Fastenal is Fascinating

(A version of this article appeared in TheStreet)

Actually, that may be a little bit of an over-statement. Fastenal (FAST) is fairly staid, at least on a conceptual level.

In a previous life, one that included legitimate employment, I flew into a New England city on a weekly basis and would pass a Fastenal store on a lonely back road with equal frequency. On the occasional daytime landings I noticed that the parking lot and sidewalks would sometimes be packed, sometimes empty and never thought twice about it, otherwise.

During an economic period when businesses opened with great expectations and closed with great disappointment, that solitary Fastenal store was there for at least the 7 years that I drove past it. Nothing terribly fancy nor ostentatious about its appearance, just a utilitarian building, presumably delivering the literal and figurative goods.

Back then I had no idea what exactly Fastenal did, nor whether it was a publicly traded company. My assumption was that it had something to do with fasteners. “Fasten All. we fasten everything,” I envisioned their ad campaign for people in need of fasteners not knowing where else to go. I’m just smart that way.

Its location certainly couldn’t be associated with high profile consumer items and the word “technology” wasn’t anywhere to be found on the building’s edifice. But at least in the recent aftermath of the dot com bust it still had a building with its name on it. Little did I know that there were many of those buildings in the kind of places or beaten paths that I didn’t frequent very often and that they had lots more than hardware and fasteners.

Years later, when I had devoted myself to full time portfolio management I happened to pass another Fastenal site, this one in rural Delaware. On that particular day the lot was packed. A year later the same lot was empty and a few months later packed again. I may be smart in certain ways, but sometimes a sense of curiosity is helpful, as well. I don’t have much of the latter, but the laws governing osmosis are difficult to avoid.

At some point following all of those sightings I had a reasonable idea of what Fastenal was about and aware that it was about lots more than fasteners. Yet, even with a little bit of knowledge in hand I had never taken the leap and invested in shares. It’s just not one of those companies that you hear discussed very much, but it casts a fairly wide footprint among those people that actually do something tangible with their skill sets, like building and improving things that we may often take for granted.

In a world that takes great pride in and expects pant waists to ride at or above the actual waist, Fastenal was treading in a world where slippage may have been more the norm.

At some point casual observations can lead to intrigue. Certainly the idea of channel checking has some merit, but the occasional glimpse of a single store is probably not the sort of thing that channel checkers would trumpet as validating their work. Additionally, as hard as I might try to find an association or correlation to suggest that Fastenal could serve as a proxy to herald changes in GDP or broad market averages, the thesis was just lacking.

Looking at every potential investment from the perspective of a covered option writer and having started following Fastenal shares, as is my custom when my interest is piqued, for 6 months or more, I finally decided to purchase shares in June 2013 and am currently on my fifth lot of shares in that time.

The average purchase price for those 5 lots was $47.27 with the average strike price of the lots being $47.80. Based on today’s closing price of $46.41, the average price of all shares, including those of previously assigned positions is $47.45. If somehow I could magically close the book on the positions today the cumulative return would be 23.6% when shares themselves are actually trading at a loss compared to the average cost. During that same time frame the S&P 500 has advanced approximately 8.5%.

FAST ChartWhy am I telling you any of this? Sure, boasting is one reason, but despite the lack of a coherent thesis to urge the use of Fastenal as a predictive tool, what now captures my attention with regard to future opportunities is a quick look at Fastenal’s chart over the past 5 weeks.

 
The banality of variation during that time is exactly what excites a covered option strategist. While a consistent flat line wouldn’t do very much to encourage option buyers to ante up the premiums, the occasional paroxysms of price, up or down, make selling Fastenal call options an appealing complement to an overall strategy of trying to optimize share returns and dividends. More importantly, the setting of a strike price at which options are sold establishes a discipline by creating an exit point and doing what is often left undone – taking profits. While Fastenal may be staid, most of us would consider the idea of profits to be fascinating regardless of how often we would have to be subject to them.

 

FAST data by YCharts

Cisco was a Friend of Mine

You have to be of a certain age to recognize the Cisco Kid character, but somewhat younger to be familiar with the song that paid homage to the fictional character.

After terrible earnings and poorly received guidance that stunned most everyone, Cisco (CSCO) hasn’t made many friends, but it’s still a friend of mine.

Maybe the problem is all in the name. No, not Cisco, there are worse things in the world than being confused for a food services company. Maybe the problem is in the name John Chambers.

Barely two years ago it was a John Chambers, as head of Standard and Poors’ Sovereign Debt Committee who lowered the debt rating of US Treasury debt. He wasn’t very popular at the time, as many people are put off when they can connect the dots and point fingers at the catalyst for a market wide plunge.

But the John Chambers who is the CEO of Cisco has seen his popularity mirror that of many stocks, in general, as it has gone up and down and up again.

Now it’s down.

Not too long ago John Chambers was said to be on the short list to be the Treasury Secretary in the Bush administration. He was regarded as a model CEO of the new economy and his slow drawl and transparency were welcome alternatives to the obfuscation spun by so many others. His candor during interviews in the immediate moments of earnings being released were always respected.

Then the bottom fell out from Cisco and there were calls for his ouster. Seeing share price in 2011 challenge the lows of 2009 wasn’t the sort of thing that engendered confidence and the calls went out for his head. At that point Treasury Secretary may have been looking pretty good, but that ship had long sailed.

But Chambers was eventually rehabilitated. Rising stock prices, perhaps buoyed by aggressive buybacks, will do that for you. In fact, if you conveniently have data points extend only from the lows in August 2011 to yesterday, Cisco actually out-performed the broader index.

Ironically, John Chambers is somewhat like fictional The Cisco Kid, who actually started his life as a cruel outlaw, but became regarded as being a heroic character. It’s just that Chambers can stay a hero.

Chambers has been there and done that, but now he’s back in that dark place, where people are even poking fun at his drawl and once again saying that his ship has sailed. Perhaps plunges on two successive earnings releases will create that kind of feeling. He certainly may have cut back a bit on his candor, as even his appearance yesterday offered little insight into the disappointment that awaited.

In fact, many asked, given how substantive the alterations in forward guidance were, why Cisco didn’t pre-announce or issue revised guidance weeks ago.

Personally, I don’t see the difference between getting hit with an earnings related surprise earlier, rather than when scheduled. I actually prefer knowing the date and time that i may see my shares subject to evisceration.

I owned Cisco shares and have done so on 5 different occasions this year. My shares had calls written upon them and were due to expire November 22, 2013. Barely a few hours ago they seemed certain to be assigned. Now they are more likely to be seeking rollover opportunity to a future date.

As most everyone has piled on the sell wagon, much as had occurred with Oracle (ORCL), which also had two successive share plunges after disappointing earnings, I believe that for the short term trader and particularly for the covered option trader, this most recent fall in share price is just an entry opportunity.

Yesterday, I did something that I very rarely do. I purchased shares in the after hours. Usually when I do so, in the anticipation that by morning calmer heads will prevail, I’m typically wrong. That was the case with Cisco this morning.

In addition to buying shares in the after hours, another thing that I rarely do is to purchase shares without immediately or very shortly after selling calls on those shares. In essence, both actions were counter to my overall desire to limit risk.

While I’m usually on the wrong side of momentum when entering, I look at these positions as ones to generate both capital gains from shares and option premium income, whereas for the majority of my positions I emphasize premium and dividend income.

In the case with Oracle, opportunity existed after bad news and exaggerated downward price movements. SInce I tend to be short term oriented, I only care about the opportunity and not about structural issues that may have longer term impact.

While earnings represented a risk and shares moved quite a bit more than the implied movement, suggesting that investors were surprised and unprepared, I think the risk is now greatly discounted.

I make no judgment regarding the ability of Cisco, whether under Chambers’ leadership or anyone else to compete in the marketplace and to recapture its glory or restore Chambers to a position of honor.

Instead, Cisco is nothing more than a vehicle. The Cisco Kid had his horse, John Chambers had his buybacks and for some the shares of this beleaguered company are the vehicle of the day.

A Put Primer

There was a lot of stress this week over the sale of puts on Abercrombie and Fitch.

Most of the stress was by me. Not because of the ridiculous price action, which is standard fare for these shares, but because I had to figure out how best to track the outcome of the trade when some people. including me had early assignment of the puts, while others did not and were heading toward assignment at the end of the day.

That also means different trading strategies because some would potentially have shares in hand upon which to sell calls today, while others would be faced with the decision to either roll over the puts or await assignment and hope to be able to sell calls on Monday.

The problem with that latter is that it’s hard to predicate anything on a hope, especially since today was an ideal day to rollover the puts as ANF had a large share gain intra-day. Who knows what Monday brings?

My guess, but that’s all it can ever be is that if the market is sound next week ANF will make up some more ground in advance of its earnings report on November 21, 2013.

Between the known fact that shares were stronger today and the unknowns awaiting next week, compounded by what ridiculous more news may come at earnings makes the gift horse especially appealing.

Later I’ll show you why improving price was important using some screenshots I took during the day while following shares looking for opportiunities.

But since this is a primer, let’s start at the beginning.

To start, a put is an option contract that when bought is a statement that the buyer expects the shares to go down in value, in which case the value of his option will increase.

The buyer typically wants to trade in and out of option positions, because their money is greatly leveraged. They don’t usually want to be assigned and have to take over ownership of shares.

The put seller is usually the more bullish participant in the trade. They think that the shares may go up or down, but if they go down they’re not likely to go below the strike price. The big caveat is that put sellers should be willing to own the shares just in case they are assigned and they end up owning them, as happened to me and a small number of other subscribers.

In the case of Abercrombie and Fitch its shares plummeted on the day before their planned Analysts’s Meeting, the first they had held in over two years.

On the evening before that meeting they presented revised guidance and it wasn’t very good news. I hate revised guidance, even when it’s good. There’s no way to prepare for it unless you have inside information.

I almost purchased shares in the after-hours, but decided to wait until the next day.

At first, when trading started I was upset for having waited as the price significantly improved but was still low enough to seem to warrant a position. However, just to hedge, I decided to use an out of the money put in anticipation of some continued price drop.

As an aside, but an appropriate one, I think the current market may be an appropriate one for the use of more put sales rather than initiating new positions and covered calls. That’s simply an expression of a bearish sentiment. Even though I’ve been cautious and have kept cash reserves, I’ve not used the SOS strategy as a further expression of bearishness, but I think there may be a greater role for put sales now.

Obviously, understanding them is requisite for their use.

But, back to Abercrombie and Fitch. Thanks to the utterings of the CEO, who is not terribly regarded as a person, due to his rather odd behavior and opinions,  shares suddenly went much lower during mid-day trading and then everyone on television just piled on. If you ever have any doubt about the power of basic cable television, just watch the ticker and price changes as specific stocks are discussed, especially when event driven. But even then, the continued drop surprised me, thinking that an additional 2% drop was enough of a cushion after an already 5% drop in shares.

So shares dropped even more. Normally, the escape strategy when having sold puts that are now in the money is to simply roll them over at the same strike price, assuming you continue to be reasonably bullish. Otherwise, you can roll down to a lower strike price, but that will cut into your net premium, perhaps even causing a “net debit” from the transaction.

However, Abercrombie and Fitch made any kind of transaction difficult because the more it was in the money the less became the time value of the contracts, being instead made up almost entirely of intrinsic value, that is the difference between the strike and the current value. To make it worse, there was a large gap between the bid and ask prices.

The net result was that at one point earlier in the day a rollover trade would have resulted in incurring a Net Debit.

You don’t want a net debit. You would prefer to make money, even if it’s not that much money.

In this scenario you would have still been obligated to buy shares for $35.50 a week later, but it would have cost you $0.20 of your earlier option premium profit.

As long time subscribers know, I have patience.

In this case the patience was measured in hours and not option cycles.

 

 



 

In the meantime, though the price of shares started recovering in the late morning, the Net Debit went only to break-even.

The differential between the expiring contract and that of the next week  saw naturally more erosion in the expiring contract as price moved in a direction toward the strike price. Obviously, that’s not something in your control. It’s just a measured risk, knowing that even if nothing is done you’ll end up with shares in your account on Monday morning and then just do with them as is done with every other holding.

But simply being at break-even is fine if the brokerage is your uncle. Otherwise, it’s not very satisfying.

 



Then it went to a Net Credit.

Bingo.

That’s what you want. In fact, you can see from the timestamp on this image and the previous one, that even though the price of shares was more favorable earlier, the premium differential actually improved as the clock was ticking, even though shares moved away from the strike.

 

 

 

  

The problem was that the bid-ask spread was still on the large side, leaving only a small net profit

Here’s where it’s helpful to look at the call side of things.

Even though pricing isn’t always rational, it’s reasonable to expect that whatever irrationality there is would be equally distributed between call buyers and put buyers.

Hard to prove, but equally hard to argue.

On the call side of things the equivalent trade, that is selling the November 16, 2013 $35.50 call was yielding a bid of $0.18 with a more normal differential between bid and ask.

So in placing a trade to rollover the puts, rather than using the bid on the sale and the ask on the purchase (as outlined here), for a Net Credit of $0.08, use an intermediate figure determined on the call side of the aisle.

For those that haven’t owned Abercrombie and Fitch in the past, it is a stock that can be very rewarding with a modicum of patience and has been ideally suited for a covered option strategy, but all in all I would much rather see put sales expire and simply decide whether I want to pursue the stock on my own terms the following week, as was recently done with Coach, another company that takes big price hits, but always seems to work its way back into good graces.

In general, if your put sale shares are just slightly in the money you are usually much better off simply rolling over the puts just as you would normally rollover a call position sold on shares that you own.

Unfortunately, I don’t have it documented with screenshots, but for my personal trades some of you may have noticed that I’ve been doing that with the ProShares Ultra Silver ETN (AGQ) speculative hedging position. In this case using a $20 strike price I haven’t really cared too much whether the price was above or below the strike. I just allowed events to dictate whether rolling over when expecting a price increase in silver or sitting on the sidelines when expecting price increases. As with stocks, it’s all about being able to do the trades on a serial basis and watching the premiums add up.

When history repeats itself it can be a beautiful thing.

If this is your first foray with Abercrombie and Fitch I believe that this is a good price at which to do it over and over again, whether through the sale of puts of through the use of covered calls.

I’ll leave the personal feelings about the CEO to others, as long as there is a way to milk some dividends from this pig.

Implied Price Moves

On rare occasion I actually get some indication that someone is reading these articles.

In this case I was recently asked a question about “implied moves,” citing the fact that I refer to that concept with some frequency in articles. For me, that implied someone actually having read at least one article. The use of the word “frequency” further implied that I did so either on multiple occasions in a single article or perhaps in many articles.

That which is implied isn’t necessarily precise.

There are lots and lots of different metrics and measures that are used in assessing stock charts and stock fundamentals. I have long maintained doubts about the validity of many of those measures, at  least the ones most frequently cited and presented. It always appears that for every expert’s interpretation of data there is another equally esteemed expert who takes an opposing position.

For someone who had spent about 20 years in academic environments and who respects the “scientific method,” I prefer common sense approaches to investing.

You can be certain that for the widely used tools and measures everyone under the sun has already applied the tools and the chances of an eye popping discovery that flies below the radar is not likely. So why bother?

The same may or may not be true of more closely held metrics or proprietary tools. Presumably the PhDs in statistics, physics and applied mathematics are being paid princely sums for their algorithms because they produce results at the margins.

If you followed the announcement of this year’s Nobel Prize in Economics you may have thought it to be ironic that the prize was shared by Eugene Fama and Robert Schiller. The ironic part is that one was recognized for his work supporting rational markets, while the other was awarded on the basis of endorsing irrational markets.

So clearly black and white can be the same.

While I only passingly glance at charts and various measures and completely ignore the traditional measures used to characterize options, better known as “The Greeks,” I do consider the option market equivalent of crowd sourcing, better known as a measure of a stock’s  “implied price move.”

While I believe that the option market usually gets it wrong, which is a good thing, because those are the people that are buying the goods that you’re selling, the crowd does provide some guidance. As in real life, it’s often good to stay away from the crowd, despite the fact that crowds can create a sense of comfort or security.

Or frenzy.

In this case the guidance provided by option market participants is an estimation of how much the option market believes a stock’s price will move during the period in question by looking at both the bull and the bear perspective as based on the most fundamental of all criterion.

What is considered is the price that someone is willing to pay to either buy a call option or a put option at a specific strike price.

I only use “implied movement” when a known event is coming, such as earnings being released. I want to get an idea of just how much the option market believes that the stock is likely to move based on the event that is going to occur.

In articles I refer to the phenomenon of “Premiums Enhanced by Earnings” or “PEE.” During such times the uncertain way in which stocks may respond to earnings news drives option premiums higher. It’s all a case of risk and reward.

But because earnings introduces additional risk I look for a measure that may suggest to me that I have an advantage over the crowd.

The calculation of the “implied move” is very simple, but is most accurate for a weekly contract, because that minimizes the impact of time on option premium.

To begin, you just need to identify the strike price that is most close to the current share price and then find the respective call and put bid premiums. By adding those together and dividing by the strike price you arrive at the “implied move.” which tells you that the option market is anticipating a move in either direction of that magnitude.

IMPLIED PRICE MOVE = (Call bid + put bid)/Strike price,  where Strike price is that closest to current share price

The implied move is expressed as a percentage.

Using Facebook as an example, the graphic below was from the day prior to the announcement of earnings and with approximately 3 1/2 days left to expiration.

Facebook was trading at $49.53 and the $49.50 November 1, 2013 call option bid was $3.10, while the corresponding put option bid was $3.05



At a point that shares were trading at $49.53 and using the $49.50 strike level, the combined call and put premium of $6.20 would result in an implied move of approximately 12.5%. That would mean that the stock market was anticipating an earnings related trading range from approximately $43 to $56.

Great, but how do we capitalize on that bit of information, which may or may not have validity, especially since it is based on prices that in part are determined by option buyers, who frequently get it wrong?

I use my personal objective, which is a 1% ROI for each new trade.

In the case of Facebook, whether buying shares accompanied by the sale of calls or simply selling puts, the ROI is based upon the premiums received, plus or minus capital gains or losses from the underlying shares and of course, trading costs.

In general, there is a slight advantage in earnings related trades to the sale of puts rather than using a covered call strategy. Doing so also tends to reduce transaction costs.

In the case of Facebook, the first strike price that would yield a 1% ROI is at $42, because the bid premium at that strike is $0.44 and the amount of cash put at risk is $42.

The key question then is whether that 1% ROI could be achieved by a position that is outside of the implied range. The further outside that range the more appealing the trade becomes.

Again, in this case, with shares trading at $49.53, it would require a 15.2% decline in price to trigger the possibility of assignment. That is outside the range that the crowd believes will be the case.

In this case, I’m currently undecided as to whether to make this trade because of other factors.

There are almost always other factors.

First, the positive factor is that I prefer to sell puts on shares that have already started showing weakness in advance of earnings. That increases the put premiums available and perhaps gets some of that weakness out of its system, as the more squeamish share holders are heading for the exits in a more orderly fashion, rather than doing it as part of a rushing crowd.

The negative factor is that tomorrow is another event that may impact the overall market. That is the release of the FOMC minutes. Although I don’t expect much of a reaction in the event of a surprise or nuanced language the market could drag Facebook along with it, possibly compounding any earnings related downdraft.

So in this case I’m likely to wait until after 2 PM tomorrow to make a decision.

By that time the likelihood of any FOMC related influence will be known, but there will also need to be a recalculation of implied move as premiums will change both related to any changes in share price, as well as to decreased option value related to the loss of an additional day of premium.

In general, everything else being equal, waiting to make such a trade reduces the ROI or increases the risk associated with the trade.

Aren’t you glad you don’t read these articles?

I Love Caterpillr

That may be a bit of an over-statement. There’s probably a psychiatric diagnosis for someone who professes deep emotional attachment to inanimate objects.

But when it comes to being a poster child for a covered option strategy, not too many can do a better job of demonstrating what is possible than Caterpillar (CAT).

Caterpillar reported earnings this morning and by noon its shares were about 5% lower. Its earnings and its reduced guidance were not the sort of things that inspire confidence. It’s CEO, Douglas Oberhelman, has been vilified, pilloried and himself been used as a poster child of an “out of touch” CEO in the past. Today’s news confirms that feeling for many. If there is such a thing as a “rational market,” today’s response is reflective of that kind of market.

Even objective people, such as Herb Greenberg of TheStreet.com described Oberhelman’s appearance on CNBC this morning as seeming or sounding “distraught.” That’s not a terribly good image to present if one’s objective is to inspire confidence in leadership and offer support for share price.

Caterpillar has long been the stock that everyone loves to hate. Down almost 6% year to date, essentially all of it coming today, it has certainly lagged the broader market and has had very tangible opportunity costs, even prior to today’s disappointments.

The smart money bid shares up quite strongly yesterday, approaching $90, a level not seen in 7 months. Presumably, it was the smart money, because it seems unlikely that individual investors would commit with such urgency in advance of a scheduled risk factor.

Certainly, the very high profile position taken by famed short seller, Jim Chanos, calling a short of Caterpillar as his best trade idea of 2014 and pointing out that Oberhelman “routinely misses forecasts,” hasn’t done much to propel shares forward.

But that’s the point.

What has made Caterpillar such a wonderful covered option stock, whether owning shares and selling calls or selling puts, is its mediocrity. It has simply traded in a narrow price range alternating between disappointment and hope. That creates the perfect environment in which to put a stock to work, not be capital appreciation of shares, but rather through production of premium income and dividends.

In the example illustrated below, representing Trading Alerts sent to subscribers during a 15 month period, there were 14 different occasions initiating new positions or selling puts. The average share price was slightly above today’s noon time price of Caterpillar shares. In essence indicating no movement in price over that time. Including dividends, however, Caterpillar shares would have shown a 2.4% ROI during that period.

By contrast, the approach of serial purchase of shares or sale of puts, awaiting assignment or rolling over option contracts when possible, as expiration occurs or is likely to occur has had an ROI of 47%, assuming equal lots of shares purchased in all transactions. During that same time period the S&P 500 appreciated 30.8%

In the example above very little of the gain can be attributed to capital appreciation of shares. In fact, most of the share purchases was coupled with the sale of in the money or near the money options in an effort to optimize option premiums at the expense of capital gains.

Over the course of the time period evaluated Caterpillar shares did reach a high of $99 on February 1, 2013. Perhaps not coincidentally, that occurred during a period of time that I didn’t own shares, having had shares assigned in early January 2013 and not finding a comfortable re-entry point until March.

For the buy and hold investor with perfect timing who had purchased shares on July 2, 2013 and sold them on February 1, 2013, the ROI including dividends would have been 18.9% for the 7 month period.

I’m one usually loathe to annualize, because I believe it tends to inflate returns, but assuming the 18.9% return could be maintained for an entire year, the annual ROI would have been 32.4%

Not shabby, but remember, that required perfect timing and the ability, discipline and foresight to sell at the top and further assumed that performance could be replicated.

Compare that to sticking with the mediocrity exhibited by Caterpillar and using it as a tool of convenience. Trading in and out of positions as its price indicated, rather than based on technical or fundamental factors. That can be left to the smart money.

With shares taking today’s hit I’m likely to consider adding shares, with already two open lots in hand, one of which is set to expire next week at $84 and the other at the end of the November 2013 cycle with an $87.50 strike price.

If not now, the one thing that I feel fairly certain about is that Caterpillar will present other opportunities and price points at which to find entry and capitalize on its inability to thrive in a thriving market.

Thank you, Doug Oberhelman. We need more CEOs who can walk that share price tight wire and stay within narrow confines. It would take the strain of thought and luck out of the investing process.