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Shopify Inc. (SHOP) reported higher revenue and strong FCF margins on May 8. But SHOP stock is down on market disappointment. That gives a cheap entry point for value investors, especially by shorting out-of-the-money (OTM) put options.
SHOP stock is trading at $58.32 in midday trading on Friday, May 17. This is down 24.5% from a recent peak of $77.37 on May 6 before the earnings release.
I discussed this stock recently in a March 16 GuruFocus article, “Shopify's FCF Margins Could Push It Higher.”
I discussed the underlying value of the stock and concluded, based on FCF projections that it could be worth $106 billion in market value. That is 42.3% over today's $74.5 billion market cap and implies it is worth about $83.00 per share.
Selling OTM Puts to Buy-In
However, it could take a while for the market to appreciate the value of this stock. So it makes sense to use a disciplined approach to buying into SHOP stock. One way to do this is to sell short OTM put options.
For example, look at the June 7 put option expiry period, which is three weeks away. It shows that the $55.00 strike price puts, 5.68% below today's price, trade for 58 cents per put option contract.
That implies that a short seller of these puts can make an immediate yield of 1.05% (i.e., $0.58/$55.00). Here is how that works:
The investor first secures $5,500 in cash and/or margin with their brokerage firm for every put option contract to be sold short. Then the investor enters an order to “Sell to Open” 1 put at the $55.00 strike price. The account will immediately receive $58.00 for every put contract sold at this strike price. That presents an immediate yield of 1.0545% (i.e., $55/$5,500).
So, for example, if the investor invests $22,000 to sell short 4 put option contracts at the strike price of $55.00 the account will receive $220.
Moreover, if the investor can repeat this trade every three weeks for a quarter the account can potentially make $880. That represents an expected return (ER) of 4.0% ($880/$22,000) over that period.
Downside Risks
Moreover, this is a disciplined way to buy into the stock. For example, the breakeven level at this strike price is $55.00-$0.58, or $54.42 per share. That is 6.7% below today's price. In other words, the investor has a way of both making income and potentially buying in at a much lower price.
Granted, this involves a potential unrealized loss, since the stock price has to be at $55.00 or lower for the short put contract to be assigned to the seller of the puts. But, given the potential upside in SHOP stock as discussed earlier, the investor can keep holding the newly acquired shares until SHOP rises to its target price.
Or the investor can sell covered calls at higher or out-of-the-money call strike prices in nearby expiry periods. That allows investors to recoup some of the unrealized losses at the buying price.
The bottom line is that SHOP stock looks cheap here and one way to acquire shares cheaply is to short OTM puts.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
