volatility (IV) of the March calls, is likely around $56.5.

Maximum Profit Price: Because of the 3 March 60s, profit is theoretically unlimited. Profit at $57.5-60$, depending on IV at the expiration date, would likely be around $1200.

Potential Downside: Downside is limited to the net debit, or $5,173.99.

Greeks: At entry, position delta (or sensitivity to a $1.00 change in MCD stock) is 347.77, and gamma (the decrease in delta due to a $1.00 change) is -43.33 (gamma will in turn decrease as the stock rises due to the 3 March 60 calls). Position theta (the increase in the value of the position in a day, assuming a flat stock price and no change in IV) is 9.7 at time of entry, which will increase as we near November expiration and then decrease as the extrinsic value on the November 57.5s evaporates. As position theta approaches negative, I will look to exit the position or roll the November calls to December. Theta will decrease as the stock rises above or dips below the near-month strike price, 57.5. As with any diagonal spread, vega (sensitivity to IV) is substantial - which will be profitable in the event of a sudden increase in general market volatility (but will result in a decrease of the value of the position if volatility continues to decline over the next month).

Rationale: MCD is a terrific diagonal spread candidate because it's a stable, dividend paying, well managed, and recession "resistant" business, with a compelling valuation at around 15x earnings. These factors create a figurative "floor" on the stock price not too far below current price (52 week low is around $50 per share), and create opportunities for additional trades in the event the shares fall substantially below their current price and valuation becomes even more compelling.

Note that MCD reports earnings on 10/21 which will likely cause a larger than normal increase or decrease in MCD's stock price, and will also result in a decline in extrinsic value of all three options, but disproportionably affect the November 57s. In the event the stock declines drastically following the earnings release, I will look at increasing exposure to the current position, or entering into a similar position at a lower strike price (unless the earnings demonstrate a systemic issue affecting MCD's fundamental valuation).

The ideal outcome here would be for MCD to stay (or finish) relatively flat prior to expiration, allowing me to profit form the decline in the extrinsic value of the November 57.5s, and then roll into the December 57.5s, and so on. A sharp rise in MCD would be profitable but would limit the future potential of this and other positions on MCD given an increased and potentially unsustainable valuation.

On a side note, one way to look at the cost of purchasing an in the money option like the March 52.5s is to compare the extrinsic value to the alternative cost of borrowing funds to purchase the underlying stock. At a value of $6.20 per share, and a MCD stock price of $57.5 on 10/13, the March 52.5s have $1.2 of extrinsic value, and $5 of intrinsic value, which is a 2.2% borrowing cost on the $52 (or about 6-7% annualized once taking into account the effect of the dividend). However, unlike real margin debt, purchasing an option is "non-recourse" - one just pays the extrinsic value (interest), and isn't liable for the entire value of the alternatively borrowed funds. An imperfect analogy to selling short term, at the money, options against long term, in the money, options is borrowing long-term at a low interest rate, and lending short term at a higher interest rate.