VLO : Hedging an undervalued refiner

Today we initiated a new strategy (well, new for us anyway). The strategy uses in the money (ITM) married puts over 6 months (or more) trading period. We chose VLO as it has underperformed (relative to the market) and is potentially undervalued. We will play it from the long side for 2012, but will keep our maximum possible losses to around 10% for the next 6 months. If we are wrong we will live to fight another day.

VLO – Valero

VLO is an oil refiner and often appears on “undervalued” stock screens, but has made no upward progress in the last 1 year.

Trade :

Long VLO 600 * 24.53 (Feb 27th 2012 close price) = $14,718

Long 6 VLO Sept 2012 Puts strike $26 costing $3.70 = $2,220

Total trade cost = $16,938

Risk:

Max risk (at expiration) : $26 put strike minus $3.70 put cost is $22.30. The stock was bought at $24.53 so maximum risk is (24.53 – 22.30 / 24.53) = 9.09%

Initial Trade Delta :

Position delta : stock (delta of 1 obviously), put option (delta of -0.54), so long delta 0.46

Trading notes

Dont plan to leave the put option on all the way until expiration (due to time decay) – we will investigate if it worth rolling up or down every month (at monthly option expiration) while the trade is on. If we get to 3 months and no trade presented itself, we would probably roll up to another 6 month put (Dec 2012?) to avoid the battle with time decay in the last 3 months of the options life. A bad thing that can happen with this trade, is if the stock just moves around in a tight trading range for 6 months (but historically they have been somewhat volatile (VLO beta = 1.42) and hopefully this volatility will continue).

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