Option Investor
Educational Article

The Light Finally Goes On

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Today's article will be a bit different, as I'm going to discuss a structural change to the way I'm implementing and tracking plays in the LEAPS column. If that isn't part of your trading focus, you can feel free to click away and you won't hurt my feelings in the least. I've intended to cover this material in both of the last two weeks in that column, but there just hasn't been either time or space to get to it on the weekend. So I'm taking advantage of this venue to try to explain (or at least begin the process) of what we're going to change and why.

I don't mind telling you (and if you've been with me for awhile you already know) that the past year has been exceedingly frustrating to me in terms of the plays we've tracked in the LEAPS column. As a point of interest though, it isn't the losing plays that have caused my this frustration. No, it is the plays that we missed getting an entry point in and then watched as the stock has gone on to perform beautifully, but sadly with us on the sidelines.

A significant contributor to this unfortunate dynamic has been my lack of confidence in the intermediate to long-term direction for the market. I see many factors that ought to lead to a significant slide, while at the same time the continued bullish price action suggests that playing the downside is a bit too risky. As a way to mitigate the risks of holding long-term positions in a market that has the potential to either continue on its upward trajectory or reverse sharply, I've been a bit too demanding in terms of the entry points I'm seeking. The result is that many of the plays we've listed in the Watch List over the past several months have never fulfilled their entry points and we've watched as large missed profits have accrued. Two of the biggest misses are NEM at $23-24 last spring and QCOM at $44 last November. Plays currently on the Watch List that may fall into this trap as well are HD, where we're looking for a failed bounce in the $37-38 area and SNDK, where we're hoping for a significant pullback to afford entry into the play.

On the other side of my frustration are the large number of plays that we've actually put into the Portfolio, that simply haven't worked and price action has then proceeded to go against us until our protective stop is hit. These plays are frustrating as well, as each one results in a financial hit, not to mention a hit to our confidence. So the question becomes, how do we take the entries into the winning plays and mitigate the damage on the losing trades without getting an advance copy of tomorrow's newspaper? Put another way, what do we do to mitigate risk in any other aspect of our lives? We buy insurance!

Insurance Reduces Stress

Imagine owning a $500,000 house without insurance against fire, theft or any other potential hazard. How about driving your new SUV without insurance against collision and liability. Unthinkable isn't it? Without insurance, we'd all be constantly worrying about what could happen to these valuable assets. So why not take the same approach with our long-term investing. It doesn't matter whether our long-term position is a LEAP or a long/short position in the underlying stock, the approach will be the same.

After initiating a long position, we buy a protective put, using a slightly out of the money strike with 2-4 months of time premium. The intent of this strategy is that we never need the insurance and the stock will move far enough in the intended direction to allow us to place a stop near break even, while at the same time selling the put for any residual value.

It works the other way around as well. We can buy a LEAP Put as our main position, betting on a long-term downtrend in the stock. Then we buy a protective call to hedge against the risk that the play goes against us.

In either of these situations, we're still going to suffer a loss. Think of the net loss on the position if forced to close it out due to an adverse move as the deductible we pay when involved in a vehicular accident. Would you rather pay the $500 deductible for rear-ending another vehicle, or the full cost of the damage, which can very easily rise into the $3000-4000 range. The answer is obvious. It is the same thing when we're using insurance on a long-term investment. The insurance option won't completely make up for the loss on the core position, but it will significantly reduce the damage.

I don't know why it took me so long for the light to come on and for me to come to the realization that this is a strategy that ought to be routinely applied to our LEAPS investments, but it slowly dawned on my during and shortly after writing all my plays for the end of year stock picks. In order to be sufficiently protected when writing those plays so far in advance of the desired entry points, it was necessary to build some sort of insurance into those plays. I figure, if it can work there, then why not in our LEAPS trades?

So from this point forward, I'll be changing the structure of our plays in the LEAPS column. Each bullish play will have a listed protective put and each bearish play will have a listed protective call. Purchase of this insurance policy will reduce the overall gain of each winning play, but I think the reduced damage on the losers will make the additional cost more than worthwhile. I haven't yet worked out the details of how I'll be displaying all the pertinent information in the playlists, but we'll find a way to cram it all in there in a legible format.

As a side note, I think our bearish play on EK will make a good case study in the application of this strategy. Following better than expected earnings, the stock skyrocketed through our $31 stop today and we'll be dropping it this weekend. As part of that drop, I'll detail how the results would have been different if we had employed a protective call. I would have done that analysis and description tonight but I just didn't have time before my publication deadline.

There are still many details to be worked out in the actual presentation of the minutia of each trade each week, but hopefully this gives you a heads up for the direction we're headed and over the next couple weeks, we can flesh out those details, answering questions as they come up.

Probably my favorite part of adding this tool to our regular strategy is the fact that we can afford to be a little less stingy with our entry points, avoiding the emotional pain of missing trades that go on to perform beautifully. If we don't get the 'perfect' entry, it's alright because we're insured!

Remember, questions are always welcome!


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