From time to time, we like to share alternative investment approaches for readers to consider. Today we share a compelling income-generating idea. The strategy is certainly not for everyone, but some of you may want to consider this one. It’s timely and powerful. Without further ado…
The Trade:
Selling Put Options on Chipotle Mexican Grill (CMG) is attractive right now. For example, we like the August contract with a strike price of $305, and expiration date of August 18, 2017, and for a premium (income) of around $3.40 (this comes out to an annualized premium (extra income) of approximately 14%). This trade is a way to generate income now, and to potentially buy the shares later at an even lower price.
Why:
We believe this is a rare opportunity to take advantage of significant market fear in order to generate significant income. If you sell the puts, and the shares do get put to you before expiration, then you get to buy the shares of this attractive company at an even lower price (the shares are already down significantly in the last week), and whether or not the shares get put to you, you get to keep the attractive income ($3.40 x 100 per contract) you can generate by selling the puts, no matter what.
The Current Chipotle Situation:
Chipotle is a “fast-casual” restaurant that sells essentially burritos and tacos, made to order, using fresh high quality (often locally grown) ingredients, and the restaurant (and the stock price) had been growing rapidly up until the Fall of 2015 when a series a food-related illnesses broke out (customers were getting sick) that drove the share price sharply lower. The stock had finally been showing signs of recovery (almost two years later), until just recently (last week) when news broke of several dozen people getting sick at a Virginia restaurant. The stock has fallen very sharply (it’s down about 18%), and herein lies the great opportunity.
The Technicals:
Before getting into more details on Chipotle and this trade, it is worth considering just how fearful the market is about Chipotle right now. For example, short interest on these CMG shares has spiked to nearly 20% over the last week, and we believe this is an indication of the high amount of fear in this stock.
As contrarians, we like the fear (“be greedy when others are fearful”) because it causes option premium to increase, which we view as an opportunity to generate more income.
Also worth noting, we monitor a metric called “money flow index,” and on this metric Chipotle is extremely oversold. Money flow index is a technical measure of price and volume, or money flow over the past 14 trading days with a range from 0 to 100. A MFI value of 80 is generally considered overbought, or a value of 20 oversold. Chipotle currently scores only 7, which is an indication of an extremely oversold stock.
More About Chipotle’s Latest Customer Sickness Outbreak:
We believe this latest incident is likely isolated, the market has over reacted to the downside out of fear, and we are interested in owning Chipotle as a long-term investment because of its powerful earnings growth power. However, we don’t know if there is “another shoe to drop,” and if the stock will continue to fall significantly lower in the short term. And this is why we like the puts with a strike price of $305. Specifically, it means if the shares fall 10.7% lower (to $305) before expiration next month, then you’ll get to buy the stock at an even lower price (it’s already low). We like to buy stocks on sale, and selling puts is often a great way to do it. And even if the share price doesn’t fall far enough, and the shares don’t get put to you, you still get to keep the attractive income you generated by selling the puts in the first place.
A Few Words On Risk:
Before considering this trade, investors should be aware of a few potential risks. For example…
…if bad news comes out, and the stock crashes, you could still have the shares put to you at $305. Theoretically, this is okay, because if you like the stock, then $305 is a better price to buy at than the current market price of $341. However, psychologically, it still hurts to have the shares put to you if the actual market price has fallen much lower (for the record, we don’t believe the share price will fall much lower than $305, and it may not fall that far at all).
Another consideration is that your brokerage account must be approved to trade options. And if you’re going to sell these puts then your broker may require you to keep some cash on hand to buy the shares if they are actually put to you. In this case, the annualized return on this trade is approximately 14%, which is not at all a bad return, but investors should still be aware of the opportunity cost of holding cash until the puts expire (if your broker requires you to hold cash, then this is cash that you’re no longer able to invest somewhere else). Alternatively, you may be approved by your broker to buy the shares on margin (with borrowed money) if they are put to you. This is another level of risk exposure altogether.
Conclusion:
Overall, this trade is NOT for everyone. In some ways it is a higher level of risk than simply buying and holding individual stocks. It also involves more activity (unlike “buy and hold”). However, it also provides a diversified stream of income (diversified from typical “buy and hold” strategies) that some income-focused investors may want to consider.
