Option Investor
Educational Article

Preventing Whiplash

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Anyone who has been watching the intraday market action over the past 2 weeks can tell you that these are some whip-saw markets! Many technical tools are giving false signals, as the markets crash at the open, rally back by noon, sell off in the afternoon and then rally back to close positive. When I signed up for this gig, nobody told me that I needed to keep some Dramamine on the desk. This type of action is great for the hyperactive day-trader types (a club I frequently visit), but for those that like to enter into a position and ride a major move to its eventual destination without getting spooked out by all the volatility, it's safe to say you've been eating Tums like they were candy.

Every day presents a new dilemma of "Is this the top?". Let's assume you took advantage of the huge July selloff to enter some longer term positions and you were smart and brave enough to pick the very bottom. Being the conservative type you are, you opted to buy shares of your favorite large-cap stock, avoiding paying through the nose for the sky-high volatility then priced into the options. Since that time, you're looking at a solid rally off the lows, but you don't want to sell out just yet. "What if that was The Bottom? I don't want to settle for a paltry 15-20% gain, when there might be another 30-40% in store." Those of you that have been reading my ramblings for awhile know that I don't happen to share that view, but let's run with it just the same.

Wouldn't it be nice if there were a strategy that could protect our current gains, while still giving us the ability to participate if the rally continues up the charts? Well, today's your lucky day! Such a strategy does exist and it is known as a collar. I didn't invent it (I'm not that clever!), but I sure can learn and apply the lessons of those that have gone before me.

Here's the basic strategy. You have a long position (let's assume for the sake of discussion that you bought shares of MSFT near the low on July 24th at $42), and while it looks like the stock is breaking out, you want to insure against a drop in price, which could wipe out a big chunk of your gains in a hurry. So, figure out how much of a loss you are willing to accept, and buy a protective put at that level. Let's assume that we don't want to absorb any further loss below the $50 level. In that case, we would want to buy a $50 put to protect against potential downside risk. If MSFT falls below that level, we will make money on the protective put at the same rate that we are losing it on the long shares, meaning that our loss on the long position stops as soon as the price drops below $50. MSFT can go all the way to zero, but we only lose $2.28 on the position (Current price = $52.28 - $50 strike). But that costs money, cutting into your paper profits. So let's sell a higher call, to finance the purchase of the put.

Effectively what we are doing is turning the long position into a covered call and using the proceeds from the covered call to finance the purchase of a protective put. Sounds great, huh? The best part is that due to differing timeframes and our associated expectations, we can create all sorts of different scenarios, tailored to meet our needs. Think of it like the collar that the doctor gives you after you've suffered whiplash from being rear-ended in your car. It restricts your movements (puts a cap on potential profits), but protects you from further injury (reduces the risk of giving your profits back).

I think the best way to demonstrate the concept is through example, so let's go. Start with 1000 shares of MSFT with a cost basis of $42. The stock is now trading at $52.28, giving us a paper profit of $10,280. We are concerned about near-term weakness causing the price to drop below $50. We don't want to incur a loss below the $50 level, so we will buy protective puts at the $50 strike price. Since we're just getting ready to enter that nemesis of bullish traders, the Ides of September and October, let's buy puts with enough time to get us through the bulk of that timeframe, selecting the OCT contracts. That is enough time to protect our position for the next 8 weeks, getting us through the upcoming earnings warning season and through the worst of the foreseeable near-term risks. The OCT $50 Put (Symbol: MSQ-VJ) is currently selling for $2.45, making our net insurance cost $2450 (10x$245).

Now we need to pick a call to sell that will allow us some upside in our underlying MSFT shares, but one that has enough premium to offset the cost of the puts we want to buy. There seems to be significant resistance waiting overhead in the $57-58 area (with the additional obstacle of the 200-dma just over $58), so let's sell strikes just above that area to minimize our chances of getting called out of our shares. The October $60 calls are a little too cheap to get my attention (currently priced at $0.60), so now I need to make a decision. I can either sell a lower strike, limiting the upside of my long position in the event that my fears are ungrounded, or I can sell the call with a longer timeframe.

Selling a longer term call is the approach that appeals to me, because it gives me more potential upside on the play. So I decide to sell the January $60 calls (Symbol: MSQ-AL for $2.40 each, bringing in a total of $2400. We could have chosen a closer strike in a nearer expiration month, so long as the calls we sell bring in enough premium to cover the puts we bought. We're looking to put on the collar for no out of pocket expense. Granted, we didn't quite accomplish that with our example, as the collar on MSFT cost us $50. For the benefits available from this strategy, that's a cost I'm more than willing to accept.

It is a matter of personal preference, whether to take in more premium now by selling a closer strike, or give the position more potential room to run to the upside. Since I'm primarily concerned with protection without sacrificing upside potential here, I want to select the higher strike. If I'm called out of my MSFT position in January, then so be it. I will have protected my gains and ended up with a solid gain for the overall trade.

So let's review. I own 1000 MSFT shares with a cost basis of $42,000, and a current profit of $10280. Selling the JAN-60 calls brings in $2400, and buying the OCT-50 puts costs $2450. Adding it all up, gives me a hedged, profitable position with $2330 (2280+50) of downside risk and $7720 of upside potential. That's a reward-to-risk ratio of 3.3 to 1; a situation that will definitely allow me to sleep at night!

Just in case the math isn't clear, let's run through some possible outcomes, so you can check my math.

Case #1: The bottom falls out of the Software sector, and MSFT craters, falling back to $40 at October expiration. The long position has lost all of its profits,...and then some! What originally cost me $42,000, is now only worth $40,000. I gave up over $10000 of profits and then lost another $2000 from there. So from the time of initiating the trade, my long position lost $2,000...OUCH! Aahhh, but don't forget about that little insurance policy. Those 10 $50 strike puts (that cost us only $50 because of the covered calls we sold) are now $10 in the money, meaning each of them are worth a cool grand. Total profit on the puts is $10,000. The calls are so far out of the money now that they are next to worthless, and we could likely buy the whole lot back for about $100. So the worst thing we could imagine came to pass and our loss is limited to $2330, or 4.5% of the position value when we initiated the collar. Here's the math:


Cost Basis = $42,000(MSFT shares)+$2450(Puts)-$2400(Calls)
           = $42,050

Expiration Value = $40,000(MSFT shares)+$10,000(Puts)-$100(Calls)
                 = $49,900

That leaves us with a total profit of $49,900-42,050 or $7850. The best part is that we still own the MSFT shares, and unless the NASDAQ looks like it is headed much lower, we are set to enjoy another nice and profitable rally.

Case #2: The economy roars back to life and MSFT announces blowout earnings (the day before option expiration in October) and the stock soars to $75. Needless to say, our puts will expire worthless, and we are in a position to pocket a portion of the gains from our long position. The MSFT shares are worth $75,000 now, but it will cost us $15 to buy back each of those covered calls. They are so deep in the money that all the value is now intrinsic...no time value. So if we buy back the calls, it will cost us $15,000, leaving us with a profit on the long position of $17,950 (75,000-15,000-42,050). That's a profit increase of more than $10,000 for an additional 8 weeks in the trade. Seems to me like the collar was a good idea.

Case #3: Finally, the most likely scenario. The NASDAQ continues to waffle in its current range, and MSFT is only able to claw its way to $56 by October expiration. Our puts expire worthless and we are left with a nice little covered call position. We could then evaluate the current market condition and decide what to do next. By now we are through MSFT's earnings, and if things are starting to look healthier, I might just hold the position. Ideally MSFT would end at $59.99 and I wouldn't be called out of my shares. If they closed above that level, I would likely be called out, ending the play and locking in my profits. If the current cycle of earnings was looking weak and Greenspan was starting to make noises about raising interest rates, I might decide to just close out the play early, buying back the calls and selling the shares, also locking in my profits. Either way, the collar served its purpose, allowing me to stay in the position a little longer without putting all my profits at risk.

There are innumerable variations to this strategy. While we didn't cover half the possibilities, hopefully this little discussion gives you a glimpse of how combining options can allow you to obtain a free insurance policy, giving yourself a little more staying power in an uncertain market.

Until next time, protect your profits.

Mark



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