Although I preach about having a long-term diversified portfolio, I also set aside about 10% of it to do some trading. My strategy is such that, after 20 years in the market, I’ve learned that certain stocks follow certain patterns you can take advantage of. Other stocks may present an opportunity for a swing trade.
Occasionally, though, that trade moves against me. It’s not fun, but it happens.
Most often, I’ve already put a stop-loss in place, so I just get stopped out of the trade. Sometimes, I simply don’t have one in place, so I have to sell out and just eat the loss.
But you can also handle a bad situation using puts and calls. And while there are a number of strategies you can use via puts and calls, I’m going to focus on one situation today.
Example: Escaping El Pollo Loco With Puts and Calls
Let’s say you bought 500 shares of El Pollo Loco (LOCO) at $26. It closed Wednesday at $20.89. You decide you want to get out, but you’ll be eating a loss of $2,555 on a $13,000 investment.
What can you do using puts and calls to exit this trade, possibly with a profit?
You notice that LOCO stock reports earnings in early September, so you are going to choose from September monthly options. You think LOCO stock is going to deliver great earnings, but you are exposed by holding the stock in the meantime — after all, sentiment could shift to the negative, and given that LOCO is a fairly new, volatile issue, the stock could drop like a rock.
The first thing I would do here is buy five Sep $23 calls for 85 cents each. Yes, you’re actually investing an additional $425 here, but if the stock pops, you will effectively double your long position, making it easier to escape with a smaller loss or even a gain if the stock moves up anytime between now and then.
However, you still are exposed on the downside, and that’s a legitimate concern. So on top of the calls, you want to consider doing one of two things from here.
The first: Buy five Sep $21 puts for $2 each. That’s an additional $1,000 you are buying as protection. If LOCO stock falls from here, for every dollar it falls, you will be protected with an offsetting put contract.
The closer you get to the expiration date, the less time value the option will have, so if it doesn’t fall to $19 or less by then, you will lose a bit more money on this trade.
That’s why you may want to consider buying 10 Sep $20 puts for $1.50 each instead. Now you have doubled your downside protection, so for every dollar decline, you pick up two dollars in profit from your put position. You also still have your calls if the stock should recover.
If you take the second put choice, then you are investing a total of $1,925 additional to escape this trade. Is this throwing good money after bad? That’s the conundrum … and that’s why puts and calls aren’t always the right move. I can give you trading ideas all day. But you have to decide how much risk you are willing to tolerate. That’s what ultimately matters most.
Still, if you’re good with trading options, I have one last piece of advice.
If you think the situation is dire on the downside, but have some hope for upside, then you can still use puts and calls. In this case, since you think down is more likely than up, you can sell five Sep $22 calls for $1.10. If the stock gets called away, you have effectively sold out at $23.10, for a total loss of $2.90 per share or $1,450.
Hey, that’s better than where you were!
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
