Friday, January 25, 2013

Sears Holdings: Try This Options Strategy Instead Of Shorting The Stock

Sears Holdings (SHLD) same store sales fell 5% last month. Sears could possibly lose as much as $500 million this year. Goldman Sachs (GS) thinks that next year could be just as bad or even worse, Sears fiscal year ends and begins in February so this year’s numbers are due out soon. Depending on how this quarter’s numbers come out Sears may have as much as $900 million cash on hand, they had about $600 million at the end of the third quarter and may have had positive cash flow during the holiday sales season.

It looks like its debt load is unsustainable and from here out its cash burn rate could be rapid. They’ll need about $2.2 billion to keep going over the next 12 months. I’m not going to spend a great deal of time on the company fundamentals in this article, there are numerous sources available online to delve further into the deteriorating situation at Sears. The story has been widely reported by the major news sources. I’ll leave further fundamental analysis to the reader.

What I want to discuss is an option strategy that could be an alternative to simply shorting the stock outright. Buying puts on Sears doesn’t make a lot of sense because the news is out on Sears and as a consequence they are very expensive. The implied volatility on the January 2013 at the money leaps is over 120. When options are expensive we want to be sellers and be buyers when they are cheap.

So how can we take advantage of the high IV on Sear’s options and have a position that profits from a decline in Sears? One answer is to use the covered put strategy. Most investors are aware of covered calls, but covered puts are not nearly as popular. To put on a covered put we’ll short the stock, and then sell a put option. Our profit on the downside is limited and our risk on the upside is theoretically unlimited as with any short stock position.

Looking at the closing option prices from January 13th, 2012 on Sears we could have shorted the stock at $33.31 and sold the January 2013 32.50 puts for $13.85. The most we can make on this trade is $14.66 or $1,466 on a 100 share, 1 put trade. We have upside protection up to $47.16 in the event that Sears turns around somehow and rises. Investors who are more risk averse can purchase an out of the money call for upside protection in the event Sears were to be bought out buy a rival at a premium or something like that.

The sale of the put gave us upside protection to $47.16, we could buy a 47.50 call for 3.80. The IV on the 47.50 calls is only 49. The difference in IV between the calls and the puts is a whopping 72. The calls are cheap because no one wants them. The puts are expensive because everyone is buying them. Now the most we can make from a price decline is $10.86, but we have limited the potential loss to $0.34 cents.

As always with option trades there are literally hundreds of different combinations of strike prices and expiration that could work, I selected the January 2013 LEAP as an example of what type of position can be constructed. The possibilities are almost limitless. One of the best ways to take advantage of the high IV on the Sears puts is to be a seller and use a covered position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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