Bull Trades (and trading AIG)

Bull

As I mentioned in my previous post, I talked about the investment thesis for AIG – a huge potential turnaround candidate undervalued relative to peers, focusing back on their core business.  I’m extremely bullish on the company and have invested in the company for me, my wife, and my mom-in-law.  Being extremely bullish, I’ve decided to be aggressive in how I invest in the company, using a variety of trades that equate to stock ownership:

  1. Owning stock
  2. Buying Deep-in-the-money Leaps
  3. Synthetic Longs
  4. Buying Warrants

***** WARNING: This post discusses the use of options – be sure to understand the risks of options before investing in them.  When investing in stocks, you are predicting price direction.  With options, you are predicting both price direction and within what time period.  Options may also not be suitable based on an individual’s risk tolerance and investment objectives.  *****

1) Owning Stock

This one is pretty basic and understood – for mom’s account, we basically just invested directly in AIG shares.  Her account does not have option trading enabled – which basically removed all other methods – as we’ll see later on anyways, this would be the preferred choice for her.  She would also benefit from if/when the company decides to issue out dividends.

2) Buying Deep-In-The-Money Leaps (e.g. January 2015 $30 Calls – currently at $16.80)

LEAPS are just like regular options – they just have far-off expiration dates – in this case, the furthest out we can get is January 2015.

We’re investing in deep-in-the-money calls ($30 exercise price when the current stock price is $45). This offers a total return equivalent to investing in shares, but requiring less capital, for a small time premium of $1.80.

3) Synthetic Long (e.g. Buy January 2015 $45 Call for $7.30, Sell January 2015 $45 Put for $7.30)

A synthetic long consists of two parts – buying a call, and selling a put. For my purposes, I’m using the same expiration date and strike price. A synthetic long option strategy works out to nearly owning the underlying stock – without having to pay up front. This is a great strategy if you are extremely bullish on a stock (as we are with AIG).

For illustrative purposes, for AIG, we’re using LEAPS, buying the $45 Call and selling the $45 put. The transaction doesn’t cost us anything because the money to buy the call is funded by the sell of the put. If our investment thesis holds true and AIG appreciates, the call will increase in value, and the put will decrease in value. The opposite is true if AIG does not appreciate in value.

4) Buying Warrants

As part of the government bailout to AIG, the company was not only owned by the government, but they were given warrants to buy AIG shares at $45, expiring in 2021 (yes, 8 years away!).  Think of it like a very long term option – but the only difference is that the strike price gets reduced in the event of dilution or cash dividends.  It’s unfair to really try and compare the warrants (which expire 8 years from now) from the LEAPS (that expire in 2 years) but just wanted to mention it as I have basically invested in AIG across the board with all these different methods.

What’s the difference between the first three options?

Well, I put together some scenarios just to show they all have pretty much the same effect:

AIG Strategies

Scenario 1 – Buying Stock: We buy 100 shares of AIG at $45.25 and the profit/loss is pretty easy to calculate as the price moves up and down. If the stock price goes to $25, we’ve lost $2025. If the stock goes up to $65, we’ve made a profit of $1975.

Scenario 2A – Buying the January 2015 $30 call for $16.80: Our break even for this trade is $46.80 ($30 strike + $16.80 that we paid for the option). You’ll notice that the profit/loss on the LEAP is very similar to the actual stock – it’s off by $1.55 because of the time premium on the option but requires us to put way less capital up front ($1680 vs. $4500) for pretty much the same dollar return. Even better is that in an event of a collapse in the stock price, our loss is limited to just what we paid for the option (i.e. we don’t lose any further once the stock price drops below $30 – unlike owning the actual stock).

Scenario 2B – In scenario 2A, we spent $1680 to get the equivalent return of owning the stock. If we were extremely bullish on our stock (as we are with AIG), we could take that $4500 that we would have invested in the stock, and invest all that money into LEAPS – buying close to 3 LEAPS. Now your profit/loss becomes magnified – if the stock rises to $65, you’re making 108% on your investment, more than double the 44% you would have made by just investing in the stock itself. However, the flip side is also true – if the stock goes below $30, you’ve lost your entire investment, whereas owning the stock, you’d still have about 65% of your investment.

Scenario 3 – The Synthetic Long costs us no money up front (the price of buying the call was cancelled by selling the put) but we get the gain/loss as owning the stock (the numbers are slightly manipulated so my graph below could show the similar profit/loss line). Now, this doesn’t mean I should go crazy and have 15 synthetic longs because it doesn’t cost me anything.

For one, if the stock were to tank below the $45 strike price (say even $40), my puts would likely get exercised, and I’d have to buy the stock at $45. At $5 a share loss * 1500 shares (because each option represents 100 shares), that’s a whopping $7500.

There’s also another thing to consider – because a synthetic long involves a naked put, the broker will likely have a margin requirement – which is typically 30%, although it depends on the security. This is in case the investment goes in the wrong direction forcing you to cover. Even at 30%, for our synthetic long, if would require us to lock up $1350 per synthetic long. Multiply that by 15 and you’ll need to lock up $20K.

And just a chart showing that the profit/loss profile is very similar for the different scenarios:

AIG Scenarios

So in the end, if you are bullish on a stock, there’s a variety of options (pun intended) that produce the same result as owning the stock. Again, you should understand the risks associated with investing in options before you do so. This post is not intended to be a tutorial on options and definitely does not identify all risks with each scenario/strategy.The scenario you pick has to be based on your understanding of options, risk tolerance, investment objectives, etc. and that’s exactly how we’ve invested:

Mom: Scenario 1
Wife: Scenario 2A
Me: Scenarios 2B, 3, and 4

Since I am extremely bullish on AIG, I’ve decided to use a combination of these scenarios to mimic owning a number of shares but without having to put so much capital in up front.  For my wife, I wanted her to own AIG, but not enough to make her financial services content so high in her portfolio (she already has XFN, AFSI, and RY).  For my mom, straight shares.   In any event, here’s to hoping the AIG thesis turns out within the next 1.5 years (when all those leaps expire)!

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3 thoughts on “Bull Trades (and trading AIG)

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