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Stay Liquid, My Friend

May 14, 2014 | About:

Grab an edge with this buy-write combination.

On May 8, 2014, I highlighted Liquidity Services (LQDT) as a potential bargain buy at $12.24 per share Playing with a Busted Stock. LQDK was down from $66.57 at 2012’s peak and had traded as high as $40.90 less than 12-months earlier.

The formerly high-multiple stock rebounded slightly, to $13.06, but is still available at about 11.1 times the recently reduced fiscal 2014 (ends Sept. 30, 2014) guidance of $1.10 to $1.27 per share. This is the lowest P/E on this stock since it first came public early in 2006.

I’ll be surprised if LQDT doesn’t recover to $15 or better before year's end.

It is not too late to play LQDT if you missed getting in the other day. Set up a buy/write combination through outright purchase of shares accompanied by the sale of both December 2014, $12.50 puts and $15 strike price call options.

My example is based on purchase of 1,000 shares plus the sale of 10 covered calls and 10 naked puts. The same percentages would apply to any round lot quantity.

In theory any stock could go to zero. In reality that does not happen with debt-free, profitable companies. My illustrations show three broad categories of how this trade might play out by the Dec. 18, 2014, expiration date.

To achieve the best-case result LQDT needs to move up by about 15%.

The middle scenario assumes no change at all from the May 13, 2014, trade inception price of $13.06.

The worst-case example I use reflects a decline to LQDT’s absolute lowest trading price from the last 48 months. There is no guarantee that level could not be broached to the downside. Not even 100 shares of LQDT have changed hands at that low a price, though, since May 11, 2010.

The profit figures shown are the cash-on-cash returns you would achieve if these trades are done in a margin-type account using paid-up equity to secure the puts. The gains are nominal figures for the approximately seven months (219 days) until expiration. Annualized returns would be 67% higher than shown.

The stated return for the worst-case illustration understates the actual results. The final $12,500 doesn’t become due until puts are actually exercised. A 7.7% drop to LQDT’s four-year low still results in a respectable gain (if the whole position is immediately liquidated) on the options' expiration date.

Outright buyers of LQDT who don't sell the calls and puts would need a move from $13.06 to $19.09 to lock in a 46.2% gain. They’d need to hit $16.62 to do better than the "static return" from our buy-write strategy. Option-less shareholders at $13.06 would suffer 7.7% losses if LQDT regresses to $12.05. Our buy-write trades be dead even.

Using option sales in this conservative fashion gives us a distinct edge.

The put option buyer is betting on a fall to below multi-year lows. The call buyer can only win if LQDT rises above $16.15 per share. Both the option buyers can be wrong on expiration day but only one has even a chance of making money on Dec. 18.

I have been using buy-write combinations for more than 35 years. The win percentage tends to be well north of 75%.

Disclosure: Short LQDT Dec. $10.00 and Dec. $12.50 puts.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.TalkMarkets.com
http://www.MutualFunds.com

Visit Dr. Paul Price's Website


Rating: 5.0/5 (6 votes)

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Comments

HrZg
HrZg premium member - 6 months ago

LQDT seems to be a quality company with a good value proposition and a narrow moat built on network effect. The company is undergoing a multiyear transformation with an aim to depend less on governmental contracts, however, for those willing to wait the stock can be had at a bargain right now.

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