Rising Stars Trade: Buy-Write Covered Calls on Activision Blizzard

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This article is part of our Rising Star Portfolios series. Follow all of Alex's trades on Twitter.

The most successful video game company around, Activision Blizzard (Nasdaq: ATVI  ) , is selling for a discount -- just as it has for the last three years or so. But the stock's recent volatility has pushed option prices higher. Today, I'm going to take advantage by buying shares and writing covered calls.

The business
Activision Blizzard is no newcomer to the Fool, and fellow Rising Star Jason Moser made it his first purchase back in November 2010. The company actually comprises two related but very different businesses that merged in 2007.

The Activision side makes video games for consoles, such as those produced by Sony (NYSE: SNE  ) , Nintendo (OTC: NTDOY), and Microsoft (Nasdaq: MSFT  ) . In my opinion, this is a poor business. Your business depends on console makers. Yet these companies also make their own games, competing against yours, and insist that you hand them your programmers' code, so that they can complete each game's final production. Your customers pay you once for a game that they eventually beat or finish. If they don't like it, they are unlikely to buy your next game. This is not a great situation.

The Blizzard side, on the other hand, is basically synonymous with World of Warcraft, far and away the world's most popular MMORPG. (That's "massively multiplayer online role-playing game, and yes, it is an actual term.) Though this is also a video game business, it's vastly different from the Activision side.

Here, games are played entirely online, with no console makers looming over every aspect of the operation. Games can be modified and expanded in real time, and gamers play with and against each other, creating an essentially never-ending game with monthly subscription fees. Gamers don't need a console to play; they are limited only by their access to a computer and broadband connectivity. Even better, each new player makes the game more valuable to all players, creating a network effect that makes the game very sticky—and makes it very difficult for a competing game to gain traction. This is a fantastic situation.

Risks & valuation
Building a model for Activision Blizzard isn't dauntingly difficult; using that model to put a precise valuation on the company is. I think the business hinges on the relative value proposition between console and online gaming; the company's ability to continue producing hit games; and computer and broadband penetration, especially in Asia. Small changes in any of these important drivers can induce drastic swings in the company's valuation, creating key risks on the downside, but also possible home runs on the upside. Fortunately, Activision's current price is near the bottom of the $9 to $22 range that I consider the most likely spectrum of the company's value possibilities.

Why this strategy?
Activision looks undervalued today, but frankly, it's looked that way for a long time. The stock has traded within the same $3 range for the better part of three years, even as operating margins have more than doubled and earnings have grown 375%. The market has seemed unwilling to reward that performance, but it hasn't had any problem punishing the stock for perceived shortcomings. Shares took a swift 10% hit in February when management issued guidance below what analysts were expecting.

Prices remain within that tight three-year range, but Activision's shares have shown above-average volatility in the past six weeks. Starting at $11.99 on May 31, shares plunged about 10% to $10.87 in mid-June, before rebounding about 11% in early July. Although we've ended up just about where we started before that miniature roller-coaster, the volatility has driven up options prices, rendering premiums high enough to catch my interest.

I will be buying shares and writing August $12 calls, which currently offer a $0.34 premium. If shares stay below $12 on August 20, we keep both the shares and the $0.34 premium. That 2.9% return may not sound like much, but it's coming in just 39 days. On an annualized basis, that's a 27% return. Of course, you can't spend annualized returns, but if shares are below $12 in August and our calls expire unexercised, I will likely write new calls for additional income.

If shares exceed $12 in August, on the other hand, we will be obligated to sell our shares at that strike price (though we still keep the $0.34 premium, making our effective sell price $12.34). The risk here is that shares finally take off in the next 39 days, because we would miss out on any upside over our strike price. That would obviously be suboptimal, but I'd still be fine with that outcome, which would deliver us a 4.7% return in just more than a month.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here. Keep up with all of Alex's wit and wisdom on Twitter.

Alex Pape does not own shares of any company mentioned. The Motley Fool owns shares of Microsoft and Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Microsoft, Activision Blizzard, and Nintendo. Motley Fool newsletter services have recommended creating a diagonal call position in Microsoft. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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