Bulletproof THIS! Part II

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

About Kurt Frankenberg

Kurt Frankenberg is an author and speaker about entrepreneurship, martial arts, and trading the stock and options markets. One of several "Biznesses" he founded as a teen, The Freedom School of Martial Arts, has been in continuous operation since 1986. Kurt lives in Colorado Springs with his wife Sabrina, German Shepherd Jovi, and his ninja cat Tabi.