Hello Fools,

I'm not so sure this a 'Falling Knive', so much as it might be a knife that's stuck in the wooden block, vibrating back and forth. Nonetheless, I'm looking at 3M Inc. (MMM) with an eye to a long-term option strategy (if that isn't an oxymoron). Below is my reasoning, and my calculation of payoffs. I apologize, but length-wise, this one's a doozy. I welcome comments and constructive criticism.


Summary
=======

MMM is trading at a low valuation relative to its discounted cash flows, its historical relative multiples, and its competitors. Uncertainty surrounding its CEO departure, as well as perhaps the perceived ease to digest its recent CUNO acquisition has punished the share price. I believe a synthetic long option strategy provides a lucrative way to profit from this situation.

The Business
============

I'm not going to go into too much description here. You all know who 3M is, and undoubtedly use more of their products than you know. There are seven major business segments (pretty much lifted verbatim from their website):

Consumer and Office - Supplying an array of products that keep homes cleaner, offices organized 
and buildings well-maintained.  Scotch tape, Post-it Notes, ScotchGard anyone?

Display and Graphics - World leader in films that brighten the displays on electronic products, 
also touch screens and touch monitors; optical components used in projection TVs; reflective 
sheeting for highway safety; and materials and systems for producing high-performance, attention-
getting graphic images.

Electro and Communications - Leading supplier of innovative solutions to the electrical, 
electronics and communications industries

Health Care - innovative products and services help increase efficiency in the delivery of 
patient care. Compete in multiple market segments, including medical and surgical products, pharmaceuticals, 
dental and orthodontic products, health information systems, and personal care products

Industrial - strive to understand the diverse market segments – construction, food and beverage, 
metal fabrication, oil and gas, woodworking and more – that make up the industrial marketplace. Use 
that knowledge to provide innovative products and other solutions that make industrial customers 
more competitive.

Safety, Security and Protection Services - major products include personal protection products, 
laminates that help prevent counterfeiting of documents, reflective materials for personal safety, 
window films, cleaning and protection products for commercial establishments, roofing 
granules for asphalt shingles, and fire protection products that help 
protect against the spread 
of fire, smoke and toxic fumes.

Transportation - products and components for the manufacture, repair and maintenance of autos, 
aircraft, boats and other vehicles.  Major product categories include abrasives, tapes, films, 
adhesives and specialty materials.

Beyond their product lines, I've put together, in no particular random order, a bunch of bullet points that I find interesting regarding how MMM has shaped their business:

*  Consistent, long-term performer.  A 25-yr CAGR of 10.5% without considering dividends, or 
   reinvestment of those dividends.  Truly a stock that you could have bought and forgot about.

*  Dow Jones Industrial Average component.  First person that brings up 'Dogs of the Dow' gets slapped 
   with a Motley Fool Investment Guide.

*  CEO has recently departed for Boeing.  Uncertainty may be weighing on stock.  

*  Reputation for innovation.  Six-Sigma a huge part of their business.

*  Financially, things have looked great over the past five-and-a-half years, through the bubble
   top, fall through 2002, and rise over 2003/2004.  Some points:

   - Continuing share buybacks:  Shares O/S reduced 4% since 12/31/99

   - Continuing rising dividends, although payout ratio has fallen to ~40% from 50% in 1999.

   - Revenue growth compounded average of 5% since 1999

   - EBITDA growth compounded average of 7.6% since 1999

   - Net Income growth compounded average of 10.7% since 1999

   - EPS growth compounded average of 11.5% since 1999

   - FCF (as proxied by Owner Earnings) growth compounded average of 12.3% since 1999

   - Given the disparity between top and bottom line growth, I likely don't need to tell you 
     that margins have steadily improved.

   - Net debt has fallen from around $2.5 billion at the turn of the millenium, to essentially 
     nothing ($44 million) today (note, this is net of the effect of the CUNO acquisition, but then 
     again, I've not assumed any benefits in my forecasts either.

   - Working capital management has steadily grown more efficient.  The Flow Ratio (remember that?) 
     has fallen from 2.11 in 1999, to 1.47 as of Q2-2005.  MMM's cash conversion cycle has fallen 
     from 113 days in 2000 to 82 days in the TTM ended Q2-2005.

   - Cash flows have been depressed by the LARGE contributions MMM has made to fund their retirement 
     plans ($2.4 billion over the past three years).  This repair work seems largely complete, and 
     so I expect their operating cash flows to increase going forward.

Other Fool Mentions
===================

I know MMM was an IV pick, but not being a subscriber I know little beyond that. However, we can make a few assumptions about the IV pick to support my thesis that MMM is undervalued. (I'll ignore the obvious - that MMM was recommended by a Value newsletter).

Since MMM is trading near it's 52-wk low, we can surmise that TMFAdmiral picked MMM when it was trading higher than today, presumably after the Q1 results knocked the stock from the $85 range to the $75 range. I'll assume the pick was made in the $72-$75 range. Given IV's focus on buying at a significant discount to intrinsic value, and assuming a 25% margin of safety, I'll guess that Philip's intrinsic value is in the $90-94 range.

Also, for those of you who subsribe to the BMW Method, MMM looks at least interesting. I admit, I'm not a proponent of the BMW Method, but that is due entirely to my lack of sitting down and digesting the material, rather than any comment on the work done by BuildMWell et al. In fact, I think Mike Klein's site is tremendous, so what better way than to shoehorn one of his excellent BMW charts into a post:

http://invest.kleinnet.com/bmw1/stats25/MMM.html

MMM currently trades at near it's -2RMS line of $69.26. As I understand it, only 2.5% of all observations will fall below the -2RMS line (a normal distribution, two standard deviations below the mean) and at the current price to return to it's long-term (25 year) CAGR, we could 'expect' a return of 21% as it returns to it's historical CAGR.

So there are at least some other proponents of a MMM value thesis.


Valuation
=========

Discounted Cash Flows
=====================

I won't bore you with all of the details, but my DCF valuations, tweaking various inputs, show a reasonable value range of $83 to $88, so we have, at least, a moderate margin of safety.


Relative Valuation - MMM Historical
===================================

Over the period Jan-00 to Aug-05, MMM is trading at near lows on a multiples relative valuation approach. Calculated on a month-end rolling TTM basis (for example, the month-end price in July 2002 calculates multiples based on the TTM financial results of June 2002). The table below shows the multiples over this time, and the current numbers (as of close, Aug 31).

                              P/E
                   P/S     (diluted)   EV/EBITDA    EV/FCF*  P/FCF   EV/OE**   P/OE**     
--------------------------------------------------------------------------------------
Mean              2.90       25.3         12.3       23.8    22.9     24.9     23.9
Median            2.94       25.4         12.4       22.1    21.3     23.7     22.8
Max               3.78       35.0         15.3       39.0    36.9     36.8     34.8    
Min               2.05       18.0          8.8       16.8    16.7     17.9     17.8
--------------------------------------------------------------------------------------
Current           2.64       18.1          9.4       16.9    16.9     17.8     17.8
--------------------------------------------------------------------------------------
*  FCF defined here simply as Free Cash Flow: FCF = CFFO - CapEx
** OE defined here simply as Owner Earnings:   OE = Net Income + Depr/Amort - CapEx

I'm sure some could argue that 3M going forward will not command as high multiples as in the past. So we'll try to build that in somewhat going forward. (And besides, if 3M is granted higher multiples going forward, it will improve my strategy, so there's really no downside there.)


Relative Valuation - Competitors
================================

Fairly brief here. Who are 3M's competitors? Not such an easy question with conglomerates. I'll admit, I'm pulling these competitors and data from Yahoo! and MSN. Labeled as part of the 'Conglomerates' industry group, the top 10 are: GE, Tyco, 3M, United Technologies, Honeywell, Mitsui & Co., Fortune Brands, PPG Industries, Textron, and Rockwell Automation (a disparate group, to be sure, and not a direct competitor in the bunch). Still...stacking them up:

                              P/E
                   P/S     (diluted)   EV/EBITDA    EV/FCF*  P/FCF    ROE** 
------------------------------------------------------------------------------
GE                2.19       19.8         22.0       32.2    16.0    17.4%
TYC               1.38       23.2          8.1       15.7    13.1     8.9%
UTX               1.31       16.9          8.6       18.7    17.0    21.9%
HON               1.23       25.4         10.8       21.9    19.6    11.3%
MITSY***          0.51       15.8         15.9      110.9    42.0    11.7%
FO                1.74       15.7          9.9       27.4    24.3    26.3%
PPG               1.07       15.5          7.0       17.2    15.9    21.7%
TXT               0.84       20.8         10.9       25.1    15.5    11.8%
ROK               1.97       17.6         10.7       17.5    17.0    27.4%
--------------------------------------------------------------------------------------
MMM               2.64       18.1          9.4       16.9    16.9    33.2%
--------------------------------------------------------------------------------------
*   FCF defined here simply as Free Cash Flow: FCF = CFFO - CapEx
**  I calculate ROE as Net Income divided by the average of starting and ending equity
*** I don't trust the FCF numbers for MITSY. There are no proper filings for TTM, so I'm relying on 
    Yahoo! which is sketchy.

Looking at our poorly-chosen comp table, I'd say MMM is at least in the upper echelon quality-wise, with the highest ROE, and second lowest EV/FCF (and I think Tyco's past scandals might still be weighing on that price) relative to the others.


Forecasted Prices
=================

In my DCF, I forecast pro-formas based on past performance such as growth, margins, and various turnover ratios. From the pro-formas, I then apply price multiples in order to infer future prices. In the case of MMM, in recognition of the perhaps continued low price multiples granted by the market, I used multiples that are closer to the bottom of the historical range:

      P/S - 2.75x
      P/E - 20x
EV/EBITDA - 10x

From my pro-formas and these assumed price multiples, my forecasted price ranges (worth what you paid for them) are:

Q2-2006 TTM - $80.00 - $83.50   (Prices assumed upon release of the particular qtrly numbers)
Q2-2007 TTM - $86.00 - $89.00
    FY-2007 - $90.00 - $93.50   

Option Strategy - Synthetic Long
================================

Quick primer: A synthetic long uses options to recreate the profit payoff of a long position in a stock. This is done by simultaneously buying a call and selling a put with the same strike price and time to expiry.

The specific synthetic long I'm thinking of here is:

Buy the JAN08 $75 Call for $8.50
Sell the JAN08 $75 Put for $9.40  Note - prices will vary as the stock price fluctuates

Advantages

*  Long time horizon (relatively speaking - this is an option strategy, not LTBH)
*  Call purchase completely financed by sale of put.  Small credit of $90 per contract 
   deposited in account.

Disadvantages

*  The strategy is out-of-the money, meaning the call has no intrinsic value and is completely 
   comprised of time value.  The delta of the call option is around 0.55, meaning a $5 fall in 
   the price of the stock will translate to a rough drop of $2.75 in the price of the call.  However, 
   that $5 drop in stock price is only a 7% loss for the stock, as opposed to the $2.75 option 
   price drop, which translatse to a near 33% fall in option value.  Those without strong stomachs 
   for volatility could get queasy (actually, I'd just advise avoiding looking at your option prices
   on a daily, or even monthly, basis).
*  You'll need significant margin collateral in your account to affect this strategy, since the 
   put is sold naked and uncovered.
*  MMM pays a nice 2.4% dividend yield. However, the holder of a synthetic long does not profit 
   from dividends.
*  This strategy will hopefully result in a rich payoff.  However, the taxman will certainly 
   have his hand out.  Were we to simply buy the stock, we'd avoid the loss of capital to the 
   taxman (although the option payoff should compensate us for that loss of capital).

Payoff Expectations
===================

I'm using the Black Scholes option pricing model to price options on dates between now and expiry. I realize this will tend to understate true value, but it's a good tool nonetheless. Payoff expectations on those interim dates are assumed as if I've closed out the respective option contracts (buy put/sell call), but I'm not including commissions.

Also important to note, I've had to make some assumptions with regards to the parameters for the option pricing. Those assumptions are:

*  Increasing dividends.  Assume that the remainder of 2005 will see quarterly payments of $0.42/shr,
   2006 will see quarterly payments of $0.46/shr, and 2007 will see quarterly payments of $0.50/shr.
*  Flat yield curve.  Current risk-free rate is ~3.80%
*  Constant underlying volatility, currently around 22.3%

Using our forecasted prices from above, and using the dates when the up-to-date quarterly numbers
likely will become available, the table below shows the payoff per contract:

	  Forecasted                                    Payoffs/Contract		
   Date	  Stock Price  Call Price  Put Price	    Call       Put      Total
===============================================+=====================================
20-Jul-06   $80.00       $11.57      $5.19     |   $1,157    -$519     $  638 
	    $83.50       $14.03      $4.14     |    1,403    - 414        989 
19-Jul-07   $86.00       $12.64      $1.21     |    1,264    - 121      1,144 
	    $90.00       $16.13      $0.70     |    1,613    -  70      1,543 
18-Jan-08   $90.00       $15.00      $  --     |    1,500       --      1,500 
	    $93.50       $18.50      $  --     |    1,850       --      1,850 
===============================================+=====================================

Risks - Action if Things Go Poorly
==================================

The worst-case scenario is that the call expires worthless, while the put expires in-the-money. We have two-and-a-half years for that to play out, but you'd be looking at an effective buy price of $74.10 per share if this occurs (since we get the $0.90 credit due to the disparate option prices). That's $7,410 per contract folks, so don't sell 10 contracts unless you can afford to pony up for the shares at the conclusion. Sure you could sell the put fairly close to expiry, but it would essentially be for intrinsic value (strike minus then-current stock price). At the worst, you'll end up owning shares in a fairly good company (I can think of worse fates), at a higher price. You could then use a covered call strategy, or other income strategy to try to recoup some losses.

Again, using my forecasted prices come Jan-08 (and I believe I've been conservative, forecasting 7% bottom line growth, and no improvements in margins or working capital efficiency), price multiples for MMM shares would be:

                                       Option Strategy
Price    P/S    P/E    EV/EBITDA   Gain/Loss (Held to Maturity)
================================================================
$75.00   2.31   16.0     8.3           $   --
$70.00   2.16   15.0     7.7           $  410
$65.00   2.00   13.9     7.2           $  910
================================================================

All (except some P/S multiples, which I put less stock in) are lower by a good margin than anything we've seen since 1999 (and likely before, I just didn't bother calculating those).


Conclusion
==========

I think this is a substantially lucrative payoff on a fairly low risk (again, if that isn't an oxymoron) option strategy. The stock's in the dumps, but it will not always be so. There is uncertainty regarding leadership and acquisition integration, but it will not always be so. The risk of loss is fairly minimal, and I believe my forecast has been made conservatively, and doesn't reflect the company's history of improvement and increased efficiency.

No money down, potentially big rewards.

Okay Fools. Have at 'er.

Cheers,

Jim

Jim,

Interesting idea... Just a clarification, in your risk area, those are losses, right? You have them without () or -...

So I've quickly looked at some other companies to look at similar situations, and it's interesting the results. With most, it looks like a similar situation. But a few (JNJ and MDT), well the calls are much more expensive than the puts, perhaps it's just the relationship to where their stock price currently is, but I also think it's that they're in medical space:

	Current Strike	Call	Put	Dsct    DIV   Prm     % strike
GE	33.14	35	3.3	4.1	-5.3%	2.6	0.8	2.3%
JNJ	63.13	65	7.3	6.5	-2.9%	2.1	-0.8	-1.2%
MDT	56.99	60	7.3	6.3	-5.0%	0.7	-1	-1.7%
MMMM	70.86	75	8.5	9.4	-5.5%	2.4	0.9	1.2%
MSFT	27.2	30	2.4	3.6	-9.3%	1.2	1.2	4.0%
PG	55.75	60	5.1	7.8	-7.1%	2	2.7	4.5%
WMT	45	50	4.9	7.1	-10.0%	1.3	2.2	4.4%

So I guess it's the ones that have the smallest discount that you'd have to pay up for, which makes sense. But do these violate the put-call parity relationship? probably not. They were all fairly close when I took dividends into account.

You chose MMM Because you thought it was undervalued at the current levels... I'm curious what you think of these other names as well.

Cameron

I can't think why you would bother with a synthetic long position when you can do the same thing with a lot less trouble and less transaction fees by just buying the equity.

gg

Hey Cameron,

Interesting idea... Just a clarification, in your risk area, those are losses, right? You have them without () or -...

D'OH! Yes, those numbers should be bracketed - they are losses per contract position.

As to your list above, I've not put much (any?) work into any of them with the exception of WMT. I actually think WMT is due for a turnaround, but retailers seem to be garbage right now, so it's a longer-term hold I suppose.

Cheers,

Jim

Jim, I'm delighted to have a place to host that fine post. The formalized valuation of the options is great. I wish I had more time to discuss this but... maybe this weekend.

I would like to bring up one small point/question. B-S pricing, as you pointed out, has some flaws with long dated (and near term) option pricing. There's one other flaw I wish I could find some dicsussion on... (I hope this makes some sense)

imagine a cork floating in the sea... it rides up and down, the rate/speed dependent on wave action. Height of waves might be compared to volatility levels. At wave peaks much more likely the cork will travel down more than it will travel father up. Likewise at wave troughs, it's much less likely you'll see the cork travel father down.

compare that to option pricing. At MMM's current ebb, it's far more likely it'll travel up 25 points than farther down... yet the Black-Scholes prices the option with an equal chance for volatility on either side of the present price... intuitively you know that's wrong but I've never seen a pricing model that figured aysmmetric volatility ranges. I know it's out there.

I thought maybe it could be seen in the actual pricing of calls vs puts... but it almost magically the opposite

for instance

with your prices...
$8.50 on the call option gives an implied volatility of 14.5%
$9.40 on the put option gives an implied volatility of 21%



your syn long strategy seems to trade more than time... you are making a savey volatility purchase also. You're buying the cheap volatility and selling the dear one.


I'm assuming you intend to profit from the options only and do not intend to establish a long term position on the cheap. If that is the case... here is some wisdom. It's critical that one does not make a "framing mistake" with this play. The two positions are seperate trades linked only by the use of money from one for the other. There may well be a time in the life of this trade when it will make sense to extinguish one and let the other ride. What I'm trying to say (for new option players) is that each position should be evaluated on its own merits. If MMM rolls up 15 points, one might be able to make a drastic reduction in risk by doing something with the put at that point... and letting the call ride. For instance... one of the things I love to do... if MMM rolls back up 15 points on a random walk swell in the volatility sea... there'll be an excellent chance you could unwind 1/2 the call position and use the proceeds to buy back the entire short put position. Sure you've decreased your profit outlook but you've completely eliminated the risk of the position.

I always want to remember that option positions are specualtions and MUST be treated and traded as such. They are not investments. Never ever make the mistake of thinking you are investing when you are speculating. My general idea of an investment is this... time is on my side! The longer I hold the more likely I'll show a profit. An investment puts time on the side of the investor. A specuation, on the other hand, always has a clock ticking... you are trying to make your profit in some period of time. Options, futures, , long/shorts, Day trades, swing trades, trades based on TA... all have time factors built in (I think I can argue that effectively) and are speculations.

It's also interesting to note the very same position might be an investment... let's say I've got 75K of bonds that mature in '08... and I fully intend to take the position either way... in that case, the syn long IS an investment and should be treated as such.

gg

I can't think why you would bother with a synthetic long position when you can do the same thing with a lot less trouble and less transaction fees by just buying the equity.

1- leverage

2- he doesn't esp want MMM... he just wants more money

3- bonds that mature in three years and he's want to establish the position now as he feels MMM is way undervalued

4- etc etc

the reasons are legion. Some very bad... but Jim has laid out a good case for a leveraged buy

gg,

I can't think why you would bother with a synthetic long position when you can do the same thing with a lot less trouble and less transaction fees by just buying the equity.

1)  Transaction fees are not a big deal.  

    I'm with E*Trade, so to trade (buy and sell the stock) would be $26.99 * 2 = $53.98.  
    To buy and sell the option would be $26.99 + $1.60/contract * 2 = 57.18.  

    I'm not going to quibble over $3.20/contract over 2+ years.


2)  The synthetic long requires a smaller investment than buying the stock does.

    Example per contract:

    Closing stock price on 9/1/05 = $70.86

    Buying 100 shares of stock = $7,086 (ignore commissions for example)

    (or $3,543 if buying on margin with a 50% rate - but then you're paying interest on your margin
    loan, which we don't want to do)

    In the case of the synthetic long, we need:

    - collateral of 20% of the stock:                   $7,086 * 0.2 = $1,417.20
    - put premium:                                       $9.40 * 100 =    940.00 
    - difference b/w stock and strike prices:     (75 - 70.86) * 100 =    414.00
    - less initial credit from disparity of call and put prices      =   ( 90.00) 
                                                                     -----------
                                                      Net Collateral = $2,681.20


    And of course, this is money that you've already invested in other companies, not new money
    that you must put up, or money you must free up by selling other positions.  In other words, 
    it's all about leverage, and using that leverage in regards to your existing assets.  (Of course, 
    this require comfortability with options and leverage, which some are unwilling to do; and that's cool).


3)  The payoff is greater, and potentially much greater.    The flip side is that the payoff 
    may be less than that of the stock, and I am more than aware of that (and hopefully that came 
    across in the original post).  

    Being an option strategy there are risks (stock doesn't perform as intended, put finishes 
    in-the-money), and disadvantages (we don't get the dividend, which I expect to continue rising).

    Going with my 'best case' example presented in the original post (and the true best case would be 
    higher stock appreciation, but my intent was to try to be as conservative as possible, 
    being respectful of the loss potential of options).  

    At expiry (Jan 18/08), I'm forecasting a share price of $93.50.  In such a case, the put expires 
    worthless, and the call pays off 18.50.

    Again, ignoring commissions, interest (assume no margin loan), and taxes (on dividends), as well as
    time-value-of-money principles on received dividends (since you could presumably reinvest those):

    Stock Return
    ============

    Capital Return for Stock:         $9,350 - $7,086 = $2,264
    Expected Dividends over Period:       $4.26 * 100 =    426
                                                     ---------
    Total Return on Stock over Period:                = $2,690
                                                     ---------

    Total Return = 2,690/7,086 = 37.96%

    CAGR = [(7,086 + 2,690)/7,086]^[1/(869/365)] - 1 = 14.47%


    Synthetic Long
    ==============

    Payoff from Option Strategy:      $1,850.00
    Initial Collateral:               $2,681.20

    Total Return = 1,850/2,681.20 = 69.0%

    CAGR = [(1,850 + 2,681.20)/2,681.2]^[1/(869/365)] - 1 = 24.66%

Hope that answers the question.

Jim

Hey ed!

Couple of things.

First, to any and all who enjoy options, buy this book: http://tinyurl.com/aqzt7

I see that it's <$50 at Amazon which is a bargain IMHO (since I think I paid about $100 CDN for may copy a couple of years ago IIRC).


You got me on the volatility trade, and the flaws in B-S. But I figured if I started talking about volatility trading techniques I'd be writing all night. And if you ever want a definition of hell, try sitting in a 3-hr derivatives class where the whole subject was volatility (volatility 'smile', volatility skew, trading volatility, implied versus historical volatility, et cetera, ad nauseum). I've got a nifty little options calculator from one of my MBA texts, so I typically always run my trades through that (in addition to my own spreadsheet), so my IV's are not exact to yours, but close enough.

You are correct that I'm not actually looking for MMM the stock, but am attempting to profit from what I believe is a mispricing by Mr. Market.

It's good to mention that these trades are only tied together in the mind - the broker doesn't care. I typically let naked puts expire worthless (but that's only because I've been lucky/good - take your pick on any given day).

If MMM turns around and moves into the $90s in the next year (which seems to be analyst expectations - I'm not yet convinced, but a guy can dream right?), I'd likely kill the put pretty fast, but keep some (or all?) of the call on the table.

Glad you liked the idea.

Cheers,

Jim

Hi Jim

Excellent write up and beautiful presentation. You have a way with tables. Made it very easy to follow.
Strategy is a good one for a company like 3M that is very likely not got much further to fall.

Looked at them when the departure of McNerney sent them sliding. Had been waiting for a buying opportunity and the decline to the low $70s was a significant fall from $90 something.

You make a good case for the intrinsic value of the company and the earnings going forward being worth more than the current $70+ price. The opportunity to make money from options and not have thousands of dollars tied up in the stock make this a worthwhile strategy. Your percentage return on collateral requirement is higher for options strategy rather than ownership. Theoretically this allows you to use funds in other areas to make money rather than having it tied up in 3M stock.

There is a downside and it has happened to me. However, with your careful evaluation of 3M you make a solid case for little downside risk

I opened up a synthetic long on Boston Scientific after they fell from around $46 per share to about $33. This was on news that Taxus was going to be recalled. I felt this was temporary(which it was--fixed in a week or two) and that this was a real buying op. Competitor stents were almost 3 years away and Taxus had a commanding lead over JNJ's Cypher. They had fabulous margins, good returns, excellent double digit growth and a stable of products beyond Taxus to create a stable base. Seemed like a no-brainer

I bought calls sat $37.50 slightly out of the money and sold puts slightly in the money and some out of the money. There was a small profit on the position when opened. At first it behaved just like it was supposed to and the calls began to pay as the company went up to around $40. Then came the Cardiologist Conference in February, some negative trial results, poor comps with JNJ and Medtronic and a small decline in Taxus sales. BSX sank below my strike price and I bought a company I didn't really want for $35.00 with the stock price at $34. With the profit on the options my basis was $34.70 and I should have bailed with a small loss. But unfortunately, I still own 300 shares of BSX now selling at $26 with options like covered calls so far out of the money if I cover my basis they don't even exist.

Even though I thought I had a good idea of the company's potential, future developments went wrong and the stock declined to record lows. Analysts hate it and contrarians consider it a value play. To me its a millstone and a lesson in synthetic long options

At MMM's current ebb, it's far more likely it'll travel up 25 points than farther down... yet the Black-Scholes prices the option with an equal chance for volatility on either side of the present price... intuitively you know that's wrong but I've never seen a pricing model that figured aysmmetric volatility ranges. I know it's out there.

You mean like a bi or tri-nomial option model [w/ or w/o the volatililty smile?]

A quick work-around, if I understand your issue correctly, would be to do the simple binomial model, assume a 55% chance it rises 45% it drops [or the reverse] and you can use different size 'moves' as well.

Naj

Naj... appreciate your input. I was under the impression that binomial models were, by nature, symmetric. I don't think the volatility smile is what I've been after. I think sticky delta models might be what I'm looking for bt I've sure not been able to find anything that puts this concept in any format remotely accessable by math challenged amatuer investors.

I've read about sticky deltas but I've never seen anything that seems to "translate" these papers into good general concept information. I've read a couple of papers on using sticky deltas to develop implied volatility smiles. The conclusions being that more "lifelike" smiles are deveoloped than those using constant volatility and delta.

This whole business has actually frustrated me to the point of enrolling in a "distance learning" class from a local University that starts this fall. I'm pretty sure I need to first understand the magnitude of what I don't understand :)

I hope you'll continue to add anything that might help us (me!) understand real world option behavior. I continue to believe options are an area of marked pricing inefficiency where individuals can still play.

ed

Kit...

Even though I thought I had a good idea of the company's potential, future developments went wrong and the stock declined to record lows. Analysts hate it and contrarians consider it a value play. To me its a millstone and a lesson in synthetic long options


I'm sue you know one wonderful thing about puts wirtes for large companies.... you can "roll them over" and you'll really never have to loose actual money.

I've rolled a LEAP over as many as three times in the past before coming out of the tunnel on the other end. Clearly, that sort of business needs to be done with a company you have tremendous confidence in... but I think BSX fits the bill

Hi e

I actually have been doing that as it sinks. They earn enough that there should be a bottom offered by the stable income from the other surgical and medical devices. One analyst has pegged them at $18. My basis is now around $33. I unfortunately do not get paid a dividend to wait which is one reason I didn't want to own them and preferred the synthetic long.

Here is something I can't believe--my last puts were at $27.50 and just expired. I figured I was going to be the proud owner of 200 more shares since the stock was at $26. It never got exercised. What happened? Someone didn't want to make a $1.50?

What would you do from here with BSX?

>^..^<

I don't think the volatility smile is what I've been after. I think sticky delta models might be what I'm looking for bt I've sure not been able to find anything that puts this concept in any format remotely accessable by math challenged amatuer investors.

Hi e

After looking through my copy of McMillan, I can't find any smiles or sticky deltas. Can you give a short description of what these are and are they known by other names(in McMillan)

Also I use a spreadsheet for valuing options and there is no input for varying the input for different percentages for upside and downside risk. How would you do this? Calculations by hand are not an option :)

kit...

here's a simple explanation of sticky deltas and volatility smiles...
http://www.riskglossary.com/link/volatility_skew.htm

the idea of a sticky delta is pretty easy to conceptualize. As in the example...
assume an option exibits a delta of .5 when the instrument is priced at 75 and the strike is 75...

then if the instrument moves to 80, a "sticky delta" would imply that an option with an 80 strike should now have a delta of .5

the delta is "sticky" and keeps it relation with successive at the money strikes.

my understanding is that assuming a sticky delta allows predictive modeling of option prices in a way that more typical models do not achieve
......................................

the volatility smiles and skews are interesting and pretty intuitive. Simply graph the calculated volatilities of a series of strikes and connect the dots. You get a characteristic curve. It may be a smile, a skew, a "smirk" or what ever. I think the idea is that the shape of the curve of volatilities generally remain constant for a particular asset. If that's true then there is a predictive ability in forcasting volatilities of various strikes in relation to changes in the underlying asset. For instance, calculate the volatility for MMM Jan06 $85 call when MMM sells at 70. If MMM moves to 80, you should be able to make a prediction on how the Jan06 $95 call should be priced via use of the graph of volatilities.

(anyone... please feel free to correct me)
.................................................................
Also I use a spreadsheet for valuing options and there is no input for varying the input for different percentages for upside and downside risk. How would you do this? Calculations by hand are not an option :)


The binominal option pricing model Naj suggested would do it but for one big problem... binominal pricing models use a recursive pricing procedure that is based on the assumption of risk neutrality and constant volatility. (the mentional trinominal model can handle changes in volatility but I don't have any idea how trinominal trees work) There are bunches of excel add-in's that apply binominal pricing models. I started a series of posts a while back on options and implied volatilities that I never really finished. It seemed to me that all equity option pricing models require an assumption of an efficiently priced equity. If an equity is inefficiently priced, that should translate into the option prices... but I don't find that anywhere. I thought the sticky delta idea might lead somewhere... but Naj is exactly right, a simple binominal pricing model would do the trick if one were able to make one very small alteration. I hope someone reads this.... what would happen to an option pricing model on MMM if you assumed the equity simply would not fall below 60 during the life of the option


that would have exactly the effect I was thinking about... the closer you get to 60, the more compressed "true" put values would be. If you assume MMM cannot go below 60, then any put below 60 would have a negative value regardless of price and should be sold. Likewise, the closer you get to 60, the greater the "true" value of a call option would be.

what's magic about 60? nothing... but make these assumptions... MMM really truly is worth $90 per share, $60 purchase really truly does give one a 50% margin of safety... and making those assumtions plus the idea that the swtock cannot fall below any specified number with/in the option period indroduces the idea of inefficient equity pricing into the option equation

I need the coven of quants to develop an option pricing model that includes inputs for the intrinsic value of the underlying asset, a margin of safety of the underlying, and a floor through which the asset is "highly unlikely" to fall.... then you'd have an option pricing model for the value investor

it's late... I'm on call and we've now had 16 new admissions from south Miss and my Coup de Grâce... the 500lb acute resp failure who floated out of the big easy

lordy

Kit...

What would you do from here with BSX?

I opened a syn long on BSX. If it continues to flounder through Jan... it may well turn into a roll over for me

I hope you'll continue to add anything that might help us (me!) understand real world option behavior. I continue to believe options are an area of marked pricing inefficiency where individuals can still play.

ed

Be happy to try, I hope my options knowledge has not totally turned into formaldehyde.

If you think options traders are inefficient, you are in for a rude awakening, however.

Occasionally markets are mispriced, but that can happen anytime anywhere, not specific to options per se.

Naj

but Naj is exactly right, a simple binominal pricing model would do the trick if one were able to make one very small alteration. I hope someone reads this.... what would happen to an option pricing model on MMM if you assumed the equity simply would not fall below 60 during the life of the option


that would have exactly the effect I was thinking about... the closer you get to 60, the more compressed "true" put values would be. If you assume MMM cannot go below 60, then any put below 60 would have a negative value regardless of price and should be sold

But this is absurdly simple, isn't it?

You build your tree with your vols and probs. Although it's recursive, you manually enter the value off MMM<60 as MMM=60 for those nodes so affected.

Problem solved....I think.

Naj

Naj... noted, an I appreciate your comments

ed

Nice analysis. I recently made MMM the largest stock holding in my portfolio, with an average cost of about $74. I did not consider options--I just think this is too attractive a proposition, given the dividend, growth history, diversification, etc. Also, I like to invest in companies whose products I love--and 3M is one of the best in that regard. Just try to name one bad or shoddy product they make. Try to name one which is inferior to a product offered by a competitor. I can't. Now add to that the great culture of R & D that they have, and I can not believe that they will not be trading back up in the 90's sooner rather than later--and probably higher with patience. And, in the meantime, I will take their dividend and smile.

<snip>
I always want to remember that option positions are specualtions and MUST be treated and traded as such. They are not investments. Never ever make the mistake of thinking you are investing when you are speculating. My general idea of an investment is this... time is on my side! The longer I hold the more likely I'll show a profit. An investment puts time on the side of the investor.
<snip>

Well, a GOOD investment puts time on the side of the investor. KMart (last year) and Delta Airlines (this year) are speculations, regardless of how you buy an interest in their future.

And, in the meantime, I will take their dividend and smile.

You make a valid point here for buying the stock instead of the options. This is one reason i also bought 3M insted of creating a synthetic long. It is also one reason I bought Bristol Myers insted of just selling puts.

3m is a great company. I had been waiting for months for an event to drop the price

>^..^<

From $72 back when this was posted, to $88, MMM has settled around $80 right now. Just a look back.