When I first became an analyst, my boss was fond of saying he’d rather have luck than brains. There are so many times, as an investor, when I have considered the understated wisdom of those words. The whole field of behavioral finance is devoted to the tricks our brains like to play on us, and there are certainly plenty of examples of cases where investors simply became too smart for their own good.
I had a little case of luck last week, when I was going to write puts on either Ceradyne (CRDN) or Verizon (VZ - Annual Report), having the capital available for only one of the trades. I chose Verizon primarily out of luck, and it has rallied nicely from the intra-day lows near which I wrote my puts, making it quite unlikely that they will be exercised against me. Meanwhile, Ceradyne lowered guidance Tuesday and lost more than 25% of its market value.
Although I have often expressed the benefits of a put-write strategy (lowering the effective price of stocks you were willing to buy anyway, or collecting a more generous yield if the stock doesn’t fall below the strike price) I thought an analysis of the Ceradyne case would offer a good illustration of the risks – and why I like the strategy even when those risks are considered.
First of all, the 25% decline in Ceradyne was going to knock put sellers or long investors regardless of any stop-loss or other strategies commonly described as “risk reduction” tools. In fact, it nicely illustrates the criticisms of the Black-Scholes option pricing model so recently discussed in Conde Nast Portfolio. Namely, the big event risks are underestimated. Only having bought puts at a lower exercise price (and thus eroding the potential returns) would have offered some protection against the sudden price drop.
That said, does the exposure to sudden price drops invalidate the strategy? I don’t think it does, provided investors focus on the stocks that they understand and are willing to be long anyway. In fact, when I looked at the put-write on Ceradyne in December I pretty much nailed the potential risks.
“Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.40. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.15.
“Then the company announces that earnings will only be $3 a share in 2008, and the stock drops to $30. You’re down $12.15, or 27% of the money you put at risk. So much for low risk.
“On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6.15 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.”
Whether simply buying a stock, or using a put-write strategy, knowing the risks is imperative. I always try to look at a disaster scenario (like the one I illustrated for Ceradyne) that is outside the limits of what most investors consider. Usually these disasters don’t occur, but they happen more often than investors like to admit. Planning for them – and mitigating them when possible – should pay off over time.