RealMoney Silver - An Interesting Options Play in BGP

An Interesting Options Play in BGP
By Tim Melvin
RealMoney.com Contributor
2/12/2008 9:37 AM EST

There is a lot to like about living on Kent Island in Maryland. It has a small-town, somewhat resort-like atmosphere, provided, of course, the small town has serious addictions to boats and seafood. The one drawback, however, is that there is nowhere to purchase those weekend staples, Barron's or the Financial Times.

So this past Saturday, as the wind whipped in off the bay, I found myself crossing the bridge to Annapolis, heading to the bookstore. I ended up at Borders (BGP) , where I walked out with the two papers and six books, lighter by some $92.38. Why do I mention all of this? Because not only is Borders on my watch list as a potentially cheap stock, it has long been one of my favorite trading stocks.

From a long-term perspective, the stock is almost cheap enough to buy. It trades at just 15% of sales, less than half the price-to-sales of its major competitor Barnes & Noble (BKS) . The company's book value at the end of the quarter was about eight bucks, and I confess that being a book value freak in the mold of Ben Graham and the Schloss brothers, I would like to see it closer to that number, but the balance sheet is in good shape.

The turnaround plan is in place and the Seattle's Best Coffee Cafés have been installed in most stores. This has driven same-store sales higher, and the coffee café has higher margins than the rest of the business, especially the fast-fading music business. Music is continuing to decline, but Seattle's Best, along with gifts and stationary, are more than taking up the slack. Sales were up in the holiday season, unlike a lot of other retailers, although they did feel the pressure of having to discount to attract customers.

Borders has something else going for it that I like to see in a stock. A large, aggressive, successful activist investor is buying the shares. William Ackerman of Pershing Square, the same activist who recently made a small fortune shorting mortgage insurers and has had a lot of success in activist situations, recently increased his stake to over 22% of shares outstanding. The successful hedge fund Citadel has over 8%, as does noted value investor David Dreman. The stock appears cheap and a lot of people far smarter than I appear to agree.

What makes it a trading stock? Borders has dropped about 50% in price over the last year. On the way down, there have been several chances to sell the put options just below the market price. Inevitably, the stock was put to me, and I immediately sold at-the-money calls.

Again, so far I have been called out every time, keeping the premiums on both options and scratching on the stock. It's not a huge profit, usually 4%-5% of the capital (I cash-secure my put sales), but I was able to do it several times during the course of the year.

At its current level, even if I am not called out of the stock when it is put to me, owning it at the next strike down -- minus the premium for the puts -- is not the worst thing that ever happened. The cost would be only slightly higher than I would be willing to buy this stock anyway.

There would also be call premium collected from the covered call, lowering my cost even further. Right now, I have my eye on the March 10 puts, and will sell them if the stock moves down further.

This is one of my favorite trading strategies. Most value investors ignore options. Options traders think value investors are nuts. This has created some interesting opportunities to execute the cash-secured put sale and covered-call strategy to create better entries and short-term profits. The key to the strategy is to be not just willing, but almost excited about owning the stock at the current price, and only sell puts for as many shares as you are comfortable owning.

Now, I am off to work my through this stack of books!