This week was a hot one for most of the eastern seaboard, including up to Nova Scotia, where I live.
Let’s hope the weather is a little more tolerable a week from now when Americans take part in Fourth of July celebrations from coast to coast.
In the four days of trading so far this week, the S&P 500 is up 2.9%. If it holds through the end of today, the index will be up 27% from its 52-week low in early April.
One look at the unusual options activity from Thursday suggests that the markets have become overheated. Stocks that retail investors have no business owning are garnering significant interest. The possibility of a pullback in July is high.
One stock that looks attractive for options investors is British American Tobacco (BTI). This UK-based tobacco company offers a range of products, including traditional cigarettes and more innovative smokeless alternatives.
In yesterday’s options trading, the volume was 10 times its 30-day average. As a result, the tobacco stock had 19 unusually active options. One of them points to a potentially profitable multi-leg strategy.
Have an excellent weekend!
The Unusual Options Activity Points to a September DTE
As I mentioned in the introduction, BTI had 19 unusually active options yesterday. All of them were call options with expirations varying from 22 to 569 days.
I’m sure you could come up with countless options strategies on your own. However, in recent weeks, I’ve been focused on a particular options strategy--the synthetic long accompanied by a long (protective) put--so I’ll go with this angle for today’s commentary.
The synthetic long with a protective put involves buying an ATM (at-the-money) call and selling an ATM put with the same strike price and expiration date, combined with buying a long put with the same expiration date and a slightly lower strike price for downside protection, hence the protective put moniker.
So, we’re looking at a three-legged trade.
To get things started, I’m looking for a call that has a DTE (days to expiration) between 60 and 120 days. Using a longer DTE will cost you more, but the additional time allows for your bet to play out.
Yesterday’s closing price was $48.09, so I’m after something within a dollar or two of the share price. The Sept. 19 $48 call with a DTE of 85 does the trick. The ask price of $2.30 is a reasonable 4.8% of the strike price.
I now need a Sept. 19 $48 put to sell for the premium income, and a put to buy with a slightly lower strike price. The bid price of $2.00 provides an annualized return of 18.0% [$2.00 / $48 * 365 / 85].
Now, ideally, the put you want to buy has a strike price $1 below $48. However, I prefer the $45 put over the $47 put because it has five times the open interest, giving you a better chance of executing the entire strategy.
1) Buying one $48 call costs $2.30.
2) Selling one $48 put generates $2.00 in premium.
3) Buying one $45 put costs $1.00.
The net debit for all three trades is $1.30, or 2.7% of the share price.
Why This Strategy Over Simply Buying the $48 Call?
It’s a valid question. As I mentioned earlier, buying the $48 call would be just 4.8% of the strike price, $100 more than trying to execute all three trades. That makes it a much simpler bet and proposition.
However, you only make money if the share price is ITM (in-the-money). As of yesterday’s close, it was--by nine cents. With 85 days to expiration, it’s more than possible that the share price will be higher in September.
BTI stock is a Strong Buy according to Barchart’s Technical Opinion with an 88% chance of maintaining its current direction. Its shares are up over 28% in the past six months, with 3% gains in the past month alone.
The profit probability on the call is 36.54% (as shown below), with a breakeven point above $50.30. As I write this early in Friday trading, however, BTI’s stock is trading 2.4% lower, below $47, now OTM (out-of-the-money).
The synthetic long combined with a long put allows for potential gains whether the share price moves up or down over the next 85 days. Unless you’re 100% certain it will move higher, this strategy allows for some flexibility.
I Like BTI Stock to Buy and Hold
In May 2022, I recommended British American Tobacco, along with BP (BP), as two potential cash cows to buy from the Pacer Global Cash Cows Dividend ETF (GCOW).
At the time, it had $9 billion in free cash flow, which translated to a free cash flow margin of 35%, a very healthy percentage. Based on its trailing 12-month figures from Morningstar—free cash flow of $9.52 billion and $25.87 billion—its free cash flow margin is 36.8%, which is even healthier.
Yet its share price has only risen 9% over the past three years, due to a significant dip in 2023. Since hitting its five-year low on April 15, 2024, its shares have gained 66%, a slight improvement over the S&P 500.
In May, I highlighted BTI’s Sept. 19 $55 call, suggesting that you could double your money if its share appreciated by $2.72 in the next 121 days. Looking at today’s action, 100 of these call contracts traded hands at $0.25, about 25% higher than in May.
While it hasn’t quite worked out as I thought, I still think BTI’s share price will be higher in 85 days than where it is today.
With a 6.3% yield, it’s an excellent dividend stock to own for the long haul. But I digress.
The Bottom Line
I like the synthetic long combined with a long put. It lowers the risk while maintaining a reward proposition.
For example, should BTI stock fall 20% over the next three months to $38.47 from $48.09, you would lose $4.30. However, if you only did the synthetic long bet, you would be out $9.83, more than double.
1) You would lose $2.30 on the $48 call because it would expire worthless.
2) You would lose $7.53 on the short $48 put [$38.47 share price - $48 strike price + $2.00 premium].
3) You would make $5.53 on the long $45 put [Strike price $45 - $38.47 share price - $1.00 premium].
In the same scenario, if the price were to increase by 20% to $57.71, you would earn $8.41, representing a return of 17.5% on the initial $48.09 share price, or 75.1% annualized. More importantly, it’s $1 more than you would make with the lone call.
1) You would make $7.41 on the $48 call [$57.71 share price - $48 share price - $2.30 premium].
2) You would make $2.00 on the short $48 put because it would expire worthless.
3) You would lose $1.00 on the long $45 put because it would expire worthless.
Is the extra dollar worth it? It is if you’re truly bullish about BTI stock.
If you are, you might simply buy 100 shares at $48.09 and wait for it to appreciate, forgoing options altogether. However, if it drops 20% come Sept. 19 to $38.47, you’ve got a paper loss of $9.62, as opposed to $4.30 with the synthetic long and protective put strategy.
Ultimately, if your goal is to own quality stocks rather than simulating ownership, this strategy probably isn’t for you.
On the date of publication, Will Ashworth 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.
