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Exponent Investment Management. Benoît Poliquin, CFP, CFA – President and Lead Portfolio Manager www.ex-ponent.com. Option Strategies for your Portfolio. Raison d’Être. Issues facing investors today. Low interest rates have increased the need for income.
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Exponent Investment Management Benoît Poliquin, CFP, CFA – President and Lead Portfolio Manager www.ex-ponent.com Option Strategies for your Portfolio
Issues facing investors today • Low interest rates have increased the need for income. • Need more capital for same level of income. • Markets have been volatile and have not offered dependable capital growth opportunities. • Makes for difficult long term decisions. • Underlying global economy does not provide for stellar environment for companies. • What will provide better returns for investors in the future?
Owning Quality Assets • Stock Market are volatile. • Expectations and economic events are unpredictable. ≠ • Your spending needs are certain. • Most investors sell low and buy high. • Humans are pre-wired to seek out the safety of crowds… • Performance chasing
Owning a business • Imagine you owned a business: • Where the brand name was established • Proven Management • Profitable • Dividends increased every year • Would you invest?
What if… • Every day, someone can quote you a price on this business. • Would you always own it? • Would you be worried if were offered 30% less than what you paid? Would you be offended or exited?
For Example: Johnson & Johnson At first glance, stock price is disappointing…$10 in growth in 10 years But better than the market JNJ +22% S7P 11% However Dividend from $0.18 in Q2 01 to $.57 in Q2 11 = 3X Earnings Per Share 2001=$1.75 / 2010=4.78 Quality Matters Boring…but profitable!
What if.. • You invested in 20-30 companies with these characteristics. • You were disciplined on purchase price & and your sale price. • You get a bid every day • Take advantage of irrational investors • Always earning dividend income. • Growing • Tax efficient (Canadian Corporations) • Passive…your money working for you
Options Basics: • An equity option is the right but not the obligation to Buy (Sell) at a specified price (strike price) by a certain a date. • They are listed just like a stock…trade them in a similar fashion. • Option Prices are influenced by: • Underlying share price. • Time until expiration of the option. • Volatility (how much the price varies over time). • Interest Rates. • Dividends.
Option Types: • A Call Option allows the holder/buyer to purchase the shares at a future price by a specified expiration date. • You can buy a call option • You can sell or write a call option • A Put Option allows the holder/buyer to sell the shares at a future price by a specified expiration date. • You can buy a put option • You can sell or write a put option
Step One: Quality • Assemble a portfolio of companies domiciled in Canada and abroad with the following characteristics: • An ability, a history and a policy of paying ever growing dividends to shareholders • Operate in profitable industries • Sound management
Step 2: Research • Determine the fair market value: • Based on historical valuation (ie: P/E ratios, BV ratios) • In relation to the company itself • In relation to the broad equity market (TSX, S/P 500,etc.) • In relation to the price of money/interest rates • Determine entry points: • Based on fair market value research • Technical analysis
Step 3: Option Research • Determine appropriate strike prices for call to be sold. • & select ideal date of expiration • Determine appropriate strike prices for put writing. • Ensure sufficient cash component for the underlying commitment to purchase • Select ideal date of expiration
Example #1: JNJ (ignoring transaction costs) • Stock Price = $64.08 • Assume stock is purchase at this price; • Sell call (Oct 22/2011 expiry) for $0.64 & Strike= $67.50 • Your net investment is $64.08-0.64= $63.44 • Probability of being exercised ≈ 31% • If JNJ trades for more than $67.50, call option in the money • If exercised, investor sells @ strike, for a profit of $4.06 ($67.50-$64.08+$0.64) or 6.4% • Profit of 6.4% in 49 days • Investor can repeat 7 times in the year • If JNJ trades below $67.50, investor keeps premium • Repeat process upon expiration of call option
Ramifications • If investor has many choices; • Can buy back call (at a loss) and keep JNJ • Keep profit and… • Investor can sell put against proceeds at a lower price • Investor can invest in another company and repeat the covered call exercise. • Benefits: • Higher cash flow = consistent return • Disciplined sell and purchase prices • But Upside is capped to $4.09 for 49 days
JNJ conclusion- Securitized Puts • Investor was “called away” from JNJ and sold at $67.50 • Investor would like to reinvest in JNJ @ 62.50 • Can wait in cash until this price is reached in the market • Investor can could sell $65 put and securitize the commitment to purchase with cash • Sell put $65 and collect ≈ $3.25 • Commitment to buy JNJ @ $65 in 50 days is set aside • If JNJ trades down to $65, put should get exercised at net cost is $61.75 to invest in JNJ • If JNJ stays above, $65, simply repeat with new put option
Example #2: RY (ignoring transaction costs) • Stock Price = $48.93 • Assume stock is purchase at this price; • Sell call (Oct 22/2011 exp) for $.35 & Strike= $55 • Your net investment is $48.93-.35= $48.58 • Probability of being exercised ≈ 14% • If RY trades for more than $55, call option in the money • If exercised, investor sells @ strike, for a profit of $6.42 ($55-$48.93+$0.35) or 13% • Profit of 13% in 49 days • Investor can repeat 7 times in the year • If RY trades below $55, investor keeps premium • Repeat process upon expiration of calloption • In this case, a $.54 dividend is payable on Oct 22, adding to the potential profit
Ramifications • If investor has many choices; • Can buy back call (at a loss) and keep RY • Keep profit and… • Investor can sell put against proceeds at a lower price • Investor can invest in another company and repeat the covered call exercise • Benefits • Higher cash flow = consistent return • Disciplined sell and purchase prices • But Upside is capped to $6.42 for 49 days
RY conclusion-Securitized Puts • Investor was “called away” from RY and sold at $55 • Investor would like to reinvest in RY @ 50 • Can wait in cash until this price is reached in the market • Investor can could sell $50 put and securitize the commitment • Sell put$50 and collect ≈ $3.50 • Commitment to buy RY@ $55 in 50 days is set aside • If RY trades down to $55, put should get exercised at net cost is $51.50 ($55-$3.50) to invest in JNJ • If JNJ stays above, $55, simply repeat with new put option
Net Result = Higher Cash Flow • Capital growth will stem from higher valuation of companies and tends to ebb and flow with investor sentiment. • The covered call + securitized put strategy harnesses this volatility and converts into higher income at the expense of limiting violent upward movements in stocks and the onset of additional transactions. • The additional income is a buffer for investors, and can be used for day to day expenses • Strong discipline is ensured by the implicit pre determined sell and buy targets.
Quality Remains • Investors still owns a portfolio of quality companies • ≈30 stock positions • Growing dividend income stream • Diversified by country and geography • Options is a profitable to harness volatility • Using daily price changes as an asset instead of a liability • Increase the cash flow of the portfolio
