Greetings Traders! IN the last post, I showed how Ahmed might take most or all of the risk out of his ownership of KLAC, but still play it for further upside.
Today, I’ll be showing another ‘bulletproofing’ maneuver in which one of our webinar attendees (Ravi) might take out all the risk of owning RCI…. but still hold on in case it goes up even more.
Ravi wrote in saying that he had RCI shares, purchased over time at $25-$30. For the purposes of today’s post, I’m going to assume an average purchase price of $27.50.
SO, I just checked and RCI is selling at $38.95. That means that Ravi can get out right now at ($38.95 sell price) – ($27.50 buy price) = $11.45 net profit per share.
Of course, that also means that he can’t do ANY more with it… he’s out of the stock and there won’t be any more upside potential, or any more participation in dividends.
So Ravi isn’t keen on getting rid of RCI just yet… he sees greater upside potential… and he’s faced with a dilemma: “do I take profits NOW, or run the very real risk that RCI will reverse and my gains will disappear?”
Ravi COULD place a ‘trailing stop order’, which ostensibly protects him from that happening. If he places it at, say, 10%… that means that with today’s price of $38.95, he’d put that stop order at around $35. If RCI pulls back, he will have locked in a profit of ($35 sell price) – ($27.50 buy price) = $7.50 per share.
That is, IF the stop order goes as planned. There are two big, very common problems with a stop order:
1) it can get filled on a dip, and then the stock takes off again without you… and that’s just plain annoying. But also…
2) if there is a sudden GAP in the stock’s price due to a market upset, that means your stop order gets filled, but very likely not at the price you wanted. If there was a $35 stop order in place and the stock opens at $26 because of some overseas crisis… Ravi gets ‘stopped out’ of his shares at $26 or less. Not cool.
How can Ravi get the best of all worlds? How can he arrange it so that if there is a sudden reversal in his stock’s price, he may truly lock in a favorable sale price… but if his stock goes up, he can also participate in the upside?
How may Ravi continue to collect dividends… and have protection in place that assures him that he cannot lose any capital he has invested so far?
Here’s one of many RadioActive Trading plays that could be used by Ravi to build a fence around his stock holdings. The strategy involves using a put option to protect the stock, but paying for that put option using a ‘nested spread trade.’ Let see how that might develop, using today’s options prices with RCI at $38.95….
First, he might buy a July $40 put right now at the ask price of $2.90. Now, this will indeed cost Ravi $2.90 per share… but with RCI’s present price of $38.95, $1.05 of this is GUARANTEED to come back. After all, the put option will guarantee him a sell price of $40 for the stock:
That’s nice, you might say. BUT, Ravi is in the business of MAKING money with RCI, not spending $1.85 for an insurance policy protecting RCI til July. How can we prevent Ravi from having to come out of pocket for this protection?
We’ll use a near term bear call spread… formed by selling the April $35 calls for $3.60 and buying the April $40 calls for .30 cents. That’s going to generate $3.30 in credit, which will more than PAY for that July $40 put option’s premium of $2.90.
Think for a minute about this new situation… We’ve actually been paid ($3.30 credit from April bear call spread) – ($2.90 spent for the July $40 put option) = .40 cents for having an insurance policy in place!
Could the ‘stop order’ offer that level of protection? No way.
Now, there is more to this setup than meets the eye. Depending on where RCI ends up at April expiration, Ravi may have actually locked in more than he could get today for selling RCI… and be able to leverage it further moving forward.
Hey, Traders! I’m not finished with this post. I want YOU to point out what you think the holes in it might be. Whaddya think?
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Okay RadioActive Traders! The following additions are made to this post on May 21st, 2012. We’re going to explore the value of knowing how to ‘roll’ a bear call spread in a bulletproof position. I think you’re going to dig this options management technique.
So, in the above example, we’re actually getting PAID to ‘bulletproof’ a stock. Nice… but what happens when the stock’s price goes UP? A bunch of folks wrote in… some posting comments as well… saying, “Why get all fancy with the bear call spread along with the put option?”
Well. I think I can satisfy your curiosity, maybe even ‘put’ a new smile on your face once you see the potential of using Nested Spreads, or the RadioActive Trading INcome Methods.
Okay, here’s where the pricing got to on April Expiration Friday: $39.66. Just as about as BAD as you could want while holding an April $35/$40 bear call spread. SO… I wanna hold on to my stock. What to do? Well, let’s buy it just before close at the present price of $39.66. Since the short calls are going to be exercised anyway, it’s like paying $4.66 to hang on to the stock.
“Wait,” you may be saying. “You’re adding $4.66 into the cost basis for the stock. You’ve received $3.30 for that bear call spread, so holding it going forward adds $1.66. PLUS, the put option you spent $2.90 on is down to only $1.80 on the bid. You’re losing all the way around!”
Tsk. Surely we remember that the put option we’re holding is clear out to July… and it’s only April. And lookee: there’s still a May $35/$40 bear call spread to be sold at a $3.50 net credit.
If you plus this into the Custom Spread Tool on PowerOptions, you’ll see that we’re still bulletproof… risk-free… and have picked up premium TWICE. That’s $3.30 from the first spread, $3.50 from the second… and oh, by the way we did need to spend $4.66 along the way to hold on to the stock. That’s ($3.30 + $3.50) – $4.66 = $2.14 net credit so far. We still own a July $40 put, we’ve got our stock protected until May expiration.
Okay, fast forward to last Friday, May 18… expiration Friday. RCI closes at $35.21. To hang on to the RCI stock, it’ll cost .21 cents. Take a look at the July put pricing from Friday:
Do you see what I see? The July $40 put is bidding at $4.80, waaaay higher than the $2.90 that we paid for it.
Let’s tally the ins and the outs of having used options to build a fence around RCI:
IN: OUT:
$2.90 for the July $40 put
$3.30 April Call Spread $4.66 to manage the spread
$3.50 May Call Spread $ .21 cents to manage second spread
So far, that’s $6.80 IN, and a total of $7.77 OUT.
In other words, after all is said and done we’ve spent .97 cents for a July $40 put option. It now happens to be worth $4.80 on the bid.
Not bad? Not bad at all.
So let’s revisit the situation at the top of this post. $38.95 was the price of RCI. No guarantees. RCI could go down at any time. Not cool.
But then we looked at using options to guarantee the sell price at $40, and how we might PAY for that insurance using near-term ‘nested’ options spread plays that I call the Income Methods.
As of today, May 21, the new situation: we have paid a net of .97 cents for the right (not the obligation, but the right) to be able to sell RCI at $40… all the way til July expiry. By the way, today RCI closed at $35.34 so being able to sell at $40 is a very nice right to have!
Can we still use a nested bear call spread to pull in another credit? Yessir you betcha. Is it necessary? Well, no, not so much. There are a number of different other “Income Methods”.
Okay gang, so I’ve put up some of the possibilities of using options to ‘fence in’ this RCI stock. Remember that I’m not recommending any stock or option to sell or buy… just showing the virtues of knowing how to use options to minimize risk and leave the possible reward open.
Other Income Method and Bulletproofing Resources
Hey, didja dig this post? 😉 Make sure and share the love by commenting, liking, sharing it with a friend. And if you’re hot on these ideas of ‘nested spread trades’, ‘Income Methods’, and ‘Bulletproofing’… here’s is a short list of other free educational resources sponsored by RadioActive Trading:
Double Dippin’… Taking Even More Premium Than Covered Calls
Catching Premium Better Than Covered Calls: The “Money Net”, Part Deux
This Simple Trick Made My Stock BULLETPROOF
Coaching Client Steve S., Makin’ Star-BUCKS…
What on Earth Is a Nested Spread Trade?
Options Trading Wisdom From The Art of War
YouTube:
http://www.youtube.com/watch?v=5yDIR4t0rjc&list=UUPvzT0P7mUh6IifL6NT3IEw&index=33
http://www.youtube.com/watch?v=m1Y3MnrS3Bs&list=UUPvzT0P7mUh6IifL6NT3IEw&index=1
For Free Options Trading Educational Webinars Every Tuesday and Thursday, Register HERE
For a free two-week subscription (no CC needed) to the PowerOptions “Search and Destroy” Platform for finding, managing, and BULETPROOFING these kinds of trades, Register HERE
Happy Trading,
Kurt
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor.
No Holes You da man…
Thanks Luke! Although my comments box got CRAMMED with comments from folks that think they did find holes. So I’ll be answering those guys as well…
Yup, this play makes RCI Bulletproof, leaves the upside open, plus you get paid to do it. I WILL say that yes, if RCI goes to $40, you give up a small amount of profit that you might have earned otherwise by not building this fence around it. The only drawback, then, is for those amazing folks that know the future and are divinely appointed with the knowledge that RCI is certainly going to $40. But those guys don’t need The Blueprint anyway 😉
You sold calls below the strike of the puts. Does that add more risk?
Yes and no. As far as risk to the capital that Ravi has put into this trade by buying shares of stock… no. As to Ravi risking assignment at a profit, well, yeah. He MAY get assigned and deliver shares at $35, but remember he owns them at a cost basis of $27.50, so he makes money there. SO that risk isn’t against his capital in the investment, it’s in his (potential) profit… PLUS, the long $40 call may be worth something depending on how high RCI does go… and the put option (that he’s been PAID to own) will certainly still have some value as there are still months left til expiration.
Ravi wanted to bulletproof this stock because he was afraid it might be at the end of its run. I’m just showing him one of several ways that bulletproofing might be done… at credit… while leaving his upside open. There are other ways to do it as well, that don’t have the same problems, but hey. That’s why I wrote a whole book about it 😉
Sam, thanks for the Q. I’ll be handling it in the second part of this blog post. Happy Trading,
Kurt
Well, the $35 April short call is in the money. Any ITM shorts will need to be closed before any ex-div date (probably June). They will also need to be rolled before the time value shrinks too low.
I’m curious why you did the call spread with April options, rather than further out to give more time value.
Thanks for the comment, Mike. The ex-date has come and gone in March, so there is no danger of being assigned by a dividend capture kind of guy 🙂 Now to your April vs. other month question: bear call spreads that are further out don’t necessarily carry significantly higher premium. The next expiration month (May 2012) setup had only $3.10 premium. Thise numbers should be similar today (March 27 2012), look ’em up. SO why do I want to take less premium and hold onto the liability of the bear call spread for longer? Nah, I want there to be ample room for management techniques after this.
Thanks for the Q, Mike! It’s helping me formulate my follow-up blog post. Happy Trading my man,
Kurt
Well, it sounds good, but you’ve sold someone the right to call the stock from you @$35…so your Put guarantee at $40 only works out if the stock @ April expiration is below $35…you’re temporarily putting another $500 per 100 shares on the table…which, no doubt, you hope to earn back by further option credits between April & July.
Slight correction, Dom: I never have to give anything back if the stock finishes below $35.40, not $35. This is because the play I showed takes a .40 cent credit. But yes, if indeed RCI hit its high yesterday, and it never ever again sees $38.95, and it steadily declines between now and July expiration… well then! I’ve been paid .40 cents to lock in a $40 sale price. That is the high end of what I can expect from this play on the down side.
Of course, if RCI actually goes to exactly $40 on April expiry, that is the low end of this play. I will need to satisfy the obligation to sell at $35, as you pointed out. My $40 call will expire worthless and my July $40 put (that I’ve been paid to own, mind you) will be down to about $1.82, according to Messrs. Black, Scholes, and Merton. So I get .40 +$35 + $1.82 = $37.22 for the stock I’ve paid $27.50 for. Hey, that’s still a healthy profit!
Again, that’s the low end if RCI goes to
exactly
$40 and I use no management techniques.
So if I was okay SELLING RCI yesterday at $38.95 because I thought its run was likely over, why would I not be okay locking in a sale price that’s guaranteed to be between about $37.22 and $40.40, but could possibly go higher? That’s the beauty of bulletproofing. I can sit on RCI for another four months, but breathe easy knowing I’ve got a certain profit in the bag. WITHOUT the options play, I have no certainty and it’s certainly possible that in the coming days, we’ll see RCI trading below $37.22. Boy they’re a lot of ‘certains’ in those last two sentences.
Thanks for participating, Dom! BTW, I didn’t say this was a recommendation for Ravi, just an observation. One of the other bulletproofing plays from The Blueprint might suit him better. Or he may just want to continue holding without any guarantees. That’s cool too. Just not the way I think I would play it.
Happy Trading,
Kurt
@ $40 on April expiration how is there gonna be over $1000 profit still in the trade for Ravi? By selling the $35 call if the stock closes on April expiration @ $40 , Ravi’ 100 shares will be taken from him @ $35 ??? His $40 call & $40 Put will expire virtually worthless. Please explain.
Hiya, Tom! That over $1000 profit is if the stock goes to $40 by April 9 and he unwinds the position. The number declines to $972 if he holds til April expiry, the stock is at exactly $40, and he has made no other ‘management’ moves. Here’s the breakdown:
Ravi gets $35 for the stock he paid $27.50 for. So that’s $750 of the profit. THEN, his July $40 put is still bound to be worth something. According to the Black-Scholes-Merton pricing model that will be around $1.82. Now, Ravi got PAID to own that put… remember… so cashing that in accounts for $182 more. And putting all these components in play ended up giving Ravi a .40 cent credit. So, yes… $35 + $1.82 + .40 = $37.22, and from a stock that cost him $27.50 to get into, he keeps $972 profit for every 100 shares.
I’ll be doing a more thorough treatment of your question in another blog post. Look for it! And thank you for your comment.
Happy Trading,
Kurt
The idea of a bear call spread has some potential but you need a big move in some direction.
The 35 Apr call has a 3.60/4.20 spread and the 40 Apr call has 0.20/0.25 spread so you can probably get a better price for the proposed bear spread.
The risk is that you may have to put the premium back into the trade plus the difference between your spread premium and $5.00 (the maximum loss). Unless the stock retreats to less than 35.00 which looks unlikely due to its recent technical behavior ( but,you never know!) you will also risk early exercise. The stock went ex-dividend on 3/15/12 so nobody is going to snipe your dividend.
I would probably pass on this one!
Yes, Fred, this isn’t the only play I would be inclined to do with RCI. I just was showing a spread that would:
1) Bulletproof the position,
2) Leave the upside open,
3) could be done at a credit.
There are other bulletproofing plays, but if Ravi asked for a play that would not cost anything, but would bulletproof him and still leave him infinite upside potential, this was the one 😉
Happy Trading,
Kurt
Why set the Put expiration only 3 months in the future? The Blueprint tells us always to chose an expiration at least 5-8 months in the future to have time for income methods to work. If RCI is, say, at 39 at April expiration, he will either need to buy back the April Short call at large expense and roll it either up or out or both, and the bought Put will be far less
valuable at that price. The long call will be more valuable, but nowhere near the cost of rolling the short call and it would have to be well over $40 for any real profit. If he delivers it at 35, he loses(-$3.95 all, or most) of the premium he received from selling the ITM call. I guess I just dont get it.
Buy the October 40 Put instead. That gives him 3 more months to pay for it and it’s about $.80 more. He then has 7 months to pay for it by selling the short calls or doing spread trades, not 4.
Mark, this is just an example of a play that would bulletproof Ravi and not cost him anything. Its not necessarily how I would play it. In fact, I like the idea of an October put more as well, and would probably try a different Income Method or bear call spread at higher strike prices like you. But my challenge was to bulletproof RCI, leave the upside open, and take a credit while doing so. I think play this fits those criteria!
Happy Trading,
Kurt
Something is wrong with the math. Max risk = 2710 – 4000 = -1290 (%risk = -47.6%). What am I missing?
What you’re missing is the obligation to (perhaps) deliver the stock at $35, if I do no management techniques and the stock remains above $35.
After I have either ‘managed’ the short call, or the stock closes below $35 in April, this will no longer be an issue and I have that guaranteed sell price of $40.
Now, if I DO have to deliver stock at $35 when it’s trading above that, I will still own a July $40 put option that will still be worth something, and that I didn’t pay anything for. So there’s still room to play, or just to cash in. That’s the other thing you are missing.
Thanks for the Q, David!
Happy Trading,
Kurt
Oh, and one more thing, THe Blueprint basically forbids the reader to set the Long Put strike above the Short Call strike.
Why are you now suggesting to violate this most basic tenet of your own theory?
Better read the book again, Mark 😉 The ‘never sell a call below the put’s strike price’ rule is relaxed when it’s part of a bear call spread or a ratio call spread.
Thanks for the question!
Happy Trading,
Kurt
I do not like this play at all. Number one, if he thinks its run is over, sell it. Nothing wrong with a 40% profit. Number two, the put option serves the purpose of protecting gains at minimal cost.(1.85/11.45) The bear call spread is a directional play with only 17 trading days left. If the stock doesn’t fall, it is breakeven at best or a money loser, thereby increasing the cost basis of the stock. Always remember the KISS philosophy.
We’ll see soon enough if this was a good idea or no. Thanks for your input.
K
I don’t understand why you just don’t buy the 40 put rather than get all fancy. I know you’re doing it to “pay” for the insurance AND leave your upside open (otherwise, you’d try to do a collar), but at the same time, if the stock goes up, it’s going to cost you (after paying back the call premium on the bear call spread) 1.70 + 2.90 for the put = 4.60. To get that back, you’re going to have to have a break even price on the hedge at 43.44 (38.84 + 4.60). Just buying the put without all the other worries, your breakeven would be 38.84+2.90=41.70. In this case, I think I’d rather give up a small portion of my gain in favor of the insurance without worrying about how the call spread is going to react. I think anybody can insure a gain. The real trick is hedging your loss at the beginning of the trade.
Exactly.
I like the last part of this comment BEST; you said the real trick is hedging a loss at the beginning of the trade.
THAT’s what I’ve been shouting from rooftops since 2002! These particular trades I’m running through are to illustrate how to retain the run up of a stock, but the married put entry I’ve been championing since 2002 is what limits possible losses in the first place down to 6% or so.
Come to one of our webinars, I think you will really dig what we are teaching about limiting risk and leaving the upside open.
HT,
K
I wish my picks all went up 42%.
🙂
Making money without having to liquidate your stock AND collect dividends? Exciting would be an understatement!
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