RealMoney Silver - Consider the Options on CRDN

Consider the Options on CRDN
By Bill Trent
RealMoney.com Contributor
12/11/2007 11:01 AM EST

Ceradyne (CRDN) makes products based on highly technical ceramic materials. It is best known for selling ballistic plates used for body armor and lightweight vehicle armor by the U.S. military. Such sales accounted for more than 75% of total revenue during the last several years.

Much of that time, shares of Ceradyne have appeared very cheap on a price-to-earnings basis. Persistent fears that the body armor market would peak have kept a lid on the price. As an example, the company in October provided guidance for next year's earnings of $5.60 to $6.65 a share. Such a wide range would normally not be much help, but in Ceradyne's case, it means the stock is trading somewhere between 7 times and 8 times next year's earnings.

Although I like a cheap stock as much as anyone, I too have been concerned that the military orders would peak. Although the company is expanding into other areas, it will be several years before any of them can offset a potential decline in military sales. As such, I have been very cautious on Ceradyne over the last couple of years.

Because of my caution, I missed the run from $50 to $80 a share over the last 12 months. But I also missed the drop from $80 back down below $50. In the meantime, I still managed to earn $16 a share on CRDN -- after transaction costs -- mostly by doing my best not to have a position in the stock.

The really good news is that I believe investors can once again profit from a relatively low-risk approach to Ceradyne. Here's how it would work today.

Selling Options

If you don't own Ceradyne today, you would sell a put option, forcing you to buy the shares at a specific price on a specific date if the shares are trading below that level. Essentially, you are selling downside insurance to someone who owns the shares, and they are willing to pay you a premium for that privilege.

That premium depends on what risk you will allow them to insure. As I was writing this article, you could get about 55 cents to insure against a drop below $45 before Dec. 22, or about $1.60 to insure the same price until Jan. 19, 2008. In either case, you get a return of close to 2% per month for the $45 you put at risk.

Alternatively, you could sell put options at $50, especially if you are confident of the current valuation being cheap. Since these options are in the money, a January $50 put would bring in about $4 -- $1.60 because it is already in the hole, and the other $2.40 being a higher premium than the $1.60 you get (see previous paragraph) for insuring a less-likely drop below $45.

So what happens if the stock does drop and your counterparty makes you buy it? Then I would sell a call option. To illustrate, let's assume you write the put option for $50 and the price doesn't change between now and January.

You write the put option for $4, and on Jan. 19, Ceradyne is priced at $48. Your put option is exercised against you and you pay $50 a share to buy it. Your net purchase price is $50 less the $4 premium, or $46, and you are $2 ahead of the game.

You immediately sell a $50 call option expiring in February. Judging from today's option prices, you might get $1.50 for this option, bringing your total outlay to under $45 per share. If the stock rises to, say, $51, you get called and sell your shares for $50, for a net profit of more than $5 a share even though you bought and sold at the same price. You may even want to write a new $50 put option at that time and start the process over again.

If the stock isn't above $50 when the option expires in February, sell another one expiring in March and collect another premium. Incidentally, this is also the way investors who currently own Ceradyne can play this game -- instead of starting with a put option, you start with the call.

Risks Are Real

I described this strategy as low-risk, and I believe it is. But anyone interested in giving it a try should be aware that there are indeed risks -- potentially substantial ones.

Let's say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.40. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.15.

Then the company announces that earnings will only be $3 a share in 2008, and the stock drops to $30. You're down $12.15, or 27% of the money you put at risk. So much for low risk.

On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6.15 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.

Pick Your Value

I did a sensitivity analysis on Ceradyne earnings more than a year ago, and I would highly suggest doing a similar one today. Given the range of estimates the company provided (and the possibility that future earnings could be lower), it is a good idea to get a feel for the worst-case scenario.

Once you get comfortable with the worst outcome, you can decide at what price you would be willing to have exposure, and you can use options to limit your risk around that level.

After yesterday's move higher, the thesis would now work with writing a $50 put option, or you can wait and hope the market moves back in favor of the $45 option. The choice will always be dependent upon the prevailing stock price and time to maturity for the option.