Option Investor
Educational Article

When You Can't Say "No"

HAVING TROUBLE PRINTING?
Printer friendly version

by Mike Parnos, Investing With Attitude

Some people are obsessed, which is hardly breaking news. Controlling one's obsessions is easier said than done. But they say that, if you can admit the problem, it's half the battle.

People say "no" to drugs. They may say "no" to alcohol, but they can't bring themselves to say "no" to owning stock in a bear market - a potentially fatal character flaw that may result in the untimely death of your portfolio. It's a disease that not even a 12-step program will help because you'll be broke before you get to step #6.

It's the Couch Potato Trading Institute to the rescue -- where the path of least resistance and the path to profits are one in the same. We're dedicating the Strategy Du Jour to all those lost souls who have no control and simply MUST own stocks in this market environment.

In one sense, I applaud a utopian "glass is one-third full" optimistic approach to managing money. Optimism is a good quality. But it has absolutely nothing to do with reality. Dear optimist traders: Be sure to let me know what it's like to stand in line for government cheese.

In this bear market, it's more likely that you'll be the first woman member of the Augusta National Golf Club than your stocks will return to the levels of 1999 and 2000.

Maybe I can help, but to do so I'll have to put you on a short leash. At the end of that leash is a "collar." In essence, what we're going to do is to put a collar on your stocks that won't let them stray too far.

For example: You own 1,000 shares of widely held Micron Technology (MU). Maybe you bought it two weeks ago or two years ago. It doesn't really matter. Early this week MU was trading at $23.00 per share. The chart indicates that it may have bottomed and is slowly working its way back up. Can we be sure? Of course not -- unless you're hearing little voices or had a recent consultation with Miss Cleo.

The fact is, we haven't had our capitulation yet. Regardless what images come to mind when you hear the word "capitulation," the one thing you don't want to do is to experience it without the proper protection. That's what the "collar" is for.

If you sold the MU August $25 call, you would take in $1.50 ($1,500 for 10 contracts). Now, where is this $1,500 going to do you the most good? It's a matter of priorities. You could:

  1. Fly to Vegas, catch a few shows, wine and dine at the $5.95 buffet and gamble away what's left.
  2. Take your Toyota to Earl Sheib for some TLC, a little bumping and grinding and a new paint job. Your car will love you for it.
  3. Treat your wife to a full day of pampering at the local Day Spa. Your wife will love you for it, but it will be forgotten in two weeks, or
  4. Buy some insurance on your $23,000 investment.

The astute Couch Potato Institute graduate will resist the temptations and forgo choices 1-3. He will use a portion of the $1,500 to buy 10 of the August $20 puts for $1.05 ($1,050). This will, in effect, protect you if Micron reverses direction and go back down. Keep in mind that Micron is only an earnings warning away from $15. The $20 put will protect you on any transgression below $20 through August option expiration. Plus, if you haven't noticed, you will still have $450 ($1,500 less $1,050 = $450) for pizza, chips, beer and . . . maybe a little bumping and grinding for yourself -- or even a new bathrobe.

The "collar" limits what could be a catastrophic loss to a tolerable two points and allows for Micron to appreciate by $2.00 before you're at risk of losing the stock through assignment. You can repeat the process month after month until your stock gets called away - which is a good thing! It means you made money, which, if I'm not mistaken, is the object of this exercise. Some people do, however, become attached to their stocks. They think that if they lost money on a particular stock, they have to make it up in the same stock. When you buy a stock, where does it say "till death do you part?" Remember, it's only a stock. Don't become emotionally involved. If it goes, it goes. Add up your profits, smile and get on with your life.

There are no monogamy laws or divorce penalties in the stock market. You can play the field. There are thousands of other stocks out there. Just make sure you use "protection." Sound vaguely familiar?

By the same token, if you're bearish, you can construct the same scenario by shorting a stock, selling an out-of-the-money put and buying an out-of-the-money call to protect your short stock position.

In most cases, you're allowed to sell covered calls in your IRA. A few brokerage firms will even allow you to establish "collar" positions by purchasing the protective put in your IRA.

In summation, you can have your cake and eat it too. The "collar" enables you to own a stock, have room for profit, possibly pocket a few dollars, and be protected on the downside.

You'll find that having your cake and eating it beats the hell out of the prospects of digesting a grilled government cheese sandwich.

We're not going to cure the disease with the "collar," but we can bandage the wound and stop the bleeding - at least temporarily. However, don't be surprised if, before long, the obsessive- compulsive stock-buyer is back out there still trying to catch those falling knives with bare hands.

Go figure.

Options 101 Archives