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Alexander Valtsev

Your Best Options Bet In 2016 - Linn Energy

About twenty days ago, I wrote about Linn Energy analyzing its financial situation. The stock was trading at about $1.07 per share back then. My analysis showed that there is a good chance the company will be able to make it through the downturn: it generates free cash flows, despite the price dive in the energy market, has eliminated dividends to save cash, and has a decent bank account to survive the crisis. The book value per share is now north of $5. The shares closed at $1.25 on Friday, January 8, 2016.

Besides being bullish on the stock itself, I also decided to see what sort of deal I can get on its derivatives, namely, on the call options. I checked Google Finance and was surprised to see the following picture:

(Source: Google Finance)

Apparently, somebody is insuring almost 27k shares at a price of $1 per share (keep in mind that one options contract is written on 100 shares)! To put it in plain English, there is a person(s) that is willing sell you Linn's shares at $1 per share up until January 2017. This privilege costs 50 cents per share, according to the ask price. Wherever the stock goes over the next year, the option holder will be able to buy it at $1 and make profit on it, if it goes above $1.50 (do not forget the price you pay for the option - you have to recover it to be profitable).

Now this seemed really strange to me because the stock traded at $10 per share just a year ago. Moreover, because the company is so levered up right now, any modest hike in the price of crude oil will send it into the stratosphere. Of course, there is a considerable chance of the company going bankrupt, if Brent stays in the 30s. However, the risk-rewards matrix definitely looks bad for the bears at current price levels. In my opinion, chances that LINE ends up higher than $1.50 per share by the end of the year are high.

I ran the numbers on an options calculator to see what the option's implied volatility and the Greeks are. I got the following output:

(Source: Option-Price.com)

Apparently, the option's writers expect the price of the underlying stock to show a standard deviation of about 80% over the next year (see the "Volatility" figure). While 80% seems a very high figure (and, therefore, the option is relatively expensive), make sure you do not make your decisions on past data only. Also make you sure you apply different skill sets when evaluating investments.

The value of the option consists of two parts: its time value and its intrinsic value. Currently, these particular Linn's options have an intrinsic value of 25 cents per contract, while the time value is also about the same amount (judging from the ask price). The delta figure, which shows the expected change in price of the option relative to a change in price of the underlying stock (dollar for dollar), implies that a $1 move in the price of the stock will result in a 76 cent move in the price of this particular option. This is extremely risky because the option will become worthless, if the stock falls to about 75 cents per share (the premium I pay now will essentially be nullified). 

But put aside your math skills for a moment and look at the options in the accounting way. If I buy these option now, I clearly understand the risk. I also understand that the chance of losing 100% on this instrument is extremely high. Hence, I do not need additional calculations to convince myself of that. Here I am betting on the probability that the company will survive and its stock will rise to at least $2 per share over this year. Therefore, the option's value is a function of the company's quarterly results. I know that the past data in this particular case are meaningless because the stock is a victim of the macro environment and poor timing decisions made by the management (e.g. the levering up of the balance sheet based on the expectations that energy prices would stay high in the long-term). What I care about as a potential buyer of the options is the increase in its intrinsic value based on the increase in the price of the stock itself.

What am I risking? I am risking to lose 100% on this investment. Sounds bad but the price of these options is ridiculously small in absolute terms. Currently, the market for the options with a strike of $1 is 269 contracts (about $13.5K at the current ask prices). A $500 investment will give me 10 contracts, which are equivalent to owning 1000 shares of Linn Energy. I would have to pay $1,250 to buy the shares itself. I do realize that options expire, while stocks are "eternal", provided that the company does not go bankrupt or gets bought out. 

However, I think that 2016 is the year when Linn Energy either sinks or swims. Hence, I do not really care to buy more shares for the long-term at this point in time. Additionally, I can look at options with the same strike price expiring in January 2018 - but they cost about $1.10 apiece, which is more than twice as high as the options I have selected for this analysis.

Given that all eyes are on the company's ability to survive this year, what are my potential payoffs? Let us see:

- If the stock goes up to $2 per share, I can get a 100% on the options, while the stock will "only" give me a 60% return (my weighted-average price for the stock is about $1.25 per share);

- If the stock rises to $3 per share, I can get a 300% on the options, while the stock will "only" give me a 140% return;

- If the stock reached $5 per share, its current book value, I can get a 7x my money on the options, while the stock will give me extra 300%.

The bottom line is, I am willing to take the risk to lose a relatively small amount in exchange for a chance to make a killing on this particular investment. Again, it all depends on your personal risk appetite and time horizon. I consider myself partially a risk-taker and I have a very long time horizon because I am a young person. This strategy may not be appropriate for many of my readers.

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