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There's nothing more frustrating than being stuck in
a losing position. You try not to think about it, but
it is always on your mind. You keep hoping that things
will change, but it usually gets worse more often than
it gets better. Your partners — fear and greed —
are painstakingly badgering you until you finally bite
the bullet and exit the trade.
Any trader who has ventured into buying tech stocks earlier
this year has experienced "sticker shock" from
drops in the stocks' value. Even with the recovery that
is now 8 weeks in the making, most traders and investors
are still looking at their portfolio with sticker shock
in their eyes. Stocks such as EMC, YHOO and BRCM have
made nice gains but are still down staggering amounts
from this time last year.
Let's face it: nobody wants to have a trade go against
him/her (let alone, have to tell others about it). Most
people, when faced with this dilemma, would rather wait
out the bad times to avoid taking the loss. This alone
could spell disaster, especially when the position goes
from bad to worse. Maybe you're right; the trade will
make a recovery. But wouldn't it be nice to average the
trade down without adding any additional risk to the position?
Using options, you can construct positions that bring
the breakeven on the trade closer to today's price without
adding any additional cost or risk to the position. But,
first, let's take a look at the choices a trader has when
faced with a losing position.
| 1. |
Take the loss and move on. Very
few traders are willing to accept defeat gracefully.
Those who do may have changed their belief on the
stock and, subsequently, realized that thousands of
other stocks out there are just waiting to be traded.
Bottom line, you have to be a disciplined trader to
take your losses and move on. |
| 2. |
Average down on the position.
Averaging down by purchasing more shares at the current
lower price is usually the first thing an undisciplined
trader will do in an attempt to lower the breakeven
on the position. For instance, buying 100 shares of
Yahoo at 100, and later buying 100 shares of Yahoo
at 50, would adjust the basis of the trade to 75.
The problem here is that the risks of averaging down
increase as you add to the position. This is true
of options traders too, who average down on calls
as the price drops. Averaging down only works on a
falling stock as long as your bankroll can support
it. Most people don't have that kind of luxury. |
| 3. |
The Religious Approach. Sad to
say, but the majority of traders fall into this category.
They take a position and then freeze like deer in
front of headlights as the trade goes against them.
What is happening here is that, not only are you hanging
onto a position that you're not sure of in terms of
its future, but you're also tying up money that could
be put to better use. |
| 4. |
Recovery Strategy Using Options.
Spreading options against the stock can lower your
breakeven on the position without adding more cost
to it. Recovery strategies are a low-risk way of adjusting
a position if you still feel it could move in your
favor. But that's the key: you still need to believe
that the stock will move up at least to where you
originally purchased it. |
Figure 1: YHOO Price Chart:
This is what a recovery for a long stock position looks
like.
Let's assume that the trader has purchased 100 shares
of Yahoo (YHOO) several weeks ago for a cost of $30 per
share. Over time, the stock has depreciated to a price
of $15 per share. The trader has a paper loss of approximately
$15 per share on the stock.
But, by understanding how options work, a skilled trader
can employ a recovery strategy using a call ratio spread
against the stock. A call ratio spread consists of buying
lower strike calls and selling higher strike calls. The
ratio is created by selling more higher strike options
than you buy. Although this position alone has unlimited
upside risk, employing it along with a long stock position
will limit the upside risk while lowering the breakeven
on the trade. Entering it properly can also be done at
no additional cost. Let's continue with our example using
YHOO's recent prices.
Long 100 shares of YHOO at 30
Stock is now trading @ 15
Yahoo January 2004 15 calls @ 7.50
Yahoo October 2004 30 calls @ 3.75
Buying 1 of the January 2004 15 calls and selling 2 of
the January 2004 30 calls creates what is called a covered
call ratio spread. The cost of this spread is zero because
the 2 options sold pay for the one option that is bought.
There is no margin on this trade because both of the short
options are covered. Risk is limited because, no matter
how high the price of the stock rises, the stock will
cover the extra call that is sold.
The position's breakeven is also reduced; by option expiration,
the breakeven on the trade is 22.50 — 7.50 points
lower than the original purchase price of the stock. The
only other way to lower your breakeven to 22.50 is to
purchase an additional 100 shares of Yahoo at a price
of 15, which ties up more money and, at the same time,
will double the downside risk. The table below shows the
profit and loss of each position over different prices.
|
Trade
|
Original Trade
|
Average Down
|
Recovery Strategy
|
|
Price of YHOO
|
Value
|
Profit/ Loss
|
Value
|
Profit/ Loss
|
Value
|
Call Value at Expiry
|
Profit/ Loss
|
|
0
|
0
|
-$3,000
|
0
|
-$4,500
|
0
|
$0
|
-$3,000
|
|
15
|
$1,500
|
-$1,500
|
$1,500
|
-$1,500
|
$1,500
|
$0
|
-$1,500
|
|
20
|
$2,000
|
-$1,000
|
$2,500
|
-$500
|
$2,000
|
$500
|
-$250
|
|
30
|
$3,000
|
$0
|
$4,500
|
$4,000
|
$3,000
|
$1,500
|
$750
|
|
40
|
$4,000
|
$1,000
|
$6,500
|
$6,000
|
$4,000
|
$500
|
$1,500
|
Looking at the table above there are some things to
consider. First and foremost, you have to believe that
the stock in question will make some sort of recovery.
Second, you must accept the fact that this trade has a
limited reward. In this example, you lose the ability
to participate in any profits above 30. If you are okay
with both of these points, then a recovery strategy may
be just what the doctor ordered.
Now it's time to take a good look at the positions you
are currently trading. Although the market recovery is
in progress, how likely is it that your stock will recover?
Overall, by weighing the risks and rewards of each position,
you'll see there are some clear advantages to using options
as a "911 Strategy," especially to those injured
positions just languishing away in your account.
TOM GENTILE, highly acclaimed author,
leads numerous 2- and 3-day advanced optionetics seminars
teaching innovative options trading across the country.
Optionetics is an educational company dedicated to providing
stock and option education fundamentals, as well as strategies
that enable traders to navigate the markets successfully.
Comments and questions can be directed to Tom at optionetics@hotmail.com.
Optionetics.com
901 Mariners Island Blvd., Suite #175
San Mateo, CA 94404
Phone: 650.378.8330
Toll Free: 888.366.8264
Fax: 650.378.8320
www.optionetics.com
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