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Sep022019

Option Selling to Reduce Portfolio Risk -- A Case Study in Ulta Beauty (ULTA)

I wouldn't blame you if you read the title of this article and decided to just skip it. Indeed, when I talk to clients about selling call options against some portfolio positions they own, I can see their eyes glaze over before I even get to explaining the possible outcomes.

In case you need a primer, a comprehensive article I wrote several years ago explains the basics of working with options in "Using Options to Enhance Portfolio Returns" . For this case study, and since ULTA shares lost almost 30% of their value on Friday, I thought I'd walk through a good example of how selling calls against a position can mitigate a bad quarterly earnings report and loss of share value.

One of the positions we've held in client portfolios (and mine) since August 2016 is Ulta Beauty (ULTA).  For these past few years, calendar quarter after calendar quarter, Ulta has been reporting and beating earnings estimates, as well as raising forward looking earnings estimates. So when the price dipped in 2016 and 2017, I decided to buy shares for client portfolios, including my own. As a growth stock, Ulta does not pay a dividend.

The rosy quarterly earnings parade came to a tire-screeching halt this past week when, in a big surprise (shock?) to Wall Street and analysts, Ulta missed its quarterly earnings estimate and lowered forward earnings guidance. The stock was hit the hardest I've ever seen, losing almost $100 per share (30%) of its value on Friday alone. Just before the earnings announcement, the options markets (which handicap expected moves) were implying a +/-$20 per share move on earnings. What we ultimately got is known as a whopping five standard-deviation move instead. That's epic as far as daily stock moves are concerned and those are quite rare.

To put that move into perspective, put options (stock options you can buy to protect your downside below a certain price) expiring on Friday August 30th, were not even available below the $260 price. That's because, even at $260, options were implying that there was less than a 1% chance Ulta would be trading that low, let alone below $240. You usually see moves like this in risky biotech stocks failing an FDA drug approval, not a loved retailer.

So yes, in one trading day, Ulta gave back its entire stock appreciation of the past three years and is now trading back to the level it was at in June 2016. The entire client unrealized profit was wiped out overnight as algorithmic traders and portfolio managers dumped the stock en masse.

The sudden loss of profits is, needless to say, disappointing to put it mildly. For our case study, I want to point out where selling call options helped to hedge the position (i.e., reduce the risk) and actually allowed locking in profits along the period of time since ownership.

Shortly after we bought the shares in August of 2016, we began selling upside October 2016 call options against the positions. You must own 100 shares of a stock to sell one call option against it. Selling a call option means that for a small deposit to your account (known as option premium income), you sell someone the right (but not the obligation) to buy your shares from you at a certain price (i.e., the strike price) by a certain date (expiration date). So when the stock was trading at $255, we sold (upside) call options at the $270 strike level (collecting $340 for that first sale).

This meant, if Ulta was trading above $270 per share on or before expiration, the buyer of the option we sold could buy 100 of our shares for $270 each. If that occurred, our per share profit would be $1,500 ($270-$255=$15 x 100 shares) plus the $340 we collected for selling the call option. Therefore, our initial total profit, if the shares would have been "called" away, would have been $1,840 or 7.2%. Since this would have been a 45-day hold, the annualized return would have been a whopping 58.5%. All quoted figures don't account for the small commissions incurred when buying or selling an option, which is about $4.95-$8.95 per transaction.

As it turned out, the shares never got called away (Ulta was trading below $270 on options expiration), and the October 2016 call option we sold essentially expired worthless, meaning that we got to keep the $340 we originally collected. This meant that we could do this again. And we did so by selling the November and then the December 2016 options at appropriate strike prices. The income generated through this process is called "option premium".

Between 2016 and 2019, over a three year period, we collected and pocketed about $5,510 in option premium that we never have to give back, nor do we have any further obligation since the options expired. That's a 21.6% return over three years, or a 7.2% annualized return on the cost of the 100 shares of Ulta owned. That certainly reduces (but doesn't eliminate) the sting from the share price decline this past week.

Having those call options sold as a hedge against the position prior to the earnings announcement, clients did not suffer the 30% loss on the shares Friday.  Instead they gave up only 12.7%. That's the power of option hedging.

To be fair, I should mention that the last call option we sold prior to earnings, was a $305 call expiring in January.  Had the shares gained 30% on Friday instead, our "upside" would have already been capped at $305 per share, and clients would have only participated to a much smaller extent to the upside. On the other hand, that cap would not have kicked in until January. Is it possible that the stock could recover by then? Options markets give that about a 15% chance today, so not likely. But then again, nobody would have ever expected Ulta to close under $238 on Thursday.

With the decline in the shares under $238, we closed the January 2020 call options on Friday for a 70% profit. To keep the shares hedged (while we decide what we ultimately want to do with Ulta Shares), we sold June $270 calls for $2,000 each. Unless the stock trades above $270 by June, we'll get to keep the $2,000 and ..... here we go again!

In hindsight, buying put options (options that act as insurance against large declines like this one) to further protect our profits would have been prudent. But with the price of protection highly elevated, and taking into account the fact that we had call options sold against the position, I weighed the pro's and con's and decided against doing so.

Although my case study is about reducing risk through selling options, the lesson here is that taking some gains/profits in a stock during its march upwards, is a prudent move, whether you're selling calls against your position or by just trimming the position. One never knows what happens, but you'll be happy that you did when your stock gets hit like Ulta did. Ultimately, it's not a gain until you take the profit off the table.

Disclaimer: None of the forgoing discussion is a recommendation to buy or sell any securities. It's provided strictly for educational purposes.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

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