Option Writers Newsletter, Thursday, 05/12/2005 02:31:36 PM ET
HAVING TROUBLE PRINTING?
Position Adjustment Techniques
There is no recent activity worth discussing in the Option Writers Portfolio, so we thought it would be a good time to talk about another repair strategy for the recent Connetics (NASDAQ:CNCT) trade.
As those of you in the position know, shares of CNCT plunged after the company forecast lower than expected earnings in the coming quarter. The sell-off was unforeseen, given the previous technical strength in the issue, and the after-hours decline prevented a timely exit in the position. CNCT is currently trading near $22.50, well below the sold (put) strike at $25, but based on the fundamental outlook, some readers may choose to accept assignment of the stock when the options expire in two weeks. After the stock is in his portfolio, the investor has a few alternatives. The easiest approach is to simply take no action and hope the share value eventually recovers. Another common method is to "average down," which involves adding new shares to the current position at a lower price. While this technique is a good way to lower the overall cost basis in the issue, it also significantly increases the amount of money at risk in the position. Possibly a better method, and one that many option traders favor in this situation, involves using a bull-call spread to lower the break-even (or basis) of the overall position while increasing its profit potential. In the book Options For The Stock Investor, the author refers to this strategy as a "covered-call plus a call-debit spread," where the credit from the sold options are used to offset the cost of the long calls. The term Ratio Call Spread is another, slightly different definition that some position traders use, but regardless of how the strategy is labeled, it is a favorable technique. Here is an example using the Connetics (NASDAQ:CNCT) position:
In the initial trade, an investor has sold 5 contracts of the (CNCT) MAY-$25.00 puts for $0.50, thus his cost basis in the issue is $24.50. Near the end of the expiration period, the stock has fallen to $22.50, an unrealized loss of $2.00. Now the investor still likes the long-term outlook for the company but is concerned about further downside risk and needs to recover lost profit potential. Thus he could attempt to improve his overall position by purchasing (5) JAN-$20.00 calls and selling (10) JAN-$25 calls. The new position would be a combination of the covered-call and the bull-call spread. The components are; LONG 500 shares CNCT and LONG (5) JAN-$20.00 calls but also SHORT (10) JAN-$25.00 calls. Notice there are no "naked" or uncovered calls and with simple analysis of each individual component, you will find that the technique offers an excellent opportunity for restoring lost profit potential at a reasonable level of risk.
Since the cost of five (5) JAN-20.00 calls [Ask = 5.20] and the credit from ten (10) JAN-25.00 calls [Bid = 2.60] are roughly equal, no extra expenses (other than commissions) are required for the play. However, if there was additional money invested towards the new position, it would simply lower the "break-even" (below the current basis) by that amount. Now, if CNCT finishes the JAN-06 expiration period below $25.00, all of the calls will expire worthless and the investor will be no worse off because his cost basis is increased only by any additional money spent for the bull-call spread. In most cases, the amount should be a small percentage of the stock price (2-5%) or, as in this example, almost nothing. If CNCT finishes above $25 at expiration in JAN-06, the strategy will yield maximum profit, easily 2-3 times more than a simple covered call. Other combinations of strike prices and expiration periods (such as OCT-22.5/25) may offer favorable alternatives but in all cases, the combined position must be structured so as to produce "break-even or better" results when compared to the original play.
The primary advantage to this technique becomes apparent as you compare the outcomes when the stock price finishes within the strike prices. The profit threshold for the new position occurs at a much lower (stock) price and increases exponentially as the value of the underlying issue rises. In addition, the downside break-even point is reduced by roughly the same amount that is invested for the bull-call spread, thus providing favorable risk versus reward for any capital spent in the recovery effort. Of course, all of the possible results for any particular position can be analyzed by simply comparing both plays at the various prices, so it is very important to do the math (and make sure your calculations are correct!) before you initiate the strategy.
Obviously, no one likes to be in a losing position, but the key to success is how we react to this type of situation and in many cases, the ratio-call spread "repair" technique offers an excellent method to recover lost share value.