Buy Downside Protection on Facebook

by Tyler Craig | December 4, 2012 8:37 am

While the latest market rally was able to vault over 20- and 200-day moving averages, the declining 50-day moving average proved too much for the already extended run. Monday’s attempt to reclaim this pivotal level was soundly rebuffed as sellers finally flooded the market with enough supply to generate short-term bearish reversals across the board.

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As shown in the accompanying price chart of the SPDR S&P 500 ETF (NYSE:SPY[1]), Monday ended with a classic bearish engulfing pattern, where Friday’s narrow trading session was completely enveloped by Monday’s sell-off. Though the SPY closed the day down only 0.5%, it’s actually the worst showing for the big-cap-laden index since the surge began two weeks ago.

While this bearish development may not spell imminent doom for the market at large, it does provide a reason to take some cautionary measure on stocks that are too extended, such as the current comeback favorite[2] — Facebook (NASDAQ:FB[3]).

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Commonly touted as a gateway strategy, covered calls provide an alluring introduction into the options realm for equities traders looking to not only improve returns, but also attain a modicum of downside protection. And with Monday’s nasty high-volume bearish reversal on FB, a bit of protection sounds like a good idea for shareholders.

The covered call merely consists of selling one call option for every 100 shares of stock you own. Typically traders look to sell shorter-term options to take advantage of the higher rate of time decay. The amount of protection afforded by the call depends on the strike price selected. Selling in-the-money calls provides a greater degree of protection, but less upside profit potential. Selling out-of-the-money calls provides a smaller degree of protection, but more upside profit potential.

Here are two strikes worth consideration:

Emphasis on Protection

Traders interested in acquiring more protection could sell the Jan 27 call for $2. In doing so, they would be obligated to sell the stock at $27. While the max profit potential would be capped at the $2 received (about an 8% return), they could also withstand up to a $2 loss in the stock by expiration.

Emphasis on Profit Accumulation

Traders more interested in boosting returns on FB could sell the Jan 29 call for $1.20. Since the strike price is above the current stock price, shareholders can capture another $2 in the stock before being required to sell it at $29. However, because the $1.20 credit is less than the $2 offered by the 27 strike, this covered call doesn’t offer as much downside protection.

At the time of this writing Tyler Craig had no positions on any of the aforementioned securities.

  1. SPY:
  2. current comeback favorite:
  3. FB:

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