The Valeant Atrocities—Pain and Gain of Put Selling Strategies

Unless you have been hibernating in a cave, you have to have seen the massive swan dive into near oblivion that is Valeant Pharmaceuticals. What is most tragic is that Valeant has taken down a few notable portfolio managers with it, the most notable of which is Robert Goldfarb of the Sequoia Fund. The Sequoia Fund has an incredible track record of trouncing the SP 500 over the past 40 years. Many of its earliest investors were former Buffett partnership refugees. When Warren Buffett ended his famous Buffett Partnership in the late 1960s, he sent partners back their money because the market was too high and he was “out of step” with the overvaluations. He suggested they invest with Bill Ruane and Richard Cuniff, the tandem that ran the Sequoia Fund in its early years. The Sequoia Fund held concentrated positions over the years and eventually closed to new investors because there were no more bargains to be had. A few years ago, they began to amass a large position in Valeant when the stock was in the low $20s. They rode Valeant all the way up beyond $200/share. At one point, it was a third of the portfolio. But then, Valeant started sprouting red flags everywhere. Recently the CEO has resigned and most frightening, they were late filing their quarterly financials. The company has announced layoffs. The stock began a sickening descent into the abyss as it dropped from 235 to its current $29/share. At one point, when the stock dropped half its value to around 120, the bargain hunters began to assemble. And, some folks no doubt sold puts in a bet that Valeant would eventually rally and they’d expire worthless. So imagine selling the 120 puts. With Valeant’s violent price swings (i.e. high volatility) put sellers would collect large premiums. While many stocks have been in solid uptrends since 2009, some stocks, especially those in the biotech sector, have had substantial corrections. Some have suffered 35-50% drawdowns or more. In Valeant’s case the stock is down 80% from its highs.

So assume an investor collects about $15 in premium for a 120 put that expires in 2 months. The investor wants Valeant to be above 120 at expiration. If it is, the $1,500 ($15 X 100 shares) is the put seller’s to keep. But as we all know, VRX’s problems have intensified and the stock continues to have staggering losses. It lost half its value in one day recently. Valeant continued dropping and now stands at $29. If VRX stood at $29 at expiration, he’d be put (also known as assigned) 100 shares of Valeant at $120/share, or the equivalent of a $12,000 investment that is now only worth $2900—a loss of $9,100. Of course that would be partially offset by the premium taken in—$1,500— that the seller is allowed to keep. Ah the thrill of victory and the agony of defeat! SELLER BEWARE. Put selling is a terrific income producing strategy, however, every so often, the losses can be painful.

For more information on put selling strategies, see In Sickness and Wealth, April issue.

 

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