From Frontwater Capital’s Options Desk:

In a matter of weeks, Apple (AAPL) stock has fallen 25% from its September 2012 high of $704. Investors are now questioning if Apple has lost its magic touch. Just what has changed in only a few months.

Has Apple Lost Its Magic Touch?

Apple is no longer the underdog, the contender; they are now the company to beat – the ones with the target on their back. And while Apple continues to be known for its excellence, innovation and quality, life at the top is much more rigorous, and pressure bound than being second in command.

Factories are demanding higher wages and better working conditions that are putting pressure on margins. Competitors like Samsung are constantly improving their own phones, tablets and computers. Furthermore, we are starting to see limited sales of the iPhone 5 due to supply chain issues. And finally, the newly released mini Ipad was only warmly received by analysts who noted marginal, insignificant upgrades with the mini.

That said, Apple’s stock looks to be in bargain basement territory. Even with competitive pressures Apple’s gross margin remains above 40%. Most important is that Apple has an ecosystem that few others can rival. Apple users link and connect their Mac laptops, iPhone, and iPad so that, for example, a library of itunes can be automatically distributed to each gadget. This convenience factor makes it extremely difficult for users to switch to a new platform.

Finally, much of the sell off in Apple stock can be explained by the approaching ‘fiscal cliff’. Investors who have held Apple stock for some time are likely sitting on large capital gains and are wishing to realize their capital gains in 2012 prior to potential tax hikes in 2013. This is creating downward pressure on the stock. Yet the company remains intact.

Here are some different ways to play Apple in today’s sell off:

1. Go Long!

Apple has been the trade of the year and up until recently, momentum and speculation had taken the price sky high. Now, with the momentum going against Apple, we think it is an attractive entry point. Even if we forget about ANY growth, this company seems like a bargain — valued at 12.5 times earnings; with more than $120B in the bank; and zero debt.

2. Sell a Put

The panic in Apple today has created a great opportunity if you are willing to take on exposure to Apple if it continues to drop. The options market will pay you $19 between now and December if the stock were to drop below $525 and you sold a put. Your downside risk here is that you own Apple with an effective price of $506. On the other hand, if Apple stock trades above $525, you effectively pocket $19 in option premium.

3. Buy a Collar

If you were willing to take the on additional Apple shares with an effective cost of $506 from the above example, you could turn around and purchase a March 605 Call using the $19 dollars that you received from selling the put. This will give you upside on Apple and enable you to profit in the event that Apple’s stock rises above $605.

Bottom line is that if you believe in the company’s long term value, there are a bunch of different and creative ways to play Apple using option

As an options trader and as a specialist in risk management, I often get annoyed when I read about risk mitigation strategies in any number of business newspapers and magazines. Rare is the case where I read an insightful article on the use of options strategies, particularly the protective put, to manage volatility within one’s portfolio.

All too often, authors focus on asset allocation as the primary mechanism for managing risk. In order to preserve capital, low risk investors should overweight fixed income products like GICs, government bonds, investment grade bonds, and underweight equities.

To further this argument, authors often display historical chart information to graphically illustrate the steadiness and consistent returns from bonds over the last twenty, even thirty years.

Problems With Relying On Asset Allocation

There are a number of problems I have in relying on asset allocation as a risk mitigation tool. First, only two years ago, we laid witness to the fact that all asset classes were hit hard. It did not matter if you held investment grade bonds, junk bonds, small cap stocks, preferred shares, or blue chip stocks in your portfolio, everything took a beating. Asset allocation did not turn out to be the safe haven that many thought and counted on.

Is Fixed Income Really A Safer Haven?

The second issue that I find bothersome is the assumption that fixed income is a steady eddy asset class over the long run. Many investors are oblivious to the fact that we have been in a declining interest rate environment for the last thirty years. Interest rates have dropped from twenty percent to one or two percent. So is it any wonder that bonds have done so well – it is simply a function of falling interest rates — as interest rates go down, bond prices go up.

On that note, one has to question a historical bond chart, even one with thirty years of history, if it is statistically representative.
Now that interest rates are slowly creeping up from their all-time lows, it could get very ugly, very quickly for bond holders. Unfortunately, I foresee a lot of seniors taking it on the chin once this bond bear market kicks in — especially those seniors being advised by their bank mutual fund salesperson to buy into bond mutual funds.

Capital Preservation At The Risk of Inflation

Finally, the third issue I have with the ‘bond safe haven’ argument is that few advisors make mention of the risk of inflation. And in today’s high commodity price environment, I fear too many investors are exposed to inflation risk – specifically the loss of purchasing power.

It does an investor little good to earn 3 percent on a long term government bond if inflation is running at 4 percent. True, the investor is almost certain to see his initial cash outlay returned as the bond matures, but the investor will have lost in real purchasing power. Unfortunately, too many investors associate capital preservation with the likelihood that cash is returned all the while ignoring the risk of inflation.

Problem With Laddered Bond Strategies:

That brings us to the next type of business news article which discusses the benefits of a laddered bond strategy. In a laddered bond strategy, an investor owns a number of different bonds, each with various maturities. Some bonds mature earlier and some mature later. Presumably, if interest rates rise, the bonds that mature earlier can be re-invested in potentially higher yielding bonds. Thus the exposure to inflation and higher interest rates is diminished.

On paper, the strategy sounds great. One problem though: in this low interest rate environment, the returns from this strategy are lousy.

The Protective Put

All of which brings me to the protective put strategy.

The concept of an index put is very simple. It is very much like insurance with the added benefit that it trades on an exchange. Unlike ‘asset allocation’ which did little to shelter portfolios against an outright collapse in the financial markets, puts most certainly protect investors against extreme market events.

Furthermore, puts give conservative investors much more leeway in bumping up the equity portion of their portfolios. Generally, it would be unheard of for a conservative investor to assign more than 65% of his portfolio towards equities. But with put protection in place, an investor has the flexibility to increase the equity portion towards even 80% with the knowledge that an effective hedge is in place should the market collapse.

Puts: The Concept Of Insurance

As mentioned, puts are equivalent to insurance. Like insurance, there is a cost to a put. A buyer of a put pays cash to the seller in what is known as the option premium. What is kind of neat is that the put premium is liquid and trades on an exchange. Investors can buy and sell put premiums exactly in the same manner that they buy stocks (eg. enter a ticker symbol, enter a price, and click ‘buy’ or ‘sell’)

Like many types of insurance, there is an expiration date associated with a put. After the expiration date, the put no longer trades and is considered terminated.

Put premiums appreciate in value when the market drops and decrease when the market goes up. But, put premiums cannot go below zero. Upon expiration, the put will be “in-the-money” and have monetary value, or it will be worthless.  Keep in mind, that the maximum amount that a buyer can lose is the put premium. The buyer cannot lose more than what he paid for the premium.

One More Feature: The Strike Price

In addition to an expiration date, puts are described by a strike price. The strike price enables investors to further customize the level of protection.

For example, if the TSX is trading at 14,000, an investor may choose a put with a strike price of 14,000. That particular put protects the investors against a market drop below 14,000.  Another investor, however, may choose to insure his equity portfolio at a lower strike price, say 13,000. Here, the investor has protection but only if the index falls below 13,000.

Why would an investor choose a strike price of 13,000 versus 14,000, one might ask?  The answer is cost. A put with a lower strike price costs less than one with a higher strike.

Having the ability to buy insurance at various strike prices gives investors a tremendous amount of flexibility in tailoring a risk strategy.  Some investors may be fine with a marginal drop in the market but want protection to kick in only in the event of a catastrophic event. Those investors are more likely to choose a strike price below current market levels – say 13,000. Other investors may want a higher amount of protection and choose a higher strike price that is more in line with the current market – say 14,000.

Volatility and Put Premiums

While both expiration dates and strike prices affect put premiums, volatility is the most important factor in determining relative value.  This is why many option traders track a volatility index called the VIX in order to assess the relative value of options.
When volatility is low, option traders know the cost of the put premium is relatively cheap. Likewise, the reverse is true. If volatility is high, put premiums become relatively more expensive.

Intuitively, this makes sense. Investors are more fearful in highly volatile markets and are therefore willing to pay more for insurance in order to protect their portfolios.

With investor sentiment bullish and the VIX trading at near lows in Jan & Feb 2011, Frontwater loaded up on 2012 protective put options on the TSX, DJIA, and S&P 500. This week we were rewarded. As stocks dropped, the index puts that we bought increased in value and our portfolios only suffered marginal paper losses. With insurance in place, not only were we able to avoid knee jerk reactions but we were positioned to take advantage of the first weekly drop in several months and added to our equity positions at depressed levels.

Admittedly, we bought the puts from a purely risk management perspective and not because we had a crystal ball that could possibly forecast the political unrest that would break out in the Middle East or that a terrible natural disaster would hit Japan.

That said, we complement ourselves for recognizing the most cost efficient way of managing risk at the time was through the use of put options. The protective puts offered great value, enabled us to comfortably maintain a higher level of equity allocation (close to 80%), and then positioned us to further take advantage of a market drop.

Option strategies can be a powerful risk management tool within one’s portfolio. All too often they get dismissed as being ‘too sophisticated’ for the average investor which draws my ire. True there are many complex option strategies but buying a put is a very simple investment strategy and insurance policy at the same time.

Jeff Kaminker

President, Frontwater Capital

Long-only portfolio managers traditionally manage risk through asset allocation strategies that concentrate on finding a balance between equity, fixed income, and cash. Portfolio managers wanting to minimize volatility generally do so by increasing exposure to fixed income products while simultaneously underweighting equities.

But what happens when demand for seemingly safe fixed income investments, such as government and investment grade bonds, drives prices up to ‘bubble’ territory. Shifting assets out of equities and into an inflated asset class such as bonds does little to minimize risk.

Here, long-only portfolio managers are handcuffed – constrained by the fact that the fixed income alternative is in fact no alternative at all. That leaves cash as the only substitute for equities. Of course, cash tends to be dead weight. And while there may be times that sitting on cash makes sense, investors simply do not need to pay professional money managers to hold onto cash.

This is where option licensed portfolio managers outperform their long-only counterparts – not only in higher returns but in managing the overall risk profile of the investment portfolio. Suitably designed options strategies can add considerable value to a tactical asset allocation program.

Rather than change asset allocations in order to modify risk profiles, option licensed portfolio managers can use puts and calls to preserve capital, enhance income, and reduce market volatility without having to sell equities outright.

Many unsophisticated investors see derivatives and options as instruments used to increase, rather than to reduce risk. Nothing could be further from the truth. Investors interested in prudent risk management strategies should be looking at option instruments including puts and calls.

Buying plain vanilla puts are similar to buying portfolio insurance and protect investors against a market fall. These type of instruments are great for conservative investors who want capital preservation. Not only do puts provide a floor in the event that the market falls, but they allow investors to enjoy all the benefits of a rising market as well as any dividend payouts. In this environment, where fixed income instruments are overpriced and bond yields offer next to nothing, maintaining equity exposures with put protection is the way to go.

In addition to buying puts, income oriented investors can also consider option strategies including covered calls and collars. These strategies are a tad more complicated than simply buying puts. That said, they are not beyond the reach of ordinary investors who have been brainwashed to think that risk profiles are based on asset allocation.

Make no mistake, there’s a real bond bubble forming and unfortunately many conservative investors are on the verge of a rude awakening. Whereas the stock market crash of 2007 punished greedy, risk seeking investors, this time around it will be conservative, risk-averse investors who take the hit. Protect your portfolio with options.

Jeff Kaminker
Frontwater Capital

Both shares of McDonald’s (MCD) and Burger King Holdings (BKC) have underperformed the Standard & Poor’s 500 index over the last year. However, Credit Suisse recently upgraded McD’s while cutting Burger King. At Frontwater we like both for various reasons.

Let’s first take a look at McDonalds…Earlier today, Credit Suisse upgraded McDonald’s to Outperform from Neutral and upped its price target to $71 from $69. Currently McDonald’s trades in the $63 range with an attractive 3.5% dividend yield. The restaurant operator maintained positive-traffic growth in 2009, while the rest of the industry saw declines. Credit Suisse thinks now is a good time to refocus attention on solid dividend payers with a dominant global platform. McDonald’s fits that bill.

So overall, lots to like about McDs…But if you think today’s price of $63 is a good buy, then certainly $55 or $57.50 has to be that much more attractive — in which case we encourage our investors to look at June 2010 $55 and $57.50 puts. These put options are typically trading anywhere from 70 cents to $1.40 per option…Sure the upside is not as great with selling puts but the risk is also that much lower. And at $55, we would be more than happy to own McDonalds.

Burger King is a bit of a different story than McDonalds. Burger King shares were down 3.3% today to $17.88.
But Burger King trades at a 12.8 price earnings multiple vs. McDonald’s 16 times. The resulting higher valuation for McDonalds may be justified as some analysts expect McDonald’s to get more of a lift from improving beverage sales and a general turn in the economy. Coffee sales continue to be a significant opportunity for McDonald’s. The higher-margin product now accounts for 5% of U.S. sales, up from 2% two years ago.

Still with the discount in P/E ratio, an investor might want to play Burger King through the use of put options. An April 2010 $17.50 put trades for $0.85 and basically implies share ownership in Burger King at a multiple below 12 — which in our opinion is quite attractive.

In conclusion, I would keep my eye on both companies and continue to watch the spreads in the P/E ratio. Probably the safest bet and most appealing from a risk reward perspective is selling McDonald put options. But for those who want exposure to the fast food industry, it is not a bad strategy to get exposure to both McDonalds and Burger King by owning shares in each — McDonalds’ for its higher growth potential and Burger King for its discount to the P/E multiple.

Jeff Kaminker

Research in Motion is a real Canadian success story.   The company is worth more than $36 billion.  It generates over $600 million in profit every quarter.  It carries no debt on its books. It has a dominant position in the US with a market share greater than 55%.  And it is expanding aggressively into sought after international markets including Russia and China.

Yet, in spite of all its past success, the company has become an enigma for investors and analysts alike.  Today, price targets vary from a low of $50 to a high of $120.  In the past three months alone, the stock hit a high of $85 (USD) in late September; crashed in October/November to $55 (USD); and rebounded last week up 11% to close around $63.  Now this is a volatile stock.

3rd quarter earnings will be announced after market close on Thursday December 17.  Interesting enough, RIM’s stock tends to be most volatile the day after it announces its earnings.  An analysis of the last 6 quarters of earnings announcements shows that RIM’s stock tends to go either up or down an average of 18%.

Here are the percent changes in prices from 1 day before earnings announcement to 2 days after the announcement for the last 6 quarters:

2^nd quarter: 2010               -11%

1st quarter: 2010               -29%

4th quarter, 2009              +10%

3rd quarter, 2009              +32%

2nd quarter, 2009               -16%

1st quarter, 2009                -10%

While there is no guarantee that history will repeat itself, this kind of statistical information suggests there is a high probability of a considerable move up or down later this week.  It also suggests that the share price adjusts very quickly to changes in announcements.

It thus begs the question: Is there a way for an investor to play RIM so that the investor benefits in the case where earnings exceed expectations and the share price jumps; and at the same time, losses are minimized in a case where RIM disappoints and the share price tanks.

Basically, the investor wants upside benefit with limited downside risk.   Sounds too good to be true – perhaps not.   For option players, RIM presents a rare potential opportunity.

For those who have forgotten, a call option gives the owner the right to buy shares at a specified price.  Currently, an investor could purchase a December 2009 call option with a $65 strike price for $2.30. Should the stock trade below $65 at Friday’s close, the call option will expire worthless (because no investor is going to exercise his right to purchase RIM shares for $65 when he could buy it in the market for less).

Keeping in mind the following two facts: (1) that the stock is currently trading in the $63 dollar range and (2) a December 2009 call option expires literally in five days on Friday December 18th; it almost seems ludicrous for an investor to spend $2.30 on something that looks like it will be worthless in less than a week.

Interesting enough, however, the call option presents some attractive scenarios.  The worst case scenario for the call option buyer is a loss of $2.30. This scenario happens if the stock trades below $65 at market close this coming Friday, December 18, 2009.

However, in a best case scenario, the call option buyer gets to enjoy all the upside if the shares trade above and beyond $65.  In a case where the shares trade above $65, that same investor will exercise his call option right; he will purchase the RIM shares outright for $65; and perhaps sell them for a profit the following Monday morning at the higher price to realize a profit or continue to hold onto the shares.

Needless to say, for this strategy to be profitable, the stock must rise above 67.30.  That said, when one compares this strategy to owning the shares outright, it seems tempting if only because the maximum loss to the investor is the call option premium which in this case is $2.30.

In conclusion, purchase of RIM shares prior to earnings announcement is risky.  Options are a great way for willing participants to maintain a stake in RIM while keeping losses to a minimum.

By the way, a similar strategy could be structured but in reverse for those investors favoring a decrease in the share price. Puts allow the investor to benefit from a price drop rather than a price increase. Bascially, a person expecting a drop in in the stock price could buy puts outright. And like the case with the call option, the put strategy ensures that the maximum loss is no more than the premium paid for the option.

Author: David Kaminker

www.fwcapital.ca
www.frontwater.ca