A perfect play that could lead to a 270% return

When a large enough investor with ideas of his own starts to make moves to influence the direction of his investments, all kinds of things can happen.

Activist investing isn’t new. But it doesn’t have an incredibly long history either. It wasn’t until the 1980s that these activists starting becoming household names. Carl Icahn and T. Boone Pickens were among the first to rock the boat on corporate decisions at the board of directors level.



Now, it is becoming such a common occurrence, investors are used to management shake ups and restructuring plans.

Sometimes, these kinds of moves really do unlock shareholder value. But more often than not, they actually have the opposite outcome.

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As you can see, after successful takeovers or restructurings post-activist campaigns, shares of those companies actually drop. When a company resists efforts by activists, shares actually do quite well.

This is not 100%. But it does show the folly of believing that activist investors know what they’re doing more than management.

So, with all of this in mind, we turn to Marriot International (MAR). The hotel giant is now in the hotseat with its own activist intervention.

The Wall Street Journal reported today that the hedge fund Land & Buildings Investment Management has been privately trying to talk Marriott into selling off or closing down some of its 30 brands.

The fund owns less than a tenth of 1% of MAR. Yet, it is now seeking to get its own founder on Marriott’s board. The hotel chain is considering it.

So far, this activist intervention hasn’t become hostile. But a shake up of this size could have drastic effects if any part of it goes forward.

Marriott acquired Starwood Hotels & Resorts three years ago. Land & Buildings Investment doesn’t think it handled that buyout well since. To be fair, the hedge fund has stated it thinks Marriott’s management has performed well elsewhere. But it now holds too many brands and could handle its incentives programs better.

It’s far too early to tell exactly how all of this will play out. But it wouldn’t be too shocking to see some resistance and fighting between the two parties. And that could depress share price in the short term.

Even if the two sides come to agreement, the process for unwinding those brands from its portfolio and restructuring its prices across the brands that are left is a monumental task… one that will no doubt have an impact on Marriott’s current fiscal year.

Such a slump or negative outlook would no doubt send investors into short positions. But you don’t have to join them and short MAR to take advantage of this activist investor issue. There’s another strategy we often use to play similar short-term dips.

A Strategy to Play Short Term Weakness

A bear put spread is a net debit trade that involves two put option contracts. The trader would first buy a put option on a stock he believes will fall and sell a second put option with a lower strike price.

This results in an entry cost… but not as large of one as simply buying the put outright. You see, that second put does two things.

First, the premium the trader receives by selling it offsets a portion of the premium paid for the bought put. This limits the trader’s amount at risk.

In exchange for that reduced risk, the trader does give up some of the upside potential of the trade. If shares collapse, the trader can only profit from a share price fall down to the sold put option’s strike price.

You can see how this works here:

bearputspread

Source: The Options Industry Council

As you can see, the trade’s profit potential is capped… but so is the risk. If shares fall, a trader can make a nice chunk of change without risking much if shares go the other direction.

For Marriott’s situation, this is the perfect play. You see, the market could remain rocky for MAR until the activist situation is settled. But that doesn’t mean it will most definitely go down all at once. It could bounce higher before investors consider the cost and impact such structural changes would have on their bottom line.

So, we like the idea of capping the amount of money at risk with this particular type of trade. To see just how profitable such a strategy is, let’s take a look at a specific example of a bear put spread on MAR stock.



A Specific Trade on MAR

A trader looking to use this strategy on MAR could buy an April 18 $120 put for $2.45 per share and sell an April 18 $115 put for $1.10 per share for a cost of $1.35 per share. Since each contract is worth 100 shares of MAR, that works out to a net debit of $135.

That’s the total amount at risk… just slightly more than the cost of a single share of MAR and only a fraction of the cost of buying the put outright.

This trade will profit if shares of MAR fall over the next four weeks. If this activist investor situation continues on, that is a distinct possibility. Even if the activist hedge fund withdraws his efforts, it could send some hopeful shareholders out of MAR stock too. Either way, a decline is likely in the short term.

To find out exactly how much this trade could be worth, take the difference in strike prices between the two options ($120 -$115 = $5) and subtract out the entry cost ($5 – $1.35 = $3.65).

On 100 shares, that’s a maximum profit potential of $365. Based on the $135 to get in this trade, that works out to a potential return of 270% on the amount at risk.

Shares would have to decline a bit for this to happen. They’d have to fall to $115 per share to lock in this maximum profit. But even if they fall part of the way, this trade can still be positive.

To find that threshold, subtract the cost of this trade from the first strike price ($120 – $1.35 = $118.65). That represents a decline of just 2.6% from today’s price. This stock can move that much in a single morning. So, the chance of us seeing a move of that size is pretty good.

It’s impossible to say exactly how all of this drama will turn out for Marriott. But a potential 270% return on risk, makes this a trade worth taking.
bearputspread

— The Option Specialist

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About the Author: The Option Specialist