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Extreme Return Naked Put Options

December 21, 2011 4:39 am
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Extreme Return Naked Put Options

It’s hard to imagine that one can ‘long’ a stock, when the stock fell from above $8/share to less than $3/share, and yet returned almost 20% in half a year. If you think it’s fiction, welcome to the world of extreme naked put options.

The stock being referenced is China Medical Technologies, Inc. (NASDAQ: CMED), a Chinese medical device company. The stock IPO’ed in 2005, and traded as high as $55/share in 2008, when Chinese stocks were the hottest tickets to wealth creation in the investment world. However, as more and more Chinese companies – which took the route of reverse mergers to be listed in the US stock markets – got questioned, they were investment darlings no more. In fact, it was the exposure of potential fraud of one particular company that set off a wave of selling in Chinese ADRs during summer, which created the opportunity on the trade on CMED.

The company that was questioned of fraud, made by a report from Muddy Waters Research, was Sino-Forest, a Chinese forestry company traded in the Toronto Stock Exchange. The fraud charges not only set Mr. John Paulson’s fund back $500 million, it also caused a ton of Chinese ADRs to drop significantly once the news hit, as investors sold first and asked questions second. However, the effects were even more far reaching in the options market. With the internal options report we generated, we noticed that CMED’s Jan 2012 $2.5 option was selling for $0.85/contract. In other words, it was yielding 34% in a little over half a year, if the stock stayed afloat above $2.5/share within that period. With the stock trading at over $8/share at that time, that’s an over 80% margin of error before losing money. The market essentially believed that CMED is a fraud, and that there’s no value in the company after all.

However, we believed that CMED has a real operating business, and even while profit margin is shrinking, it’s not the same as pure fabrication of a business. The CEO of CMED also bought ~$500K of the company’s stock after Sino Forest’s shenanigan, which also sank China related stocks. Thus, even if it’s a fraud, there are forces that want to keep the company going for more time. We ended up selling the Jan 2012 $2.5 put for $0.85/contract and Dec 2011 $3.0 put for $0.75/contract.

Since then, CMED gradually sank all the way from >$8/share to ~$3-4/share, which was still above our options prices. Earlier this month, Glaucus Research issued a report accusing CMED of potential fraud, causing the stock to drop to ~$2.7/share. While it plunged below our Dec. option strike price, we nonetheless are still in the money for the option, since we got a $0.75 premium for the option – thus giving us a break-even point of $2.25. In any case, we also believed that the accusation by Glaucus Research was old news, and should not sink the company, at least not before our options expire. On Friday, when our $3.0/put expired, we closed the position and netted $0.55/contract in profit. We are still holding on to the Jan $2.5 put option unless we see more serious charges, or further price deterioration.

Options is not for everyone, and options with very high premiums more likely than not have some fundamental problems, as indicated in this case with CMED. However, because of the high margin of error provided by the far-away strike price and high premium, extreme return naked put options can also be very profitable. Before doing such trades, investors must be aware of the risks involved, as well as the fundamentals of the company, before pulling any trigger.

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