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Know Your Options, Personal Story Edition

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It’s time for some stories in the “Know Your Options” column.

Today, a half an hour before the markets closed, someone I know - who’s 81 years old, very smart and typically a fairly conservative investor - called me on the phone to run a few ideas by me about making some strategic buys in equities.

It warmed my heart to know that instead of panic selling, he was out shopping for bargains.

The Dow Jones Industrial Average rallied almost 700 points between that call and the closing bell.

I’m clearly not suggesting that his trades sent the market up all that way.

What I am suggesting is that all over the world, institutions and individuals alike are starting to look at the recent equity market behavior as irrational – and an opportunity.

I know what you’re thinking – “Some professionals are selling stocks. Isn't that because they know better than I do that something is seriously wrong?”

Nope.

It's time for another anecdote:

In the year 2000, I was trading with an index options group and on one particular day we entered with a bad position for a big down move. A big down move is exactly what hapened. We worked really hard in some extraordinarily busy markets – usually a recipe for success for market-makers – but when I got back up to the office from the floor of the Chicago Merc, I was disappointed to see that we still lost money that day.

My position manager was smiling.

He turned to another trader on that desk and said, “Phil, tell Dave what you just told me.”

Here's what he said:

“A friend of mine at XXX (brokerage firm name redacted) told me that there are so many margin calls happening right now that he’s not sure if there are enough hours in the day tomorrow for them to close out all the positions.”

Then we were all grinning. We knew the next day would be busy as well, with great opportunity.

Sure enough, we saw another big flush in the indices, a huge spike in implied volatilities (which we giddily sold into) and a profitable trading day that easily covered our losses from the prior session by a decent multiple.

A few days later, everything was back to normal. Equities were back up, vols were back down and our account balance was bigger.

The margin covering made the markets irrational, butonly temporarily.

The people who owned shares (or were short options) in excess of their capital limits were having those trades closed for them by a representative of their broker.

In industry vernacular, those customers are being “blown out.”

When a broker performs trades like that, it’s generally a dire situation and they don’t have the luxury to be price sensitive. They have zero emotional attachment to any of those positions, they simply want to preserve as much capital as they can. They sell what they have to.

In a portfolio of stocks, they might sell the best performing and strongest stocks first instead of the turds that caused the whole problem in the first place. Why, because the strong stocks still have a firm bid to sell into, while the troubled stocks are dropping like a rock.

I don’t know for sure how much of the selling we’ve seen lately in margin-related covering, but I suspect it's quite a bit.

It’s not a hard and fast rule, but when the markets fall steeply between 2:00 and 3:30pm ET, it's often blowouts.

The bottom of big market declines is always accompanied by margin calls.

I talk about selling puts in this space all the time. I’ll bet some of you are still a little hesitant to do it.

Remember, you are free to trade one option. In fact, if you’re not experienced I’d absolutely suggest trading one-lots. In the worst case scenario, all that happens is that you buy 100 shares of stock you wanted anyway cheaper than the current price.

Below, I’ve included the first “Know Your Options” I wrote after taking over duties from Zacks Executive VP Kevin Matras. I left the prices and dates at the original values.

No matter how frightening this crisis is from a health and financial standpoint, every company is not going out of business. There are some really good ones out there at low prices and high volatilities.

 

Take a look…

 

Selling Puts to Become and Investor

Here’s a simple option trading strategy for times when a stock you’d like to buy experiences a price downturn which you think is temporary and you’d like to be a contrarian and get long.


Instead of simply “buying the dip”, sell out of the money puts.


The beauty of the strategy is that even if you’re wrong about the direction of the stock price, you can still make money. 


Using Implied Volatility to Work for You


The reason this trade can work so well is that when a stock goes down, the implied volatility of the options – especially puts – usually goes up. 
It’s a well-known fact that stocks tend to fall more steeply than they rise.  Bad news affects the price to the downside more than good news does to the upside.  The magnitude and speed of downside moves tend to be greater.


Since traders are willing to pay more for options on a stock that is moving, or likely to move, they raise the volatility component in their pricing models, raising the price they are willing to pay for options.


In fact, the sophisticated options pricing models used by professional options market makers usually have this change in volatility built in.  When the stock price declines, volatility inputs are automatically raised.


This means that in periods of high volatility, especially on moves to the downside, option sellers receive higher than normal premiums. 


If you were thinking of buying the stock anyway, selling out of the money puts can be a less expensive way to go about it.  If the stock continues to decline through the strike price of the put you sold, the option will end up in the money at expiration and you will be obligated to buy the stock at the strike price. 


Your net price on the purchase will be the strike price minus the premium you collected on the sale.  Because the put was out of the money when you sold it (it has a strike lower than the current stock price) your basis for the purchase will be lower than the market price for the stock was when you initiated the option trade – effectively a discount.


If the stock doesn’t decline below your strike price, your put will expire out of the money and you will keep the entire premium. 


Obviously, there’s risk associated with this strategy because if the stock price continues to decline, you own it and will suffer losses.  It’s the identical risk you assume whenever you buy a stock.


Example:


Lam Research (LCRX) is down $14.50 on changing outlooks about the semiconductor industry.  You know that Lam is a Zacks Rank #1 (Strong Buy) and has a VGM score of B.  You think the market reaction is overdone and want to become an investor at the current stock price of $189.  Instead of simply buying the stock, you sell the 185 strike put expiring on May 18th at the current bid of $6.


If the stock is trading below $185 at expiration, your (now in the money) option will be assigned and you will purchase the stock for $185.  Because you collected $6 in premium on the option sale, your basis price is $179, a more than 5% discount to the $189 you were going to pay.


If the stock doesn’t go any lower than $185 or rallies instead, you keep the whole $6.  (Since standard options contracts are for 100 shares of stock, each expired put represents a profit of $600.)


Some notes on this trade: 


Earnings announcements


Be careful about selling options right before or after quarterly earnings announcements in the stock.  Implied volatilities (especially in short dated options) tend to rise going into a scheduled announcement because of the potential of a surprise beat or miss to move the stock quickly.  Volatilities will then decline sharply after results are announced and any resulting move in the stock happens.


If you sell a put right before earnings, you’ll collect a high premium, but put yourself at risk of a big loss if the company misses and the stock declines.
If you sell a put right after earnings, the stock decline has likely already happened and the premium you receive will be much lower.


Risk and Margin


Because of the risk involved, brokerage houses generally require that you have available cash or margin in your account to complete the purchase of the stock in the event that the option ends in the money and you are assigned.  Some houses may also require that you are experienced in trading and/or well capitalized before allowing you to execute a sale in an uncovered option.  You will need to square this away before you trade.

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.


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