AEP - bear put calendar

There was a request by a blog reader for me to do a pure option trade.

To do this, I am putting a bear put calendar trade on AEP

Fundamentals

AEP is a mainly coal-fired power producer in the United States.

In 2009, AEP incurred a huge loss on a cash basis. After earning $2.4 b in cash from operations, it spent $2.8 b on capital investments / plant maintenance. It has lost money on a cash basis since 2006 but it continues to increase its dividends payments from $663 to $761 m. This accounts for why the stock is so popular. Investors are buying for the dividends.

The key question is, how has the company been getting the cash to pay the dividends. It borrowed more than $10 b since 2005. Recently, it stopped borrowing but instead, decided to sell stocks to finance the dividends! This sounds alarmingly like a ponzi scheme. AEP actually sold new shares worth about $1.7 billion. It has to constantly raise capital simply to stay in business and pay its dividends. This is not sustainable. It is now drowning in debt.

The other factor against AEP is that coal price is going up, with all other commodities. Seventy-eight percent of China's power production is coal based. The demand from China is so huge that this will drive up coal price. Soon, many coal-fired power stations will get more expensive operationally. There is not much room to raise the price of electricity to consumers as it had already been up enormously since 2007. Yes, I will be looking to buy some coal stocks, but not in the context of this discussion. Additionally, there has been all kinds of expensive regulations that makes running more expensive while the company is not allowed to raise price for the repair. A huge increase in coal price will literally bankrupt the company.


Technical

I have been waiting for the right timing to short AEP. Because of the high dividends, if I am wrong about the timing, I will not only lose money on my shorts and I have to pay the dividends too.

The stock has been climbing despite the weak fundamentals. A lot of people are looking for high-dividend stocks. Apparently, it looks like a growth stock if you ignore the debt and capital expenditure.

The best trade for me now is to do a bear put.

It has recently reached new highs and is coming down. It is consolidating at 36.2. I expect it to break down from here.



Trade

A bear put is better that shorting the stock. I do not have to worry about the dividends.

Below is my trade.

BTO May 37 2011 PUT = 3.3
STO Nov 36 PUT = .95
Net Debit = 2.35

Delta difference = .64-.48 =.16 ( acceptable )
% of SP / LP = .95/3.3 = 28.8% ( good )

The risk profile is displayed below:



At option expiry, I will not be losing money if the stock stays below 37.4

If volatility increases, my break-even point will be better.

PE: Continue to roll the SP from 36 to 35 once the downtrend is confirmed within the next 1 to 2 weeks when it goes slightly ITM.

If it continues to be bearish and cannot hold 35, roll it down to 34 which is a major support.

My objective is that it will hit 34 in 1-2 months if the the trend is on my side.

SE: If AEP reverses together with positive technical signal and hits > 37, roll the SP up to 37 or close the trade for a slight loss.