Last week I wrote an article here on CalvinAyre.com about the use of stock options to make speculative, high-risk bets on gambling stocks. As if to prove my point about the risk levels associated with the trades, the broad market finally fell last week, wiping out the highest-risk trade on MGM Resorts (MGM) and even knocking down the ‘safer’ long-term play on Wynn Resorts (WYNN), which fell over 7% for the week.
But options do not necessarily have to be used for high-risk plays; in fact, they can be used to lessen investor risk. This is of particular value in the gambling sector, where many stocks are highly volatile. Options can be used to provide downside protection against a steep fall; to protect already-captured paper profits; or to fix an entry point for an investment at a price below the current trading price.
Given continuing concern about whether the current bull market in stocks can continue – every market in the world is up year-to-date, except for Spain – focusing on protective strategies should be of key interest to investors right now. Gambling stocks, which are often highly correlated to the broad market, have boomed as well. The BJK exchange-traded fund (BJK), which comprises 60 gambling stocks worldwide, is up 14.5% year-to-date and 40% from its lows in early October just six months ago. Investors looking to protect existing profits, or who are worried that the notoriously fickle gambling sector may have some downside in the short term, can look to the option market to mitigate their risk.
The simplest form of risk mitigation in the options market is through the purchase of a put option. A put option gives the owner the right to sell a stock at a given price at any time before the option expires. Puts can be used where a stock has a steady run-up, and an investor still feels the stock has more room to run, but wants to lock in existing profits. Las Vegas Sands (LVS) has been one of the market’s best-performing stocks, up over 35% in 2012. If an investor bought in around $40 per share in mid-December, he would be sitting on a 44% paper gain. What to do? He may still be bullish on LVS long-term, and feel that the stock may have room to run. But the continuing broad market concerns upset him, and he worries about the stock turning downward if economic worries spook the market.
The simplest way to handle this situation is to buy a protective put. A January 2013 40 put is currently asked at $2.21 per share ($221 per contract – each contract represents 100 shares.) With a purchase of this put, the investor can sell LVS for $40 per share at any time between now and January 18, 2013. His original investment is now guaranteed for over nine months, for just one-eighth of the paper profits made.
The problem with this strategy is the price. If the same investor wanted to guarantee current profits, and purchased a January 2013 57.5 put, it would cost $8.15 per share – nearly half of the profits already generated. A new investor in LVS who bought the same protective put would need to see a 14% return by January simply to break even. Given the volatility in gambling stocks, protective puts will always cost more, since the odds of a big downward move are higher.
The price issue can be mitigated through the use of a collar. A collar simply adds the sale of a call option – a right to buy – to the trade. The proceeds from the call option go toward paying for the put option; the trade-off is that the investor then gives up potential upside. The graph looks like this:
In our LVS example, our investor has a cost basis of $40. With the stock at Friday’s close of $57.57, he initiates a protective collar. He buys the January 57.5 put at $8.15, and sells a January 65 call at $4.60. The net cost is $3.55, 20% of the current paper profits generated. But the trade is locked in; no matter what happens, at any time until January 2013 the investor will be able to sell his LVS stock for a net total of $53.95 per share, a 34.9% gain from the $40 entry price. If the stock rises past $65 per share, the investor misses out any upside, but still sees a handsome 62.5% return on his overall investment. The key here, though, is downside protection. The use of options guarantees already-made profits, at a reasonable cost.
Options can also be of use to new entrants into a stock, through either covered calls or cash-secured puts. I have used these strategies extensively, and successfully, in my own portfolios. It’s important to note that the two are equivalent strategies; both entail the sale of potential upside in return for a lower entry point into the stock. Again, these strategies are valuable in relation to gambling stocks because of the sector’s volatility; options are priced based on the potential range of the movement of the underlying stock. Gambling stocks are more likely to move further, faster, and more often, so the options are priced accordingly; long-term investors in the sector can take advantage of volatility through the sale of options.
Covered calls are generally better-known, but cash-secured puts are easier to understand, so we will focus on that strategy. A covered call simply entails the purchase of the stock and a corresponding sale of a call option for an equal number of shares. We purchase LVS at $57.57, and sell the January 2013 67.5 option for $3.85 per share. The option proceeds give us 6.7% downside protection; if LVS falls to $53.72, the investor still breaks even, having already collected the option premium (which is paid up front). Should the stock rise beyond $67.50, the call option will be exercised. If the stock breaks $71.35 – a substantial 24% gain – the investor misses out on any additional upside.
But cash-secured puts better show the value of the strategy, in that they can literally allow an investor to set the entry price at which he wants to invest in a stock. The “cash-secured” is a key part of the trade; selling puts alone – a so-called “naked put” – adds substantial risk. It requires the use of margin in the account, and losses from a naked put can be multiples of the upfront premium received. The sale of a naked January 2013 50 put on LVS – with a premium of $4.75 per share – would face a 100% loss if LVS fell to $40.50, a 30% drop. Beyond that level, the losses escalate, with the total possible losses dwarfing the maximum potential return.
Selling a cash-secured put in LVS at $50 per share requires coverage of $5,000 (each options contract represents 100 shares). The investor receives the premium of $475 up front, leaving $4,525 of capital at risk. The potential return is 10.5%, or about 13% on an annual basis – not a bad return at all. In this trade, the investor is faced with two outcomes: first, the put is unexercised, as the stock never reaches the strike price. If LVS stays above 50 until January 2013 – or if it dips without the option being exercised, and clears 50 before January, which does happen – the investor keeps the 10.5% return. If the stock falls, the put seller is obligated to buy the stock at $45.25 per share – a 21.4% discount to LVS’ current price.
For a long-term investor bullish on LVS, neither outcome seems particularly troubling. Yes, sometimes LVS will dip strongly, and the investor will buy the stock at $45.25 when it is trading at $35 or $40. But the same paper loss would occur with a straight purchase of the stock. The biggest risk is the sale of the upside. If LVS doubles by January, the return is unchanged at 10.5%, and the investor has missed out on substantial profits.
But if an investor feels that the current market is due for a correction – as I do – but still feels strongly about its long-term health – as I do – cash-secured puts are a solid way to play that thesis. LVS, currently trading at $57.57, can return 10% over 9 months with a downside entry price of just $45.25. WYNN – still one of my favorite stocks in the sector – closed Friday at $124.88. But the sale of the cash-secured January 2013 110 put, bid at $10.75 per share, allows an entry point of $99.25, 20% below its current price and a price the stock hasn’t reached since 2010. The return on that trade is nearly 11%. In highly volatile MGM, investors can set an entry price of just $7.13 per share – 47.6% below Friday’s close of $13.62 – by selling a cash-secured January 2013 7.5 put. The return on that trade is just 5.2%, but the downside risk is owning a multinational industry leader with exposure to the Macau market at nearly half of its current price.
As I noted last week, options strategies require substantial research before investors put them to use in real-money accounts. (When researching on the Internet, be sure to add a healthy dose of skepticism to your portfolio as well; here is a somewhat technical piece I wrote last year on a seemingly “low-risk” strategy often promoted online.) But these hedging techniques are well-suited to the fast-moving gambling sector and can be used by investors for more control of their portfolio and more protection against the downside. And yes, often, less upside. But nothing in investing – or life – is free.