Beginning sometime in 1955, our value standards and the market parted company, and the gap has tended to widen throughout the ensuing years.
Graham, Dodd, Cottle, and Tathum, Security Analysis (New York, McGraw Hill, 1962)
The gap between the conservative outlook of Graham and Dodd and the more libertine approach taken by the Rest of the World takes two forms . First, Graham and Dodd were not buying large blocks of stock in the emerging growth companies that were popular in the early 1960s. And at the same time, the investing public shunned the prudent, undervalued industrial and utility issues that Graham and Dodd favored.
From this divergence of opinion, the Value Trap was born. Last month a brilliant industrial analyst and fund manager told me that “Alpha Natural Resources (ANR) is trading for 15 cents on the dollar.” When I asked him when it would pay out, he said “I don’t know, and I don’t care.” Value investors are content to purchase undervalued assets and hold them for eternity, secure in the belief that true value will be unlocked some day.
When market volatility is low, value trap stocks offer short term, high profit opportunities to options spread traders. The key to trading these spreads profitably is to buy them below fair value or sell them above fair value. Graham and Dodd place great emphasis on “margin of safety” and the same principle applies when buying or selling spreads on dead-in-the-water, going nowhere common stocks.
What is fair value? A market maker at Suquehanna International Group explained it best.
Fair value has nothing to do with historical price movement or anything that happened in the past. The only relevant metric is comparison with prices of similar issues that are trading in the market at the same time.
Short term, weekly expiration butterfly spreads are an ideal, albeit dangerous vehicle for speculating on a flat market. To get fair and unfair value on these issues, it helps to compare various spreads against each other to get a feel for what is possible in the market. I like to use the spread cost / wing size to value if a spread is fairly valued or not.
Lets look at a classic flat-line stock, Cisco Systems (CSCO). On Tuesday November 17 2014 the at-the-money butterfly spread quoted at 0.22, on a wing size of 0.50. A speculator buying CSCO risks 0.22 for a maximum profit of 0.28 if the stock lands exactly at the middle strike. A move outside the 1.00 wing size results in a 100% loss. In my opinion, this is fair value for a flat-line stock. I would not buy or sell.
The diametrical opposite of CSCO might be NUGT, the 3x levered Gold Miners ETF. On Tuesday, November 17 2014 the NUGT underlying moved 14.62%, compared to the 0.49% move in CSCO. Although the NUGT underlying showed 30x the daily volatility as CSCO, the options spread sold at slightly less than half that for there same 0.50 wing size. Needless to say, your author sold butterfly spreads in NUGT at 0.10 and abstained from CSCO at 0.22.
On the very same day, your author also purchased butterfly spreads in comatose Metropolitan Life Insurance (MET) for less than the price he received from selling spreads hyper-active NUGT. I put in an order for more and did not get filled.
Here is a brief checklist for portfolio managers and speculators to look for when identifying spread candidates on Value Traps.
- Weekly Options Available?
- Open Interest?
- Weekly Change in Underlying?
- Weekly Range in Underlying?
- Comparison vs. Opposites: How does the Flatliner compare vs. the Gunslinger, or Vice Versa?
- Strategy Consideration: Do you really want to trade long butterflies? It is like landing on an aircraft carrier. Butterflies tend to flutter away with your profits.
David A. Janello, PhD, CFA