How do you make money in a boring range-bound market? Well, you certainly need to be resourceful. Finance guys have given us lots of toys to play with; the trick is to know which ones to use and how to use them correctly. I haven’t spoken much about options, but they are a key weapon in my arsenal.
Longtime readers of this site will know that I have a position in Mercer International (MERC: Nasdaq). The shares nearly doubled in price from when I first wrote about them, but in the past month, they’ve been rather weak. I attribute this to two causes; to start with, NBSK prices have come off a bit from multi-decade highs. This is natural following months of increased prices. The more relevant issue is that Mercer is redeeming $37 million in convertible notes. These notes convert at $3.30 a share and naturally, owners are choosing to convert these to shares and sell them. Clearly, not all 11 million shares created by this event are being sold into the market—the majority have likely been hedged long ago—however, even a few million shares of selling are pressuring an illiquid summer market and influencing the share price.
While there’s no way to figure out when this selling will end, I feel the selling is starting to get pretty crazy. The shares trade for something like two times run-rate cash flow from operations. I already have a full position, but at a lower price, I’d certainly be willing to own more. This is where options come into play.
Over the past few days, I’ve written the November, 2011, 10 put for roughly $1.35. This means that I collect $1.35 in premium and in November, if the shares are trading for less than 10, I’m going to own more shares. Let’s do some quick math;
10 – 1.35 = 8.65 1.35 / 8.65 = 15.6%
In very rough terms, I’m risking 8.65 if the shares go to zero as I’ve already been paid 1.35. That premium is a return of 15.6% on the 8.65 that I’m risking. One of two things will happen in November; either the shares are higher and I’ll earn my 15.6% which is roughly a 50% annualized IRR—clearly a very positive outcome—or I’ll own more shares of Mercer International at a cost basis of 8.65—which isn’t too bad either. For disclosure purposes, I recently bought a bunch more at 10, so 8.65 sounds like a gift. In either case, I’m a very happy hedgie.
Of course, if the shares go significantly higher, I’ll feel silly having only made 15.6%, but that’s why I have my core position. This is simply a way for me to either get more shares cheaper, or earn a yield in a no yield environment. I have a huge cash position, writing Mercer puts certainly beats the few basis points that my broker pays. Of course I have to take on some risk to play this game, but I want to own Mercer anyway. A few extra wouldn’t bother me one bit.
It goes without saying that you should NEVER write puts unless you have the cash to buy the shares if they are put to you. Puts have a way of making you feel real safe as you go about collecting your yield for months at a time. Eventually you will be forced to own something—usually a price that is much lower than what you ever thought it could trade at. Make sure you have the cash. Otherwise, you will be very disappointed. Every year, I hear of someone with a huge loss on some option they wrote and I wonder why it is that they wrote a few times their equity in puts. Don’t be that person. Only write on things that you want to own and at the prices you are willing to own it at. Don’t just write puts because they pay well—generally, the more generous the payout, the more dangerous it is.
In summary, options are a valuable return enhancer when used right. In the low yield environment that we currently face, they are a great way for me to utilize my cash balance and wait for better opportunities.
Disclosure: My investment partnership owns shares shares of Mercer International and has written November, 2011, 10 strike put in MERC. We may adjust these positions without further notice. This is not a recommendation to buy or sell any security.