Knight Capital Group – Outstanding Underlying Shares for Option Traders

Knight [NITE: $15.98] is the largest wholesale market making firm in U.S. equity securities. Knight provides market access and trade execution services across multiple asset classes and offers capital markets services to corporate issuers and private companies. The Company has three operating segments. Their Equities segment includes market-making and institutional sales of global equities, futures and options. The FICC segment includes research, voice sales and fixed income trading, plus foreign exchange transactions. NITE’s Corporate segment provides financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains all corporate overhead expenses and all other expenses that are not attributable to the Equities and FICC segments.

Knight’s volatile shares and their current low price seem to offer an ideal platform for option traders that like to sell both calls and puts relating to one underlying stock. Knight recently completed the sale of $325 million (plus a $50 overallotment provision) in 3.5% convertible notes due 3/15/2015. The conversion price was set at $20.87 /share or 32.5% above the price at the time of issuance.  The low interest rate and the well out-of-the-money conversion ratio speaks well of the market’s judgment of NITE’s good prospects.

Management has fully hedged their exposure to potential dilution should conversion occur due to a rising share price. 

NITE is offered at just $15.98 this morning despite Zacks estimates for 2010 – 2011 of $1.59 and $1.88 respectively. That puts their multiples at just over 10x this year’s and 8.5x next year’s expected EPS. Those are extremely low by historical standards for NITE on both an absolute and relative basis.  Value Line notes their 10-year median P/E as being 21x and assumes a normalized multiple of 14x in calculating their own 3 – 5 year target pricing.

If NITE’s earnings come in as expected that would put their year-end 2010 goal price at > $22 or more than 39% above the current quote. Is that a crazy thought? No. Knight shares hit $23.11 last October and peaked at $20.50 and $21.80 in 2006 and 2007 when EPS came in at $1.49 and $1.24 – well below this year’s estimates.

Standard and Poors and Morningstar both see ‘fair value’ as well above today’s price. Their views are now at $17.80 and $21 respectively.

Here are two proposed buy/write plays for NITE that make sense for me right now:

If NITE shares rise to $17.50 or higher ( + 9.6% ) by Jan. 21, 2011:

·         The $17.50 calls will be exercised.

·         You will sell your shares for $17,500.

·         The $17.50 puts will expire worthless.

·         You will be left with no shares and $17,500 in cash.

·         You will have no further option obligations.

That best-case scenario would result in a cash-on-cash profit of $17,500 – $12,130 = $5,370

$5,370 / $12,130 = + 44.2% achieved in just over 10 months on shares that only needed to rise by at least 9.6%.

If NITE shares remain below $17.50 on the Jan. 21, 2011 expiration date:

·         The $17.50 calls will expire worthless.

·         The $17.50 puts will be exercised.

·         You will be forced to buy another 1000 NITE shares.

·         You will need to lay out an additional $17,500 in cash.

·         You will end up with 2000 NITE shares.

·         You will have no further option obligations.

What’s the break-even on the whole trade?

On the original 1000 shares it’s their $15.98 purchase price less the $1.20 /sh. call premium = $14.78 /share.

On the ‘put’ shares it’s the $17.50 strike price less the $2.65 /sh. put premium = $14.85 /share.

Your overall break-even would be $14.82 /share or 7.29% below the trade origination price.

Summary:

If you believe (as I do) that NITE will rise to at least $17.50 by next January then any move up of at least 9.6% will translate into a 44% cash-on-cash net profit while providing a 7.29% ‘margin of safety’ if things don’t go as expected.

If you’re willing to take a longer-term bullish view:

If NITE shares rise to $20 or higher ( + 25.2% ) by Jan. 21, 2012:

·         The $20 calls will be exercised.

·         You will sell your shares for $20,000.

·         The $20 puts will expire worthless.

·         You will end up with no shares and $20,000 in cash.

·         You will have no further options obligations.

This best-case scenario outcome would be a gain of $20,000 – $9,530 = $10,470

$10,470/$9,530 = + 109.8% cash-on-cash over the 23.2 months until expiration. That greater than 100% profit would be realized on any up move of 25.2% or better.

If NITE shares remain < $20 on January 21, 2012:

·         The $20 calls will expire worthless.

·         The $20 puts will be exercised.

·         You will be forced to buy another 1000 NITE shares.

·         You will need to lay out an additional $20,000 in cash.

·         You will end up with 2000 NITE shares.

·         You will have no further option obligations.

What’s the break-even on this whole trade?

On the original 1000 shares it’s their $15.98 purchase price less the $1.35 /share call premium = $14.63 /share.

On the ‘put’ shares it’s the $20 strike price less the $5.10 /share put premium = $14.90 /share.

Your overall break-even would be $14.77 /share or 7.6% below the trade origination price.

Summary:  

If NITE shares go up to at least $20 by January 21, 2012 your will see a greater than 109% cash-on-cash return on that 25.2% or better rise in the underlying shares. You will be protected against loss as long as NITE shares remain above $14.77 throughout the 23.2 month duration of this trade.

Disclosure:  Author is long NITE shares and short NITE options.

Dr. Paul Price

www.BeatingBuffett.com