I had an interesting conversation this morning with two other strategists about the effect of the Trade War, Tariffs, NATO talks and a handful of other subjects that are roiling the markets. One of them said something along the lines of “I own Micron (MU - Free Report) and it’s down lately because people are selling due to global uncertainty, but I still have a lot of profit in the trade. The hard thing to know is if I should buy more because it’s off the highs and still a great company and I can get into some more shares on the cheap, or if I should sell it because this trade war could get much worse…”
The other strategist interrupted him and exclaimed “That’s the way the whole market feels!”
I’ll bet a lot of readers are feeling that way, too.
Look at the S&P 500 lately:
It has some gut-wrenching moves on the chart, but overall it’s been sideways, essentially rangebound between 2600 and 2800. It looks like nobody knows what to do.
So let’s take a look at an options trade that might help you sleep a little better at night without giving up all upside potential. I’m going to use Micron, but this type of trade could be used on almost any large-cap liquid stock or even on an index ETF. It’s designed for someone who is still bullish on the overall market, but is willing to pay a small amount for some peace of mind.
I’m going to use options that expire in January 2019, because 6 months from now we should have a much better picture of how all the trade war issues are going to work out.
The only other requirement is that you must be protecting at least 200 shares to make the ratio aspect of the trade work.
What I’m aiming to do is fully protect the 200 shares (or a multiple of 200 shares) that I bought a year ago from a rapid downside move, while still preserving some upside potential.
Here are Wednesday’s closing prices:
Jan19 45 put $2.55
Jan 19 65 call $3.55
I’m going to buy 2 of the 45 puts and sell 1 of the 65 calls. It will cost me a total of $1.55.
Now if the stock (or the entire market) were to decline quickly, the most I can lose on my Micron shares is $9.18, plus the $1.60 I spent on the spread. That’s the worst case scenario, and since my basis in the shares is lower than $45, I still have profit in the trade overall.
Here’s the p/l diagram on my whole position after the trade:
The stock can also rally more than 20% between now and expiration and all I will have given up is the $1.55 I paid for the spread – and while simultaneously watching my shares rally hard. I’m still pretty happy.
Finally, if you look at the graph, you’ll notice that although I will have 100 of my shares called away if the stock rallies over 65, I'll hold on to the other 100 and still have unlimited upside potential – albeit on a shallower trajectory.
Another nice thing about the trade is that you don’t ever have to trade out of the options if you don’t want to, As long as you still own the shares, everything will take care of itself at expiration. It’s “set it and forget it” protection.
In some aggressive options trades, we risk a little money in the hopes of making much more.
In choppy markets however, I remind myself not to get too greedy and to pay a small amount to protect my accumulated profits while still enjoying some upside.
I sleep like a baby.
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