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Ares Capital Stock's 10% Yield Evokes Unusual Put Option Activity

Barchart - Wed Jan 18, 2023

Ares Capital Corp. (ARCC), a business development company (BDC), makes loans to middle-market companies and has a 10%+ dividend yield. It recently attracted unusual out-of-the-money short put activity from large investors for either extra income or as a long-term hedge.

On Oct. 25, 2022, Ares Capital Corp. announced earnings per share (EPS) of 50 cents per share and also a quarterly dividend of $0.48 per share. In Feb 2022, the company had also announced a 3 monthly dividend, so the total dividend this quarter was 51 cents. However, it's not clear that the quarterly 3 cents dividend will be continued. Therefore, at today's price of $19.03, on Jan. 18, 2023, ARCC stock has a 10.1% dividend yield (i.e., $1.92 annually / $19.03).

But recently an enterprising investor has decided to take advantage of high put premiums. Barchart's Unusual Stock Options Activity Report for Jan. 18 shows that there were 5,107 put options traded at 50 cents for the June 16, 2023, expiration period at a strike price of $16.00 per share. This is roughly five months from now before it closes.

ARCC Puts - Expiring June 16, 2023, - As of Jan. 18, 2023 - Barchart

The report shown above shows that this activity is over 50x times the normal outstanding interest (total contracts outstanding) in this strike price and expiration period. So what is going on here?

What This Could Mean for ARCC Investors

Normally, I would assume that this kind of volume in an out-of-the-money (OTM) put signals an income play by shorting the put option. For example, by shorting the 50 cents put at $16.00, which is over 15% below today's price, the investor can make 3.125% (i.e., $0.50/16.00) over 5 month period. That makes it worth 0.625% per month or 7.5% annualized.

For example, our Jan. 4, 2023, article shows that investors likely initiated a short put strategy in Archer-Daniels Midland (ADM) stock with this unusual activity in OTM puts. However, in this case, the puts are 5 months in the future. It's not completely out of the question that the stock could fall 15% in the next 5 months. So it's not completely clear that this trade was initiated by a short put trader.

In fact, given that the ARCC stock has a 10% yield, it's just as possible that an investor has bought the put as a long trade. In other words, the 10% yield would be hedged and the net dividend received will be 92 cents (i.e., $1.92 less 50 cents x 2). This assumes that the investor rolls over the trade twice during a year. That still provides a fairly secure 4.83% yield (i.e., $0.92/19.03).

This would give the investor a break-even price of $18.11 per share ($19.03-$0.92). But since the long put hedge only kicks in at $16.00, there is still a $2.11 spread at risk. Theoretically, the investor could also short an OTM call for the same expiration period to help cover this spread risk. But those premiums just aren't anywhere near that expensive at around 25 cents for a 10% OTM call option.

Therefore, it seems more likely that the initiating trade was from an investor who shorted a deep OTM put (i.e., 15% below today's price) in order to gain more income. That provides an additional 2.627% yield at today's price (i.e., $0.50/$19.03). On an annualized basis, this works out to 6.305% (i.e., 2.627% x (122/5)). 

This shows that an enterprising investor could copy this trade and expect to make an annualized return of 16.4% from both the dividend (10.1%) and the short put strategy (6.3%). 

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On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.

Provided Content: Content provided by Barchart. The Globe and Mail was not involved, and material was not reviewed prior to publication.