Aaron’s Inc. (AAN, Financial) had quite a year in 2016; over the last 12 months, its share price increased by nearly 43%. Not bad for a brick-and-mortar retailer, albeit a specialty retailer.
The company operates a chain of more than 2,000 stores that provides lease-to-own furniture, electronics, appliances and other miscellaneous items. It also earns lesser amounts of revenue on retail and non-retail sales, franchise fees and royalties, as well as interest on loan receivables.
It enjoys a high predictability rating from GuruFocus, 4.5 (out of 5) Stars, and is on the Undervalued Predictable screener. This predictability means it has consistently delivered increased earnings year after year, suggesting it is likely to deliver higher share prices if held for the medium- or long-term and is unlikely to experience capital losses over an extended term.
But predictability is hardly the word that comes to mind when looking at its price chart over the past three years:
Note the gap-downs in the past couple of years, price plunges that would ice the veins of most investors.
Yet, there is a way to own Aaron’s and still sleep at night, while at the same time having an opportunity to enjoy enhanced dividends and capital gains: protective puts.
What is a protective put?
A put is a contract between a buyer and a seller and functions like an auto or home insurance policy. In this case, the seller guarantees a floor price on a stock; in other words, if the share price drops below a predetermined level, the seller makes up the difference to the buyer. To get this protection against capital losses, the buyer pays a premium or fee. The seller acts like an insurance company and the buyer acts like a home owner.
When an investor buys puts to protect against losses in a specific stock, he or she is buying protective puts. If the stock and puts (both in units of 100) are bought at the same time, it is called a married put.
Brokers ensure that investors who take the risk side of these contracts (the sellers) maintain enough capital to cover any potential claims.
In summary, a protective put is a contract with another investor, one who acts like an insurance company and takes on risk in exchange for a premium.
What’s wrong with a cost-free stop or trailing stop?
Both stops and trailing stops also provide protection at no cost. Why not use them? Stops and trailing stops work well—when a stock price moves down gradually.
But when a stock declines in a hurry, or gaps down, a sell order may not find a buyer until it drops well below the investor’s target price. A dramatic example of this occurred during the Flash Crash of May 6, 2010, when the Dow Jones Industrial Average plunged more than 1,000 points and then rebounded to nearly its previous value in just a quarter of an hour. Many investors were stopped out at very low prices, thus kicking off a long round of angry negotiations and litigation.
To some extent, that danger can be offset by using a limited stop, which takes a stop order off the market once the stock drops to a second target price.
Stops and trailing stops, as well as limited stops, are commonly used but provide less robust and less certain risk management than puts.
Why Aaron’s?
Why choose Aaron’s as a stock with which to use put options? Quite simply, it has potential to grow and reward investors with capital gains. It is also an optionable stock; not all stocks are.
The potential comes primarily from its earnings power—it has a 4.5 Star rating for predictability in the GuruFocus system. This means it has consistently grown its earnings year over year, and share prices will need to adjust upward to keep up with the earnings.
Of course, the share price is not likely to go up smoothly (assuming it does rise). As the chart shows, this stock has experienced gap-downs in recent months, indicating a highly volatile stock. Volatility means lots of share price fluctuations, fluctuations that might not be palatable without the protection of put options.
A volatile stock with excellent earnings growth provides opportunities for capital gains, for investors who can manage the risk.
Puts for Aaron’s
For the sake of argument, let’s suppose we buy 100 shares of Aaron’s at $32 each, for a total of $3,200. To that we will add one contract (made up of 100 units) of $32 puts expiring on May 19, 2017, for $310. This is an overview of the investor’s position after completing the transactions:
The investor owns 100 shares of Aaron's, bought at $32, and has the right to put or sell those shares to the option seller for $32. At any time before May 19, the investor has the right to sell his or her shares for $32, regardless of how far up or down the stock price moves. Normally, an investor only exercises this right when the stock price falls below the contract (strike) price.
Creating a table like the one above helps investors develop and execute a plan to preserve their capital.
What happens if. . .Ă‚
If the price of the stock goes up, the value and price of the put options go down. If held long enough and the price goes up enough, if will decline to zero. It is worth noting that the price of a put generally decreases more slowly than the stock increases in price (for more on this topic, read about option deltas). Often this means an investor comes out ahead because the amount of the share price increase is greater than the loss on the put, which can be sold back into the market.
Note that if the investor does nothing and allows the puts to expire, the maximum loss is the original cost of the put: $3.10 for each or $310 for a contract of 100 (not including transaction costs).
If the price of the stock stays about the same until the expiration date (in this case, May 19, 2017), the option will simply expire worthless. This means the investor is out of pocket the amount invested in protecting the share price. The loss here is capped as well: the original cost of the puts.
If the price of the stock goes down, and especially if it goes down dramatically, then the value and price of the put options go up. An investor can then exercise or sell the options at a profit. Once again, the investor’s loss is capped; it cannot exceed the cost of the puts and transaction fees.
An investor who uses protective puts can quantify the extent of his or her potential losses.
Selling or exercising puts
Twice in the past few months, Aaron’s has flirted with lows near $20, well below the current levels of about $32. Suppose it happens again, the stock declines to $20 before the puts expire. The investor can then:
- Exercise the puts: This involves placing an order with a broker. The broker then passes the order to a clearing house, which randomly selects a put seller to buy back the options at the previously agreed price ($32). Few investors, at least retail investors, take this route since it tends to take longer and cost more (in brokerage fees).
- Selling the puts: This involves selling some or all the options in the open market through a simple sell order. Assuming there is reasonably good volume, the puts should sell within seconds and the proceeds will go into the investor’s brokerage account. On lesser-traded names (such as Aaron’s, compared with Apple (AAPL, Financial), for example), investors will want to watch for advantageous price spreads.
Knowing when a gapping stock has hit bottom is impossible, so investors often settle for the next best thing: selling their put options near the end of a gap-day, or after some technical analysis event. In the chart below, for example, there is a 50-day moving average (blue line) and a 200-day moving average (red line):
In this example, the investor might sell his or her puts if the share price falls below the 50-day average or the 200-day average. Some might sell when or if the 50-day average crosses below the 200-day average (a bearish cross). A host of other technical indicators can be applied to identify action points; most investors arrive at their own through a combination of knowledge and experience.
Investors working with options will want to start with an exit strategy, which in this case will involve setting a price or dynamic technical event. To implement the exit strategy, exercise or sell the option(s).
The proceeds
Whether the puts are exercised or sold, an investor will receive about $870 cash in his or her brokerage account ($1,200 - $310 - $20 = $870):
That leads to a reset of the stock’s cost basis, to $26.60 per share.
In turn, that means capital gains begin to accrue at any price around $26.60. If, for example, the share price rises to $32 again, an investor has a capital gain of $5.40 per share or 20.3%. On the other hand, an investor who simply rode the share price down and back up again would not begin accruing gains until the share price hit $32.
The dividend yield would also increase. On Dec. 8, Aaron’s paid a quarterly dividend of 0.027 cents, which works out to 10.8 cents on an annualized basis. That represents a yield of 0.34% on a share price of $32. But, 10.8 cents on a cost basis of $26.60 provides a yield of 0.41%, again a significant increase.
When opportunities arise, put options can enhance capital gains and dividends, as well as provide downside protection.
Conclusion
As Warren Buffett (Trades, Portfolio) and countless others have counselled, “Don’t lose money.”
Normally, that is taken with a grain of salt, as most investors think avoiding losses might be possible for Buffett or another guru, but is beyond the reach of everyone else.
Yet, buying put options, in the same way we buy home or auto insurance, can minimize losses for all investors.
As a bonus, you might say, it also offers opportunities to enhance capital gains and dividends for everyday investors.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
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