Trying to Call Bottoms – Impossible and Unnecessary
By Paul Price of Market Shadows
Even the best traders can’t know if a stock they think is cheap will get even cheaper. Taking partial positions to start, with the idea of buying more shares later, is one way to deal with that possibility.
The practice of buying in tranches, as prices fluctuate, is called ‘legging into a position’.
Writing puts on an underlying stock you’d like to own is another way to avoid having to ‘call a bottom’ in a chart that exhibits bad momentum while offering good value.
Industrial manufacturer Valmont Industries (VMI) offered that look in late August when its shares broke below $135 after touching almost $165 last March. Technical traders abandoned ship.
The downtrend wasn’t due to bad fundamentals. VMI has a stellar long-term track record.
The poor share price performance was not a reflection of bad finances. Valmont scored high on Value Line’s most important metrics.
VMI’s only middle of the road ranking was in share price volatility. High beta is not a bad trait if you are buying shares after a sharp decline. It suggests you may not have to wait long for a rebound.
A series of lower highs and lower lows was evidenced from late March through mid-October. I started legging into VMI on September 5th with the sale of 2 March 2014, $145 puts for $15.60 per share in premium. That set my ‘if put’ price @ $129.40 which was under the actual 52-week low at that moment in time. The stock itself ranged from $135.92 – $139.00 that day.
The following day I added two more contracts of the March Puts, but this time with a more aggressive, $155 strike price. The $21.50 premium brought the ‘if exercised’ level down to a, still attractive, $133.50 while allowing for more upside than the $145s.
VMI surged from under $135 to $148.50 in the blink of an eye. It hit $148.50 by September 24th and I was regretting not having done even more with it. That’s where the beauty of volatility came back to help me. Valmont made one final swoon which shook out any remaining weak holders.
On September 30, having observed how fast Valmont could rebound, I went in and sold two March 2014, $160 puts to increase my exposure. The $23.60 premium took my break-even point on that lot to $136.40.
On October 1st I bought 200 actual shares on the way down at $136.60. A day later I couldn’t resist adding another 100 VMI at $134.80. My timing was not perfect. The stock cascaded all the way to a new annual low of $129 intraday on October 18th.
I was done with my process of getting long through legging in. The finishing touch to my Valmont position was accomplished on November 15 after the stock ran back up to $145. That’s when I sold three covered calls against the shares I owned. I chose to write the March @ $160 calls. Premium received was $2.50 per share. My upside was now locked in at a maximum of $162.50 through March 22, 2014.
Those covered calls appealed to me because, if they end up usable for the buyer, all six shorted puts would, by definition, expire worthless. My 300 share long position, with an average cost of $136, would be callable at a $26.50 per share profit. Writing those calls reduced my absolute dollar risk by $747 after commissions.
If VMI fails to close above $160 on the March expiration date I’ll simply keep the $2.50 per share as bonus income. I’ll deal with the puts as I see fit. I might wish to accept delivery of the shares at great prices. I may want to buy to close (BTC) or roll-out to extend my maturation date.
As of Dec. 24, 2013 VMI closed at $148.50 making the $145 puts already out-of-the-money. The short puts at $155 and $160 strikes are quite profitable.
Valmont has been a major wealth creator over the past decade. I’m confident it will continue to do well in the future. Every previous pullback has been temporary. EPS are at record high levels.
Legging in allowed me to buy shares cheaply, sell puts at attractive premiums and hedge my bet slightly with the sale of covered calls after an interim move higher. In a perfect world we will buy stock and sell puts when the underlying shares are depressed. We want to write calls only after a surge.
The staggered transactions make for a smoother overall process in setting up full-sized positions. In the investment world, Leggings are, indeed, never going to go out of style.
