I talk a lot about using options trading to generate income, but options have another important utility — they can potentially help you unwind a trade that goes against you.
One of the downsides in trading stocks, as opposed to holding them for the long-term, is that the trade can go against you at any time, for reasons you don’t expect.
A diversified, long-term portfolio (which is what I think all investors should have) has the advantage of being … well, long-term. Just about every long-term rolling period of 30 years (or even less in most cases) will deliver returns of some kind because the stock market has an upward bias over long periods of time.
I use short-term trading to identify low-risk, high-reward scenarios to boost my overall performance. Sometimes, however, those trades have gone against me — but I have used options trading to claw my way back to breakeven.
Here’s an example:
Example: Cliffs Natural Resources (CLF)
Trade #1: Let’s say you bought Cliffs Natural Resources (CLF) a couple months back at $18 per share. The stock has been taking it on the chin, and is now at $15.25. There’s a proxy battle going on, so you could just hold the stock and see if it recovers, but you’re more inclined to believe the stock will be stagnant for a while.
If so, this is a time to use options trading — namely, you should sell covered calls against your entire position, and do so repeatedly until you capture $3 in premium (covering the $3 per share in capital losses you’ve sustained since May).
In this case, the Aug 29 $15 calls sell for 92 cents. If you trade covered calls against your position in CLF for three months running, you will recoup most of your loss, and then you can sell the shares (assuming they stay stagnant as expected). Along the way, if the stock starts to recover, you can always buy back the calls — say, if the stock approaches $15.92. (You wouldn’t want the stock called away if it is recovering.)
Trade #2: Perhaps you think the stock is going to improve to $16.50, but you think it’ll stall once it gets there. In this case, you should sell naked puts. You can sell the Aug 29 $14.50 puts for 79 cents each. If you sold twice as many put contracts per hundred shares you hold, the rise to $16.50 would give you $1.50 in capital gains and $1.58 in naked puts premium, bringing you to breakeven. Plus, you have downside protection to $13.71 — the effective price at which the stock would be put to you if it falls further. (As always, though, remember that if you sell naked puts, you have to have the available funds to buy the stock should the shares be put to you.)
Trade #3: An alternative options trading approach would be to sell these puts and use the proceeds to finance the purchase of calls. Sell the Aug 29 $15 naked puts for $1, and use the proceeds to buy the Aug 29 $15 Calls for 92 cents. That reduces the amount of capital you are putting up to repair the position.
Trade #4: The last strategy is a bit complex, and should only be used by avid traders.
The first thing you do is open up a short position in CLF equal to your current long position. Now you are essentially no longer affected by a move in the underlying stock, since the long position offsets the short and vice-versa.
You could then use options to buy calls outright for any given expiration date. You can buy them month-to-month, or several months out. This will limit the amount of money you are spending to get back to even, although if the stock takes a very long time to move up at all, you could end up spending a lot of capital.
Likewise, you could sell naked puts to finance those calls, but if the stock falls further, that stock could get put to you.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets at @ichabodscranium.