Nvidia (NVDA) is a leading designer of graphics chips used in PC's, smartphones, tablets, and gaming consoles. Advanced Micro Devices (AMD) is the main competitor in the PC space, with companies like Intel (INTC), Qualcomm (QCOM), and Texas Instruments (TXN) competitors in the mobile space.
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NVDA data by YCharts
Nvidia currently trades at $12.59 per share. I recently wrote an article on Nvidia where I performed a discounted cash flow (DCF) analysis and concluded that Nvidia is undervalued. I estimated a fair value range of $16.89 - $21.16. The current stock price gives about a 25% margin of safety below the lower bound of my fair value range. Looking at the recent stock performance, shares of Nvidia have briefly dipped below $12 per share on a few occasions over the last year. Given that $12 represents a 29% margin of safety to my fair value range, this price seems like a natural entry point for this undervalued stock. But instead of simply waiting for the price to drop below this level, an alternative is to be paid to wait for the stock to drop below this level by selling puts.
Selling Puts
An option has three components: A strike price, a premium, and an expiration date. By selling a put option you are giving the buyer of that option the right to sell you the underlying stock at the strike price on or before the expiration date. The buyer pays you the premium in exchange for this right. You keep this premium no matter what happens, but are required to buy the stock if the option is exercised.
Selling a cash-covered put option can end in one of two ways. If the stock never dips below $12 per share before the expiration date the option will expire worthless, you will not be required to buy any shares, and you're free to write another put. If, however, the stock does go below $12 per share and the option is exercised, you are required to buy the stock at $12 per share, which will be higher than the current market value.
Let's take a look at the different put options available to sell at a $12 strike price:
| Expiration Date (Days until expiration) | Strike Price | Premium (Last Trade) | Annualized Return |
|---|---|---|---|
| Jul 2012 (25) | $12 | $0.30 | 36.5% |
| Aug 2012 (53) | $12 | $0.59 | 33.9% |
| Sep 2012 (88) | $12 | $0.80 | 27.7% |
| Dec 2012 (179) | $12 | $1.32 | 22.4% |
| Jan 2014 (571) | $12 | $2.51 | 13.4% |
*Data as of June 25
The July 2012 expiration date provides the largest annualized return, receiving a $0.30 premium on a $12 investment, resulting in an annualized return of 36.5% (2.5% in 25 days) . So if you sell a July 2012 $12 put option you immediately receive a premium of $30 (all options are in blocks of 100 shares) and you have $1200 tied up for 25 days. If the option expires worthless you can then write another put and collect another premium. If the option is exercised you will buy 100 shares Nvidia for $12 per share, a price which you have already determined is a comfortable entry point.
The downside to this strategy is that if Nvidia tanks, say to $10 per share, you are forced to pay $12 per share and suffer an immediate "on paper" loss. Of course, had you simply bought shares at the current price or even waited for the price to reach $12 and then bought shares, you would have suffered the same fate. But by selling puts you are able to offset this "on paper" loss with premiums.
If you think that the stock will drop significantly below $12 per share, or if by the time this article is published the stock already has, another option is to sell a put with an $11 strike price instead. The August 2012 $11 put offers a premium of $0.30, yielding an annualized return of 18.8% (2.72% in 53 days), and the premium will only increase as the stock price decreases.
Conclusion
Nvidia is a seriously undervalued company, and selling puts at strike prices which offer a substantial margin of safety to fair value allows for an annualized return of up to 36.5%. The worst thing that can happen with this strategy is that you end up with shares of Nvidia for a price which you're happy with. Sounds pretty good to me.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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