Should I Close a Short Put Position Early?

I got a question from a long-time reader--Wilson M.--today, that I thought was a good one. I'm sure a lot of people have wondered the same thing, so I asked Wilson if it would be okay to post our conversation on the IOI Blog. He graciously assented, so here it is. Hope this exchange helps you as well:

Original Question

Hi Erik,

Do you have any rules that you follow on when to close out a put write position early?  I had a position in TDC and SYMC that were set to expire at the end of the week.  Both were trading within 2-5% of their respective strike prices.  I closed out of SYMC early and it looks like I could have just let it expire worthless, while with TDC I held on and they preannounced and the stock plummeted.  Argh!

Regards,

Wilson

Erik's Answer

Hi Wilson,

Thanks for the mail and sorry about the TDC—I feel your pain on that as similar things have happened to me in the past too…

There are a couple things that I usually look at.

1. Option liquidity and bid-ask spread. If the spread is too large, I usually just assume I’ll have to own the stock eventually, so do a lot of valuation work up front. Doing that, I feel more confident about keeping the thing open until expiration and don’t mind owning the underlying.
2. Perceived probability for negative news. For liquid options, I don’t mind trading out ahead of time if I start to see more signs that there could be something negative to valuation on the horizon. I did this with Western Union WU a few years ago, because I started to get worried that the Morningstar analyst was not being realistic in his assumptions for the possibility of a slow-down in European and North American migrant worker populations (one key driver to WU’s business model).
3. Unrealized profit. If I find that I am worrying about negative new on a stock in which I have a position in a liquid option, and on which, if the option expires OTM, I’ll only make an additional $0.05 or something on premium of $1.75, for example, my fear usually overwhelms my greed and I’ll leave the extra $0.05 on the table and close out.

Remember that in the case of TDC, you can write covered calls on top of your new stock position that will help you to keep lowering your effective buy price. Just make sure that the strike price at which you write your covered calls is above your original effective buy price, otherwise you run the risk of locking in a loss on your investment.

Western Union Stock Price
Source: Yahoo! Finance

Thanks again for the question--this is a good one that I think a lot of people wonder about some time or another.

All the best,

Erik

New LEAPS Listed - CAT as a Bearish Investment?

One aspect of option pricing that I discuss in The Intelligent Option Investor is that very long-tenor options tend to be structurally mispriced. This mispricing allows for an intelligent investor to tilt the risk-reward equation in their favor when investing in LEAPS--especially LEAPS on companies whose statistical volatility is low.

Today, I noticed several news stories about new LEAPS being listed for some large market capitalization stocks. These options will expire in January 2016--giving an investor more than 26 months of economic exposure to the underlying companies.

The LEAPS I saw announced today were on:
The Boeing Company BA
Caterpillar, Inc. CAT
ConocoPhillips COP

At the VALUEx Vail conference hosted by Vitaliy Katsenelson, Kynikos Associates' founder Jim Chanos presented what he described as his favorite short idea--Caterpillar. His argument deals with the company's exposure to Chinese infrastructure overinvestment, which he believes to be an issue of epic proportions.

After listening to him speak, I pulled together a quick valuation of CAT and presented an option strategy to gain exposure to CAT's downside using a put option. Vitaliy posted my CAT presentation on the web, so please take a look at that if you have not already.

Caterpillar Valuation Range
Source: Company statements, IOI analysis

As I explain in The Intelligent Option Investor, it is better to gain upside exposure through LEAPS than to gain downside exposure, but if Chanos is right about the future direction of iron ore, the January 2015 puts mentioned in that presentation look attractive, and have gotten much cheaper since I originally presented the idea.

I have been meaning to do a more complete valuation of CAT since then, but keep getting sidetracked. This is another of my many back-burner projects that I hope to come back to soon.

How Do You Know the Sun Acquisition Helped Oracle's Business?

Introduction
I recently posted an article on SeekingAlpha (Oracle's Sun Acquisition is Paying Off in Spades) that drew from the data about operational leverage that I posted previously on this blog. The SeekingAlpha posting received several good questions, and I wanted to post those questions and my answers here.

In a nutshell, the questions are:

1. Oracle seems like its obfuscating its financial picture. How do you know that it is making good acquisitions in light of the continuing shrinking in the hardware business?
2. Your operational leverage argument may not be causal, but coincidental. How do you know the software update segment wouldn't have done better without the Sun acquisition.

I split edited versions of the questions and my answers in two blog postings since each Q&A is fairly long.

How Do You Know the Sun Acquisition Helped Oracle's Business?

Your main contention is "The Sun acquisition was good, and we can show that by pointing to the increasing operational leverage of the software update segment since the acquisition."

I don't see your argument for a causative connection here. There is a temporal overlap which, in and of itself, isn't explanatory and might be coincidental. It's perfectly possible that the software update segment might have been doing even better without Sun.

Answer
Thanks for your comments and questions--I'm glad the article was thought-provoking for you.

Regarding causality, you are right that it is hard to draw causal connections with any data, and I agree that one should be careful about doing this. The points you raise are valid and you'll notice that in the text of the article, I am careful to use verbiage like "suggests" and "likely" rather than "proves".

To address your question of causality, from a statistical standpoint, the first step is to see whether or not the new data is really anomalous to prior results. In other words, before we show that X has changed due to Y, we should show that X has really changed.

Looking at the leverage data, I would say that there is the strong indication that the results of the last three years have been anomalous in comparison to its prior history:

Estimated Operational Leverage for Oracle's Software Update Business
Source: Company Statements, IOI Analysis

Looking at the above, it is clear that the firm had fairly stable and maybe even declining operational leverage in the years preceding the merger; after the merger, the measure increased markedly.

There is not enough data in this series to do a scientific comparisons of means with a high statistical confidence, but this kind of study is rare in the analysis of single companies, so we do have to make a bit of a leap of faith. Certainly, looking at the above graph, it would be harder to make the case that something substantive had not happened after 2010 than that something substantive had happened.

So, I am comfortable saying that something in the business likely changed subsequent to the Sun acquisition. The next step is to consider if there is a plausible causal link between the the acquisition and the increased profitability. Indeed, I can think of two:

Bundling Advantages
Oracle may be bundling its software in such a way as to generate greater profits from every sale. This might come from telling Solaris owners:

"You don't have to buy a new box, but we can sell you an inexpensive upgrade that will help your old box run faster. If you buy your normal db upgrade, we'll throw in this Solaris software upgrade for just 10% more and you'll get 50% faster access speeds."

Obviously, I'm making this conversation up, but this kind of "vertical integration of the stack" mechanism is one of the stated strategic goals of ORCL, so it's probably taking place in some form or another. This is the first mechanism that hit me as I was looking at these data.

Java Monetization
Along with the purchase of Sun's hardware lines, ORCL also got access to Java. There is evidence that ORCL is doing a better job at monetizing its ownership of Java than Sun was. Certainly, considering that Sun was mainly a hardware company and wasn't nearly as concerned with the software side, this improvement under ORCL shouldn't be a surprise.

A lot of programmers were worried that ORCL's ownership of Java would mean that Java would be too commercialized. It seems like ORCL has so far been very skillful in walking the fine line between playing nice in the game of the Java Standards Committee and making sure that it was getting paid for the programming resources it was expending on Java.

There is good evidence that the programming community now believes that Java has improved under ORCL's stewardship, and it is hard to believe that Ellison would not make sure he was getting some economic return on these improvements.

Regarding opinions whether the Sun acquisition was positive or not, there is anecdotal evidence on both sides of the argument.

Some ORCL insiders have criticized the Sun acquisition saying that the hardware business is terrible. Some salespeople are not happy that they're not getting credit for hardware sales that come about because of their relationship with software clients, etc. These are the kinds of things that take time to work out in an acquisition, so I tend to discount the stories as anecdotal and figure that the issues will be worked out over time.

On the other hand, Ellison has said that the Sun acquisition is the best one he has ever made. He is a software guy and the profits of his company largely stem from the software business. He's not an idiot--he can see that the paring down of the hardware business is affecting the top line--so he must be thinking that the Sun acquisition has helped his software business somehow. Looking at the data on operational leverage, we see that after the Sun acquisition, the software business is rapidly an anomalously increasing its profitability.

Taking all of this into consideration, I am pretty comfortable in making the contentions I have in this piece. Of course, I cannot be completely sure, and I am constantly looking for proof that my contention is wrong.

Thanks for your excellent question--your point is well taken,
Erik

How Do You Know Oracle is a Good Acquirer?

Introduction
I recently posted an article on SeekingAlpha (Oracle's Sun Acquisition is Paying Off in Spades) that drew from the data about operational leverage that I posted previously on this blog. The SeekingAlpha posting received several good questions, and I wanted to post those questions and my answers here.

In a nutshell, the questions are:

1. Oracle seems like its obfuscating its financial picture. How do you know that it is making good acquisitions in light of the continuing shrinking in the hardware business?
2. Your operational leverage argument may not be causal, but coincidental. How do you know the software update segment wouldn't have done better without the Sun acquisition.

I split edited versions of the questions and my answers in two blog postings since each Q&A is fairly long.

How Do You Know Oracle is a Good Acquirer?

I have been following ORCL for some time now and my unease stems from the following: 

• ORCL stopped breaking out its database and middleware business from its applications business and now reports everything under "cloud revenues." Now you do not know how each business is doing. Maybe all lines are doing well - maybe not. 

•  Too much goodwill ($40 billion) sitting on balance sheet. 

• The hardware business is yet to find its bottom. Even for Q2, Safra has guided to minimal to negative growth for the hardware segment. If the business keeps shrinking, I think they will have to write down the Sun acquisition in the same way that HPQ had to write down the Autonomy acquisition.

Answer
Thanks for the thought-provoking questions--much appreciated. I'll address each one-by-one.

Oracle financials are confusing
I know how you feel. I get frustrated with companies too when they change reporting categories seemingly to obfuscate performance of a certain segment or business. CSCO has driven me crazy with this tactic and I think ORCL is guilty to a lesser extent.

The one thing I would say is that for something as large and complex as a modern multinational, there is simply no way to get all the detail one would like and I'm not sure that having all the data would do a great bit of good in terms of tightening up the valuation.

My goal is to be 80% right rather than 100% wrong--get the direction basically right and try to find clues (like the op leverage) to either deny or confirm my educated guesses.

As an analyst, I believe that I and other analysts get caught in a behavioral trap where we can never have enough data without realizing that the marginal impact of what they are trying to figure out is very small to the valuation overall. I do think that sometimes we simply cannot know everything but think that my valuation assumptions have pretty good .

Goodwill
I know a lot of people are concerned when they see goodwill in a statement of accounts, however, it is best to keep in mind that goodwill is only an accounting convention and that its link to economic reality is tenuous.

Goodwill simply is the amount paid for an asset above the book value of that asset. There are a lot of issues with book value in the first place, but keep in mind that most of the companies ORCL acquired in the mid-2000s were software companies and that software companies have a higher proportion of 'assets' that are not reflected on a balance sheet then say, a widget manufacturer (e.g., IP of present products and those in development, worker know-how and experience, etc.).

Because the intangibles were not listed on the balance sheets of the acquired companies, their book value was understated. This understatement leads to a good bit of the goodwill on Oracle's balance sheet now.

The best way I have found to think about acquisitions and whether they are creating or destroying value is to look at a chart like this one:

IOI Estimate of Oracle's Marginal Growth in Economic Profits
Source: Company Statements, IOI Analysis

The most important thing is whether or not the acquisition of another firm is adding or destroying value for the shareholders; the easiest way to think about value creation or destruction is to look at how much wealth the firm is creating versus some benchmark (like nominal GDP growth). ORCL has done, according to this measure, an excellent job of creating value for its shareholders and that is what the second chart expresses.

The Hardware Business Hasn't Found Bottom Yet
Right--I agree that the hardware business has not found a bottom yet and its revenues may continue to shrink.

That said, ORCL's primary business is software and its cash cow is selling subscriptions to updates. My point related to operational leverage is simply that the acquisition of Sun seems to be generating steadily increasing margins for the most important of ORCL's divisions, and that no matter what happens shorter term with the small proportion of sales and profits stemming from the hardware business, it is the improvement to the software update business that is really important for ORCL shareholders.

A write-down would be appropriate if the company could not show its auditors solid proof that the Sun acquisition was not impaired. Considering the sales increases in "engineered systems" and the profitability increase in its most important division, I don't think this would be a hard case for the management to make to the auditors.

Thanks again for your excellent questions,
Erik