There are many ways of identifying opportunities and then taking advantage of them. In my way of viewing things, I like to first come up with a trading idea that starts with the fundamentals. From there, I wait for technical confirmation of my idea, and then employ the optimal strategy.
There are times when I will proceed without technical confirmation, thereby “jumping the gun” and breaking my discipline. Fortunately, as an options trader, I can get away with this where others can’t because I can choose a strategy that fully covers my risk. Thank goodness for options!
I have recently come across an opportunity that fits the above profile. I have a fundamental idea for a longer-term trade. However, I have not received technical confirmation on it. The problem is, by the time I get the technical confirmation on the trade, the opportunity may have passed, as things seem to move so much faster in today’s market.
Added to that on the risk side is the fact that this stock, along with others in the industry, is under heavy, heavy selling pressure. You may have guessed the industry I am talking about already — the oil industry. I believe that there are some fantastic long-term opportunities here.
As I said, with this great opportunity comes some pretty big risk. My advantage in this situation is options. First, by jumping into this potential opportunity, I am trying to catch a falling knife. If I were to try to buy before the technical confirmation of the bounce, I am buying on the drop, not the recovery. There is a good chance that the drop will continue after my purchase, putting me under water right off the bat, which is not good.
However, with such an aggressive, panic selling style drop, one has to think that the recovery, at least some of it in the early going, will be just as aggressive. Waiting for the bounce to occur before getting in may lead to missing a very significant portion of the profit potential.
If we buy the underlying, we could be putting up a good deal of money, thus acquiring a good deal of risk. However, there are a couple of different option strategies that can be employed here that would allow us to minimize that risk, but the one that I want to discuss is simple stock replacement.
Stock Replacement Strategy
In the case of the stock replacement strategy, with the expectation of the stock trading up, we would be looking at buying calls instead of buying the stock. What we are looking to do is to buy an option that closely mimics the performance of the stock, but only costs a fraction of the price. Let’s use a real example of this.
Play it Safer With RIG Options
Say we feel that this oil spill in the gulf, which has caused a huge sell-off in oil stocks like Transocean Ltd. (NYSE: RIG), is likely to get fixed at the end of the summer and will take the selling pressure off, allowing RIG to trade back up by the end of the year. And we decide that current prices are just too hard to pass up though, even with the risks that remain concerning potential legislation and liability.
Instead of purchasing the stock at $50, we can buy the RIG Jan 2011 40 Calls at $15. The January 40 call will mimic the stock at 75% (75 delta), but costs less than one-third of the price of the stock.
So, if we bought 500 shares of RIG stock, it would cost $25,000. If we bought five call contracts at $15, we would only have to put out $7,500.
If the stock did trade up to say $10, we would see a $5,000 gain from the stock position compared to a $3,750 gain in our option position. Obviously, the stock gain, in terms of total dollars will outperform the option gain. However, the return on equity will be much greater in the options than the stock.
The other consideration in this example is the difference in the loss scenario.
Since we are breaking our discipline by not waiting for our technical confirmation, combined with the fact that we are buying into an aggressive and possibly justified sell-off, our loss potential is just as important and maybe more important, than profit potential here.
What happens if news comes out that is not only more harmful to RIG (which is a possibility considering the current situation) but potentially devastating. Our total option risk is $7,500. However, our stock risk is $25,000. The stock could trade down another 50% or more (costing us $12,500). Heck, there is the possibility, however unlikely, that the company could go into bankruptcy. In that case, the total investment could be at risk.
In these types of situations, the use of the option’s leverage gives us the ability to obtain a performance that comes close to the maximum performance of the stock and allows us to use only a fraction of the cost of the stock to get that performance.
In essence, by purchasing the call instead of the stock, we have actually created a position that is equivalent to buying the stock and buying a put for protection. This is called synthetics, and it is the proof that when used properly, options are safer than stocks.
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