Constellation Brands (STZ), a leading beverage and alcohol company, produced excellent quarterly results with strong free cash flow for its fiscal Q1 ending May 31. However, STZ stock still does not reflect its true value. That makes shorting out-of-the-money (OTM) puts and calls a good play.
I discussed this in my July 5 Barchart article: “Constellation Brands, Which Makes Corona and Modelo Beer, Looks Cheap to Value Investors Based on Its Cash Flow.” At the time, STZ stock was trading at $257.08, and as of Friday, July 26, it was at $253.48.
I explained how the stock looks undervalued. The price target I came up with was $421 per share. That is over 66% over today's price. Moreover, I showed how analysts had price targets well over today's price.
Many analysts are raising their price targets. For example, Barchart's survey of sell-side analysts has a $301.53 price target. That is even higher than the $299.45 prior target shown in the article. Similarly, AnaChart, a new sell-side analyst tracking service, shows an average $300.16 price target from 21 analysts. That is higher than the prior $291.41 price target.
The bottom line is that sell-side analysts see STZ stock price rising from here.
Shorting OTM Puts and Calls
In the article, I suggested shorting out-of-the-money (OTM) puts and calls for expiration on July 26. For example, the $250 strike price put had a bid side premium of $1.45. That provided an immediate yield of 0.58%.
Moreover, the $275 strike price call options had a 40-cent premium, giving the short seller a 0.156% covered call yield (i.e., $0.40/$257.08). Combined this provided a short seller $1.85 in income.
Both of these options remained out-of-the-money. So, this provided extra income for long holders of STZ stock. Moreover, the investor can repeat this.
Repeating the Short Put / Call Play
For example, look at the August 16 expiration period, which is 3 weeks from now. It shows that the $2.45 strike price put, which is 3.35% below today's price, has a bid side premium of $1.45 per put contract.
That means that the short seller can make an immediate yield of 0.59% (i.e., $1.45/$245.00 = 0.00592). That makes shorting these OTM puts a profitable play. This is especially the case for existing shareholders. They can also sell covered calls (i.e., shorting OTM calls at prices well over today's price).
For example, the $270 call option has a 25-cent premium on the bid side, and the $265 has a $0.75 bid side price. That provides the covered call investor a potential yield of 10 basis points (i.e., $0.25/$253.08) and 0.30% (i.e., $0.75/253.08).
This means that with the combined the investor could potentially make $1.45 and $0.75, or $2.20 shorting both OTM puts and calls for the next 3 weeks.
For example, assuming that the investor already owned 100 shares of STZ stock (i.e., for the covered calls) it represents an expected return (ER) of 0.90% (i.e., $2.20/$245) for just 3 weeks.
That is a profitable ER, especially if the investor can repeat this play every 3 weeks. For example, over the next quarter, this works out to an ER of 3.60% (i.e., 0.90% x 4).
So, combined with STZ stock's potential upside (remember covered call investors own at least 100 shares per contract), holding STZ stock and shorting OTM puts and calls is very attractive to value investors.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
