Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Value Stocks,

The "Options Wheel" For First Solar

Yesterday, I watched a great webinar by Alan Knuckman dedicated to options strategies in a volatile market. Unlike many other topics, focused mostly on options trading, this lecture offered strategies that combined both stocks and options. One particular strategy, called “Option Wheel Strategy”, particularly caught my attention:

This strategy is not new by any measure. However, I find it fascinatingly simple and elegant. The algorithm is as follows:

  • You want to pick up shares of a company you believe is currently overvalued;
  • You sell puts at a strike that is closest to the price you want to own the security at;
  • You make sure that you have enough money in your margin account to buy the shares if the price drops below the strike;
  • If the stock does not go below the strike price, you keep the premium. If the stock falls below the strike, you buy the stock at a discount.

I would personally recommend choosing a strike below the presumable “fair value” of a stock. This way, if the stock falls below the strike, you will buy the stock not only at a discount to today’s market price buy also at a discount to its intrinsic value. The stock’s fair value (intrinsic value) can be calculated, for example, with a DCF model.

As you can see, this strategy perfectly fits long-term investors, who seek to buy equities at their fair value (or below) and hold them for many years. It is also a great way to employ your idle cash. In times of volatility, this strategy also allows you to collect fat premiums as investors holding substantial long positions will pay more to hedge their downside.

I also decided to show you an example on a real stock. I have noticed that shares of First Solar have been in a rally over the past couple of days and attracted a lot of attention from retail investors. In addition, I wrote about First Solar back in December stating that the stock is a “HOLD”, while it trades in the range between $57 and $64 per share. Back in the summer, I valued the company in mid-$50s; I obtained the valuation with a DCF model. The stock is currently trading way above the fair value bandwidth (around $69 per share as of the time of writing):

(Source: Bloomberg)

Suppose that you are a value or GARP (growth at reasonable price) investor like me. You like the company’s business and you believe it is there for the long-term. However, you are not comfortable with the current market price. Let us say, for the sake of the argument, that you are conservative and give First Solar a valuation of $50 - $55 per share. With the stock trading at almost $70 per share, you have two options:

(1) Wait for the stock to come down to the fair value range and set a necessary amount of money aside to fund your purchase. Your money will likely be earning a mediocre interest in the meantime, or

(2) Invest your money elsewhere hoping that you will save enough cash by the time the stock supposedly recedes to the more attractive valuation. This option is actually worse than the first one because you will be carrying risks of your alternative investment and you may be late for the FSLR’s auction, especially if the stock retreats into the range for a short period of time.

The option wheel strategy is the alternative to the above options. What you can do is sell the following puts:

Below are given March puts

Below are given May puts

Below are given January 2017 puts

(Source: Yahoo Finance)

The outcomes:

  • If you sell March puts with strike prices ranging from $55 to $61, which is aggressive given that we value First Solar at $50 - $55 per share in this example, you will earn 2.6% - 3.2% over a month’s period (at least a 30% annualized return)!
  • If you sell May puts with strike prices ranging from $40 to $55, which is conservative relative to our valuation, you can earn 2.7% - 5.9% over the next two and a half months (28% annualized, at most);
  • If you sell January 2017 puts with strike prices ranging from $40 to $50, which is extremely conservative and attractive from the ownership’s standpoint, you will earn 6.7% - 11% over the eleven-month period (about 12% per annum).

Keep in mind that I have excluded transaction fees and taxes from the above calculations.

Short-term puts (especially the options expiring in March) are the most attractive in the list because of the remarkable annualized returns. They also carry less risk because there is a smaller chance that the underlying will fall below the strike price over such a short time period (the time decay is very significant in this case; keep in mind that it works on the seller’s behalf).

However, the key word here is “annualized” return. That is, you will have to get into the same kind of deals right on the next day after the option’s expiration. This is not always sensible, especially if you take into account the transaction fees. Moreover, implied volatility can change dramatically. The last two months were very volatile in the market which gave rise to implied volatility. These high volatility levels may not stay high throughout the year, which means that options in general will become cheaper, and First Solar is no exception. Therefore, if you really like the stock, the best option for you is to sell the January 2017 puts (I recommend the $50 strike as you will either earn the highest return from the selection available or buy the stock at the lower end of the valuation range). Earning 11% on the cash that sits in your account is not bad at all, in my opinion. Moreover, you can earn interest on the premium you received, as well!

Where does the name “option wheel come from”? The above strategy (selling OTM puts for stock you want to own at a discount) is just one part of the “option wheel”. The entire algorithm for the strategy is as follows:

  • Evaluate the security you want to own. If it is overvalued, sell OTM options with a strike that is closest to fair value (sell even below that to later buy the stock at a discount to fair value);
  • If the stock does not fall below the strike price and the option does not become ITM, repeat step (1). Otherwise, close the position and buy the stock with the cash on hand;
  • Sell OTM calls with strikes above the upper boundary of your valuation range. If the stock does not cross the strike price, repeat. Otherwise, sell the stock and give the proceeds (the profit) to the counterparty;
  • Sell OTM puts, while keeping the cash from step (3) in your account.

As you can see, the above strategy is repeatable and works a wheel: you sell puts, cover, sell calls, cover, etc. This is why it is called an “options wheel”. Try doing that with First Solar and tell me how it goes!

Buy at a discount or get paid not to buy!