By: Brad Thomas at: http://capitalistexploits.at/ [5]
Early in 2012 I noted how cheap Royal Dutch Shell (RDSA) appeared. Certainly the stock looked cheap, though when trading options I need more than just a cheap stock.
Importantly, in this instance the availability of ultra-long term December 2016 expiration options (trading on the Amsterdam exchange) also seemed cheap, which is what I require, so I bought some options. What follows is the story of that adventure. I think it's illustrative of the importance of buying yourself time, ensuring you stick with your trading plan and trade methodically.
In early April 2012 RDSA was trading at €26.1, a mega cap stock (once the largest stock in the world by market cap) trading for a price to book ratio of 1.25x, P/Sales ratio of 0.45x, a forward P/E of about 8x, and sporting a dividend yield of about 5% – that seemed cheap, very cheap! I certainly didn't think that there could be much in the way of downside in that stock! Well, I was right but I certainly wasn't expecting it to be more or less unchanged 2 years later!
At the start of April 2012 the December 2016 €28 strike was trading at €2.0. This equated to an implied volatility of about 20%. Like I said, I thought that was cheap, but little did I know at the time that implied volatility would drop even further to a record low of 15% some two years later!
Anyway, on the 13 April 2012 I bought 50 options on RDSA with December 2016 expiration and €28 strike at €2.0 – which equated to €10,000 (the vertical green line on the graph below). This option had some 5 years to expiration, so I had a lot of time. I thought that RDSA would be materially higher after just 2 years, but to be safe rather than sorry I bought the option with the most time to let this trade "work". Normally when I trade, if I can go further out I will, and with RDSA being so liquid the opportunity existed.
Well, how wrong was I? Some 18 months after buying the option, it was worth half the value I paid for it, even though the price of RDSA was more or less unchanged at that time! This certainly wasn't amusing.
However, all was not lost. At the start of 2014 the option still had 24 months to run and I was still "confident" in my hunch that RDSA would trade materially higher in the not too distant future.
Fast forward to the 22nd of May 2014 (two years after buying the option) and it was trading at €2.27. Also, there were December 2018 expiration options available. To "buy myself more time" I decided to sell the December 2016 expiration, €28 strike call options at €2.27 (netting some €11,350). I then put all the proceeds of this sale into the December 2018 expiration €30 strike call options at €1.82. I was able to buy 62 contracts (an increase from 50).
On Friday this option closed at €2.49, which with 62 contracts equals €15,438 (about a 50% return). Let's not count our chicks before they're hatched, because this trade isn't over. If I want to see this trade through then I guess I have to wait until the end of 2018, and goodness knows what will happen between now and then.
The moral of the story is this: things rarely turn out the way you expect, but as long as you have time on your side you can be pleasantly surprised by how lucky you can get.
- Brad
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"Markets can remain irrational longer than you can remain solvent." - John Maynard Keynes