A Seatbelt for an Airline Value Stock, Just in Case

Many an investor has found that investing in airlines can produce headaches; variables such as fuel costs, the economy, competition and more make some investors wish they’d taken the bus. Southwest Airlines Co. (LUV, Financial) has done better than most companies in this business but is not without risk.

Credit

At the moment, Southwest has several favorable metrics, including margins, return on equity and EBITDA growth.

Still, the company’s share price has churned up and down for the past year and a half, from around the $50 mark to below the $35 mark.

At the current price, it has found a place on the Peter Lynch screener with its earnings line above the share price line.

On July 21, Dr. Peter Price wrote, in "Southwest's Loss of Altitude Makes for Enticing Trades," “Southwest’s pullback – providing opportunity” and “For option writers, low prices and high premiums allow for great trades.”

A different use for options

I’d also like to talk about the use of options but in this case about buying protective puts to insure an investment in a value stock. Southwest Airlines is undoubtedly a good company, and both fundamental and technical analyses suggest better times ahead for the share price.

But this is the airline industry, and it’s possible the stock might continue its downward shuffle rather than go back up again. The same holds for most value stocks, which by definition have dropped below their intrinsic value for some reason. And sometimes they just keep going down, for reasons known only to Mr. Market (who may not be telling).

So, it’s worth considering adding a protective put to a value stock and particularly a value stock that’s also an airline.

Comments: The purchase of a value stock, particularly in this industry, can bring with it significant financial risk and in some cases enough risk to consider some form of protection or insurance.

Protective puts

Briefly, a protective put is similar to the insurance we buy for our homes and automobiles. If the price/value drops, we can put the option to the seller, to make us whole again, just as we would call on an insurance company if our house burned down or our car suffered serious damage in an accident.

As this suggests, puts can be both bought and sold. One investor (like a home owner) pays a premium to buy a put that will protect her/him. Another investor (like an insurance company) receives the premium in exchange for taking on the risk. If the price of the stock falls, the buyer has the option of selling back the put at its face value. We’ll work through examples below to further illustrate how puts work.

Protective puts may also be called married puts if they are bought at the same time as the stock. Many brokerages allow you to buy this combination in one transaction, thus reducing fees. Visit the website of the Chicago Board Options Exchange (CBOE) for more information about put and call options.

Comments: Although stock options have a bad reputation in many quarters, they can also be a conservative investor’s good friend.

Which put options?

In an earlier article, "Lower or Eliminate Risk in a Volatile Value Stock: Herbalife Case Study," I argued for what I called a "higher strike/early exit strategy." This involves buying a put with a strike price well above the current share price, buying a long-term put (at least six months away) and selling it well before (at least two months) its scheduled expiry.

The goal with this strategy is to maximize the protection while minimizing the cost. It runs counter to the traditional put/insurance strategy of buying a lower priced strike and for a shorter time period to keep the price down. With higher strike/early exit we do pay more upfront but also get back a significant amount later.

Comments: I suggest a nontraditional approach to buying protective puts, which uses what I call the higher strike / early exit strategy.

Let’s compare

This table shows three different scenarios for strike prices, all based on selling the puts about two months before expiry. In this table we also assume, for the sake of keeping things simple, that the share price will be the same when we sell the puts (to look at other share price assumptions, go to OptionsProfitCalculator.com):

Contents of the cells:

• OTM: Out-Of-The-Money put, which means the put’s strike price is below the price of the stock.
• ATM: At-The-Money put, which means the put’s strike price is close to the stock price.
• ITM: In-The-Money put, which means its strike price is higher than the price of the stock.
• Column A: the stock price at the time the options were priced.
• Column B: the strike price of the option, the face price at which owners will exercise their right to buy or sell.
• Column C: expiry date of the option, like the expiry date of your auto insurance.
• Column D: the cost of 100 puts (the standard size of an option contract), using the ask price (although we may negotiate better prices, the standard procedure is to sell at the Bid price and buy at the Ask price).
• Column E: the amount you would receive if you sold the options roughly two months before their expiry (using calculations from OptionsProfitCalculator.com).
• Column F: number of months we expect to stay in the contract, which expires at closing on the third Friday of January 2018.
• Column G: net cost for 15.8 months of put protection (assumes selling two months before January expiry).
• Column H: cost per month of protection.
• Column I: the cost for one year of protection, based on the rates shown here.
• Column J: the cost of put protection expressed as a percentage.
• Column K: what you would receive if the stock price fell to $50 during the term of the contract.

What does it all mean?

Here is the table again:

By selling early, roughly two months before the puts expire, we avoid the rapid loss of value that occurs in the last six to eight weeks of an option’s life. For example, the last two months of the $35 put represent 11% of the time involved, but 32.5% of the option’s total value.

The higher strike costs more to initiate but not much more ($26) if we make an early exit. At the same time, if the stock drops in price, we can sell the $40 put for significantly more than $35 or $38 put. Behind these nonproportional results lie two key elements in put and call options: time (or extrinsic) value and implied volatility, which we won’t cover in this article.

Most importantly, our investment in Southwest is insured, and if the price of the stock falls before November 2017, even to $0, we are protected. As this summation shows, we cannot lose more than $201 or 4.8% on our investment in the stock and puts:

Of course, we might argue that if the stock stays at about the same level or goes up, we might have wasted the $700 or portion of it that we spent on the puts. But we could also say that every time our car insurance expires without making a claim it is a waste as well.

Comments: With put options, we can quantify the exact amount of risk that we are taking when we buy the stock and accompanying protection.

Risks and rewards

If you plan to buy a stock, you likely have some idea of what its potential gains might be. For example, if we look at the 52-week high of $51.05 and a chart, we might assume that’s a reasonable target:

If the price goes up to $51.05, that would be a gain of $13.20 or 34.9%.

Now, we can quantify our reward as well as our risk:

• Our potential gain: 34.9% (as estimated by the previous high).
• Our maximum potential loss: 4.8% (as guaranteed by the $40 put).
• Reward to risk ratio: 7.2.

Dividing the first by the second, we see the potential reward is 7.2 times greater than the potential risk if we make this investment with a protective put.

Comments: With the extra step we are able to quantify both the risk and reward, which takes us a step closer to calculating our expectancy.

What ifs

What if the price of the stock goes up after I buy a protective put? As the price of the stock goes up, the price of the put option will go down; in other words, the put will be worth less to you as the share price goes up. How much less is moving target, and depends on what’s called the option’s Delta (and Gamma, too, if we’re going to be precise). To estimate the value of the option at different times in the future and at different stock prices, use OptionsProfitCalculator.com. But it will only give you estimates because of potential changes in the option’s implied volatility.

In many cases when the price goes up, you will be able to replace the put options with a stop or trailing stop, for ongoing protection.

What if the price goes down after I buy a protective put? Again, use OptionsProfitCalculator.com to estimate what the option will be worth at different times and at different stock prices. Savvy investors often welcome the opportunity to roll down their put; in other words, sell the existing put for more than they paid for it and buy a new, lower strike put for a lower price. Done successfully, this tactic can help you reduce the cost basis of your stock (which also means a higher yield on the dividend, if there is one).

What if the price of the stock stays the same after I buy a protective put? In that case, you’ll likely do nothing, except sell the put a couple of months before. If you feel you still need protection, you can buy a new put, or if you feel comfortable about the stock’s prospects you can simply go on without insurance.

Conclusion

It is possible to reach for capital gains from a value stock without undue risk. As this article demonstrates, a put option can function much like the insurance policy you have on your car.

But not all put options are created equal. While you can buy cheap options, you get the equivalent of an insurance policy with a very high deductible, a policy that limits your protection.

As we’ve seen above, the higher strike/early exit strategy costs slightly more but provides more protection if the price of our stock collapses. To use this strategy we choose a strike price above the current price of the stock, and we buy a distant expiry but sell it at least two months before that expiry.

Disclosure: I do not own any of the stocks or options listed in this article, nor do I expect to buy any in the foreseeable future.

Start a free seven-day trial of Premium Membership to GuruFocus.