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August 13, 2015

Have Your Stocks Taken a Hit?

It has been a tough couple of weeks for bullish traders and investors as several events have moved the market and stocks lower. Some stock buyers are waiting for some of their losers to rally and some are buying more stock at cheaper prices. But as most experienced investors know, the market can always go lower now or in the future. Here is one option strategy that can make sense in some cases; the stock repair strategy.

Introduction to the Stock Repair Strategy

The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits

There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy

Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example

An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next three months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options.

The trader buys 1 November 60 call at 6 and sells 2 November 70 calls at 3. The spread is established cash-neutral.

Bought 1 Nov 60 call at 6
Sold 2 Nov 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. The P&L diagram below shows how the position functions if held until expiration.

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy

The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help – just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup all or some of the losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 24, 2014

Stop Loss or Trailing Stop?

The market has moved higher, lower and higher again over the last month or so. Even though the market has rallied as of late, there’s still a potential for the market to move lower. Regardless, whether the market continues to move higher or lower once again it is always a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentailly enhance a trading strategy. Well, worry no more because that is exactly what we will review in this blog entry. To get more educational ideas like this, sign up for a free two-week trial of Market Taker Mentoring’s options newsletter.

Let’s start with the basics which is defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example

A trader could purchase a stock for $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are followed.

Trailing Stop Loss Example

A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is violated. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss can be used very effectively in profit taking and it is a strategy I have used often myself. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

Consider the option next time you are in a profitable position!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 15, 2014

Ever Consider a Bear Put Spread?

The market has been on quite a run lower lately since the S&P 500 hit its all-time high earlier this month. Maybe the market will reverse and move higher at some point but traders need to be prepared like Boy Scouts just in case there is another move lower not only now, but for in the future as well. Options give traders a plethora of options so to speak for a trader with a bearish bias. Bearish directional option strategies are certainly an option but sometimes buying a put option can be a little bit more risky than maybe a trader wants because of potential price swings. A bearish option trader may want to be a little more cautious especially in this current volatile atmosphere.

An Alternative

A better alternative than the long put may be to buy a debit spread (bear put). A bear put spread involves buying a put option and selling a lower strike put option against it with the same expiration. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The options trader will realize this maximum gain if the price of the stock is lower than the short put’s strike expiration. The most the options trader can lose is the cost of the spread. This maximum loss will occur if the stock is trading above the long put’s strike at expiration.

An Advantage

An advantage of a bear put spread is that if the stock pulls back, the spread will lose less than just being long puts because of the spread typically has smaller delta and initial costs due to being long and short options. The trade’s delta is smaller because the positive larger delta of the long put option is somewhat offset by the smaller negative delta of the short put option. For example, what if XYZ stock is trading at $40 a share and an option trader purchases an ATM put option ($40 strike) with a delta of 0.50. For every dollar XYZ goes up or down, the put option should increase or decrease by $0.50. If a bear put debit spread was created by adding a short put with a lower strike price of 35 and delta of 0.20, the delta for the spread would now be 0.30 (.50 – .20). Now the spread would gain or lose $0.30 for every dollar the stock went up or down.

Trade-Off

It is probably obvious to a great many of you how a smaller delta might be a disadvantage for the trade. If the trader is correct on the movement and the stock decreases in value, potentially a larger profit could be realized with just being long the put option because of the potential higher delta. But once again a trader needs to determine if a lower overall cost using the bear put and possibly a lower overall risk is worth the trade-off versus the long put.

Finally

Understanding current market conditions (especially now) and applying and managing the proper options strategy is crucial for success at all times. Deciding when to implement a bear put spread instead of buying puts for a bearish bias is just one example of this.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 20, 2013

Trailing Stop or Stop Loss?

With several disaster films like World War Z and White House Down scheduled to be released, it’s no wonder traders may be a little nervous. But on a serious note, after this past week’s decline, there’s still a potential for the market to move lower and it’s probably a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentailly enhance a trading strategy. Well, worry no more because that is exactly what we will review in this blog entry. To get more educational ideas like this, sign up for a free two-week trial of Market Taker Mentoring’s options newsletter.

Let’s start with the basics which is defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example

A trader could purchase a stock for $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are followed.

Trailing Stop Loss Example

A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is violated. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss, then, can be used very effectively in profit taking and it is a strategy I have used often myself. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 9, 2013

Stock Option Picks Require Analyzing the Overall Market as Well as Individual Stock Assessment

Making stock option picks with huge profit potentials, whether the market is up or down, depends on diligent market research and a thorough understanding of stock option fundamentals.

Finding profitable trading opportunities can be tough. But you don’t have to do all the work yourself. Some professional trader services, such as Market Taker’s Group Options Coaching, make stock option picks that they share with protégés, saving individual traders time and effort.

But whether you do your own research or rely on a seasoned professional for your stock option picks, its essential to understand some basic facts about options trading.

Making stock option picks based on individual stock assessment requires an understanding of specific fundamental parameters. Traders may learn how to read an annual report and 10K stockholders report for income statements, past earnings, sales, assets, new products, and overall industry trends.

Stock option picks based on technical analysis is essential for success and requires the investor to examine the historical price movement and volume in order to determine price patterns and extrapolate future price movements. The single most important technical analysis technique is the simplest: Support and resistance lines. Specifically, horizontal support and resistance lines at the same price level in two or more time frames.

Stock option picks based on broad market analysis examines overall activity based on performance indices. Is the overall market bullish (moving up), bearish (moving down) or neutral (moving sideways)? The broad market will affect individual equities.

Stock option picks based on psychological market indicators attempts to interpret the facts and gauge whether a change from bullish to bearish (or vice versa) is in the wind. Successful options traders are frequently contrarians who buy puts in a bullish market and purchase calls in a bearish market — against convention.

Bottom line, a lot goes into stock option picks. The help of a professional with experience in “putting it all together” can make the process easier and can result in better trade ideas with greater profit potential.

Enroll today and take a step towards better trading.