Options Sage submits:
"The great thing about the market is it has nothing to do with the actual stock."
That’s a quote from the now infamous YouTube video where Cramer explains how manipulation works. Phil followed up on Wednesday with this article and quoted Financial Sense:
"In determining how to play these moves it is well to remember that The Cartel quite apparently likes to use (we reiterate) technical patterns (e.g. Fibonacci retracement levels, Head & Shoulders, etc.) as “lures” to lure in precious metals and strategic commodities longs and then to take them down. Longs in these circumstances are literally the hogs led into the slaughterhouse by technical “lures".”
I am not sure any of us can stand up honestly and say we haven’t fallen victim to the manipulation ourselves or haven’t capitulated to unexpected movements at some point. I realized long ago that Mr. Market liked to disagree with me on occasion and, at those times, it left my timing of the market look somewhat suspect! For most traders, the response to this surprise movement is to take a loss. And that may indeed be the most prudent approach to trading certain positions; set a stop-loss, close the trade, take the hit, move on.
That approach assumes that next time you will do better! It assumes that if you have 10 trades and set 20% losses on them and let your winners run that 5 losers could be offset by one 100% winner and the remaining 4 winning trades produce an acceptable overall return. What if you are new to the market or your timing isn’t perfect or you succumb to those human emotions of greed and fear and let them affect your decision-making? What can you do?
Turn short-term trades into long-term investments – The Smart Way!
When I am wrong, I really don’t like staying wrong! It's like being Rocky and getting hit over and over again….it hurts! Fortunately, in the words of Governor Schwarzenegger "Pain Is Temporary" and our job is to pick ourselves back up, make sure the pain is only temporary and try to end the trade profitably! Options afford us that ability to convert a trade that initially moved unexpectedly to another position that can make us money if we are willing to be a little patient.
Winning in stocks is not an all or nothing proposition, turning a loss into a small, incremental gain is a huge victory – something only the most patient investors really master.
For example, I was trading BIDU during this last expiration and, with just a few days to expiration, noted some attractive short put premiums and sold the $100 puts for $3 when the stock was hovering around that level. I expected the stock would hold the ‘psychological’ support of $100 and I also knew the 200-day Moving Average was just below at $95, should the stock even breach the $100 mark. I knew that the stock had been pinned at $105 during February expiration and, even if I was wrong and the stock went lower, I didn’t see it moving MUCH lower – since the 200-day Moving Average had held as support back in August 2006 and I believed it would hold again.
Although the hardcore fundamentalists won’t like that pinning/technical argument, I like to use a combination of fundamentals, technical indicators and sentiment to guide my decisions! As it turned out (don't laugh Phil!) my timing wasn’t perfect! The stock didn’t hold the $100 level as I had expected, falling to $95. So I was left with a choice:
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A) Take a $2 loss and hope for better next time
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B) Turn my short-term trade into a longer term investment
I chose B. Since the short put option has an associated obligation which is to purchase stock if assigned, I knew that, with the stock trading down at $95, I would be forced into buying the stock at $100. It’s not as bad as it seems since:
Anytime you are assigned any short option, you always get to keep the credit
As a result, the effective cost basis of the combined position was $97. Why was I willing to buy the stock?
For that, I reverted to my fundamentals. Yes my timing was wrong but so what! In the long-term I can rely on my fall back plan, the $2.86 of expected '08 earnings. Even if the P/E multiple contracted to 60 (and I couldn’t remember a time in recent history when it got that low) I figured that the stock would move much, much higher over the next couple of years. So, 60%+ earnings growth over the next couple of years yielding an attractive earnings per share number and even factoring in a contracting multiple would yield a much higher stock price. Plus the stock had already been sold heavily in recent months to technical support levels, down from around $135 to approximately $95 per share.
Instead of taking a realized loss of $2, I ended up profiting overall! In fact, I have decided to hold the stock as a longer term trade for the fundamental reasons mentioned above. I have banked realized gains on the option side of the original trade and I am now ahead on the stock too – all stemming from a decision NOT to take a loss but to REMAIN PATIENT.
If I had taken choice A, I would have been forced to buy back my short put on Friday before expiration and taken a loss of approximately $3 per share! Instead, by remaining patient I am currently ahead on both the stock and the options by approximately $3 per share!
This trade can be repeated with the stock still sitting at $102.59 and the short puts at $100 offering $2.60, the effective cost basis should the stock reverse below $100 by April expiration would be $97.40 (close to that same $95 support level) or for the more conservative players the $95 puts for April are offering $1.15 putting the effective cost basis at $93.85 should the stock drop below $95 by expiration resulting in short put assignment. If the stock remains above our threshold levels then both short puts expire worthless.
This is a great play to take assuming you are willing and able to accept delivery of 100 shares of BIDU per contract at $95 (or $100) per share for the long haul. Think of it this way with another stock – let's say you would love to buy AAPL for $90 but it's at $93.52. You can sell the $90 puts for $1.08 and you either make $1.08 for not owning the stock (a 14% annualized return on your non-investment) or, wost-case, get the Apple stock you wanted at the price you wanted, less $1.08.
Effectively, you are being paid NOT to own the stock – yet. For those of you who buy and sell a lot of actual stocks, think about how this could be a very effective weapon to add to your arsenal. If you have an anticipated rate of return of around 10% and you can generate 10% or more by promising to buy stocks you are planning to buy anyway – why not?
Phil likes to quote J. Wellington Wimpy, who is famous for saying "I will gladly pay you Tuesday for a hamburger today." Selling puts on a stock you intend to purchase is a way of getting paid a premium today for a stock you will not pay for until Tuesday (or Friday of expiration anyway).
Next time you have the choice between taking a loss and converting to a trade that can profit you in the longer term, think long and hard because regularly swinging from $3 losses to $3 profits on trades will have a HUGE impact on your overall virtual portfolio results at the end of the year.
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Trade Updates
How is our Wal-Mart trade working?
Review: Phil had decided WMT was likely to stay between $45 and $52.50 for the next 3 months:
Buying WMT Jan 09 $55s for $3.40 AND Jan 09 $45 puts $3.30 (total cost $6.70)
Update: WMT Jan 09 $55 Last $3.25 AND Jan 09 $45 puts Last $3.10 Unrealized Loss: $0.35
Selling WMT Apr $50s for .50 AND Apr $47.50 puts for $1.10 (total income $1.60)
Update: WMT Apr $50s Last $0.15 AND Apr $47.50 puts Last $0.50 Unrealized Gain: $0.95
Effectively the bet was biased positive that the stock would finish between $47.50 and $50 by April 20th. This week's upward movement caused the short put to move from an in-the-money option to an out-of-the-money option and the assignment risk discussed last week has been mitigated. Return: roughly 19% in two weeks. Tedious but effective.
How is our Sears Holding trade working?
Our SHLD play was not hedged on the put side (Phil loves the stock and won’t short it) and they had a nice (for our caller) $7 run this week. Our Apr $180 caller stopped out at $4.50, costing us $1 but our June $180s jumped back to $11.25, a $5.25 gain for the week so we are certainly not complaining – especially as our basis on this play is just $3.15 ($2.15 plus the extra $1 we had to pay our caller) for a nice 257% gain so far.
Good luck & Have a Fantastic Week!
Yours truly,
Options Sage!
