How to Earn a Higher Return from eBay with Options

We just purchased  eBay (EBAY) in our Hare Portfolio. This wide-moat, below-average-risk company is exactly the kind of long-term investment we look for, and near $35, we think it is a great buy. However, Mr. Market differs not only in his opinion of eBay's value, but also of its risk. He thinks it's a high-risk stock because the share price moves around a lot. But we think it not only has a wide moat, but below-average risk to boot. In short, we think Mr. Market is way off on eBay, in more ways than one, and options can be a reduced-risk way to profit from Mr. Market's crazy moods.

There are all kinds of technical (and tedious) descriptions of options theory and options investing, but let's discuss this through an example. By writing a put option on eBay, an investor is saying, "Pay me now, Mr. Market, and I'll let you force me to buy your eBay shares any time in the next a year or so, at a price we agree on today."

However, Mr. Market views options based on how scared he is of the stock's short-term price movement. The statistical measure of Mr. Market's fear is called "implied volatility"--a measure calculated from an options price, the price of the stock, and interest rates. The more volatile the stock price, the scarier Mr. Market thinks it is, and the higher the implied volatility.

In the case of eBay, Mr. Market is thinking, "Geez, stock in eBay moves around a lot. I'd be willing to pay a bunch to be sure I can unload it if the share price falls." But we're thinking, "eBay is a great company, and I'd love to own it at the right price, but some guy is paying me a whole bunch to guarantee him I'll take it at that price. I might as well sell him that insurance."

Let's see how well we'll get paid to write this kind of insurance on eBay shares. The insurance, called a put (as in "put it to him") is negotiated with a bunch of different expiration dates and a bunch of prices (called strike prices). The price paid for the insurance is called a "premium."

The bid price for an option is what a market maker is willing to pay for the puts an investor writes. On May 1, the January 2008 puts on eBay, which expire in 627 days (or 1.72 years), had the strike prices and bid prices listed below: For example, the first row of the table says that writing a put at a $20 strike price earns you a $0.75 premium, and so on.

Strike and Bid Prices
Strike	Bid
$20	$0.75
$25	$1.60
$30	$3.00
$35	$5.00
$40	$7.70
$45	$11.20
$50	$15.50
$55	$20.40
$60	$25.40

But how do we figure out which put to write? We need to know the stock's fair value estimate in the future, on the date of the option expiration. We can estimate that value from our cost-of-equity assumption and the expiration date for the options.

Morningstar's fair value estimate today for eBay is $45 and the stock is trading at $34. To estimate these values 1.72 years in the future, we use our 10% cost of equity for eBay, which also means we expect our fair value estimate, and eBay stock, to appreciate by 10% per year. (EBay currently pays no dividend, and we don't expect it to in the next couple of years, so dividends don't factor into our analysis.) This means that, in January 2008, we think eBay will be worth $45 plus 10% interest over 1.72 years, or $45 * 1.10 ^ (1.72) = $53, and the market thinks that the stock will be worth about $34 * 1.10 ^ (1.72) = $40. These estimates of the future value and stock price, shown in the table below, are our reference points for strike prices on the options.

Estimating Future Value
	May 2006	Jan. 2008
Fair value estimate	$45	$53
Stock price	$34	$40

Let's now look at the return we can expect if we write puts at current prices. (We'll round our estimate of the future values to match the strike prices.) Also, because we are writing a put, we need to keep some cash in reserve in case we have to buy the stock at the price we agreed on. This is called a "cash secured put," and we'll include the cash in our yield calculation by assuming that we buy T-bills with a cash yield of 4.75%. The cash we put up to buy these T-bills represents the investment we make and the basis for our yield estimates.

If we write a put at $35--near the current price--we get $5 right away. We add in $30 cash to get to the $35 we need to buy the stock at the price we agreed to. Then we invest our $35 in T-bills. The option premium yields $5/$30 annualized over 1.72 years, or 9.4%. In other words, the $5 we were paid for writing the option equals a 9.4% annual return. Adding in the $2.86 we earn on our $35 cash over 1.72 years at 4.75% gives us a total profit of $7.86 ($5+$2.86) over 1.72 years, which translates to a 14.5% return. Here are a few examples of the same calculation with different strike prices:

Expected Returns of Four Price Scenarios
Price scenario	Strike Price	Option Premium	Addt'l Cash to Secure	Premium Yield	Interest Rate	Interest Income	Total Dollar Return	Total Expected Yield
$34 (current stock price)	$35	$5.00	$30.00	9.4%	4.75%	$2.86	$7.86	14.5%
$40 (market-expected Jan. 2008 stock price)	$40	$7.70	$32.30	13.2%	4.75%	$3.27	$10.97	18.5%
$45 (current fair value estimate)	$45	$11.20	$33.80	18.1%	4.75%	$3.68	$14.88	23.6%
$53 (expected Jan. 2008 FVE)	$55	$20.40	$34.60	30.9%	4.75%	$4.49	$24.89	37.0%

In the current low-yield environment, those returns look pretty appealing. If we use Morningstar's fair value estimate and assuming the shares converge to our fair value estimate by the time the options expire, the yield is 37%. This is also a lower-risk strategy than buying the shares directly, because we automatically outperform the stock by the amount of the option premium.

Which strike price we pick to write the option depends on how much we want to own the stock, because as the strike price moves up, the likelihood of owning the stock increases, along with the expected yield. Also, risk increases with increasing strike prices. For example, as long as the stock is $30 or above, we will break even with the "Today's Price" strategy (also called "at the money"), because you're up by $5 as soon as you write the put.

Let's run through the potential outcome from this investment strategy:

• If we write an eBay put option with January 2008 expiration and the share price takes off, we earn the yields in the table above, but no more.
•  If we write the options and the share price doesn't change between today and the expiration, we'll own the shares, and at a lower cost basis than if we bought the shares outright.
• Of course, there's always the chance that the share price falls, but here's the beauty: If the shares drop substantially between now and the expiration of the options, we own a wide-moat company at a 5-star price, and we will outperform the shares by at least the option premium, or 12.4%. And, as patient investors, we're willing to hold on to a great company knowing that Mr. Market will catch up with the valuation eventually.

The real risk here, which we need to mention, is a change in the intrinsic value of the stock (or, of course, that our fair value estimate is too high). If news comes out that makes our opinion of the stock change, and the shares drop as well, we're exposed to a real loss. However, even in that scenario, we perform better than we would have by holding the shares themselves, because we earned the option premium.