Domino's Pizza (DPZ) produced excellent free cash flow in its latest Q2 report. This makes DPZ stock quite attractive to options traders today who sell short out-of-the-money (OTM) put options for extra income.
I discussed this situation in my last Barchart article on Friday, July 28, “Domino's Pizza Posts Huge Free Cash Flow Growth- Ideal For Options Traders.” For example, Domino's generated $204.3 million in free cash flow in the first half of 2023, up 69% from the first half of last year when FCF was just $120.75 million.
Moreover, Q2 FCF was 13% higher than Q1 FCF, which implies it could be on an annualized growth rate of over 52% before compounding.
That will eventually push DPZ stock higher once the market realizes the power of its cash flow growth.
Shorting OTM Puts
Nevertheless, given that markets are falling, one conservative way to play this is to short out-of-the-money (OTM) puts. For example, in my last article, I suggested that the $392.50 strike price puts for expiration on Aug. 18 looked attractive at a premium of $4.30 per put option.
That provided the short seller with an income yield of 1.09%, and the strike price at the time was just over 3.0% below the spot price. However, as of Friday, Aug. 11, DPZ had fallen to $394.17, so this strike price is only barely out-of-the-money. The put premium has fallen to $3.65 at the $392.50 strike price expiring Aug. 18.
The good news is that the investor now has a profit of $0.65 per put option sold short (i.e., $4.30-$3.65). So, based on the initial investment at the $392.50 strike price, the return has been 0.165% (i.e., $0.65/$392.50).
Rolling the OTM Short Put Trade
However, in order to reduce exercise risk, now it might be time to roll this trade over to a longer expiration period. That means entering in an order to “Buy to Close” at the $3.65 premium price and then shorting another OTM put.
For example, the Sept. 1 expiration period shows that the $380 strike price puts trade for $3.25 per put. This works out to a 0.855% yield to expiration (i.e., $3.25/3.80).
This means that the investor who secures $38,000 in cash and/or margin with their brokerage firm can then enter an order to “Sell to Open” 1 put contract at the $380 strike price. The account will then immediately receive $325 in cash in their account.
So, after adding in the $65 received from the first trade along with this rollover amount of $325, the investor makes $390. This is based on an average investment of $38,625 between the two trades.
As a result, the yield to expiration works out to 1.0% (i.e., $390/$38,625). If this can be repeated over the next 11 months it works out to an annualized return of 12% before compounding.
Moreover, given that the $380 strike price is just 3.59% below today's price, a more conservative trader might be willing to short the $375 strike price for a lower premium. That makes it less likely that the strike price will be exercised and the investor's secured cash will be used to purchase 100 shares of DPZ stock.
But even if that happened, that would not involve any kind of permanent capital loss, even though there could be an unrealized loss. Moreover, as long as the investor is able to keep selling OTM call options it's possible they can recover an unrealized loss amount.
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.
