Stock Market Savings

I don’t want to wear out this concept, but for many plays it’s very important. Here we’ll deal with a few option plays. We’ve already covered rolling options. Let’s now cover a peak or a slam.

Peaks

When a stock has a tremendous run up, say in one day it goes from $52 to $63, because of good news, unless there’s more good news coming out, it will probably back off. If you own the call options, get out. If you want to get in and play the downturn, buy puts on the stock and ride it back down. If the increase stalls, or even comes down a little, you could sell the options and buy back in on the dip.

If you own the stock, you could also write a covered call and again, ride it back down. You collect the premium and you also keep the stock.

Slams

When a stock takes a hit, you could buy a call and get out with a profit in hours. Here’s how it works. The company comes out with lower than expected earnings (it’s still highly profitable, but not up to what analysts expected). The stock falls from $62 to $54. The next day it finds support and even goes back up to $55. Consider buying the short term option and purchase the $55 call. It needs to be close. It’s going for $2. (Note: the $50 call is $6: $5 in the money and $1 time value. This costs more but may be a better play. Think it through.) A move to $56 or $57 could easily drive your $2 option to $3. Then get out.

You could have gone further out (two to four months) on the $55 call or the $60 call but that was not this play. This is short term. You should have placed the order to sell at $3 (especially if you can’t sit and watch it) right after you purchased it for $2. You know your exit before buying.

I have covered exit strategies on covered and uncovered calls and on selling puts elsewhere. I’ll only add this here: They are options. They have a fixed life. If you’ve sold a call or put and generated cash you have two choices.

A.   Let the option expire and keep the cash.

B.    If the option shrinks significantly and you think the stock might bounce, then you could buy back the option and sell it again as it gets more profit­able.

The best “out” enhancement strategy is to have gotten in at a bargain in the first place.

A lot of your investing will come down to how you feel. Your fears may keep you out of trouble. Your desire to get in when you hear great news will usually help you get great results. For example, all your research says a stock could hit $30 in a short time. It’s currently $20. If it gets close to $28 you may want to sell. If you had purchased the $25 call option (or even the $30 option) and it’s had a nice run, check the news, see if there’s more potential upside and consider selling. If the stock is at $30 and no new news has come out, definitely sell.

Remember options have a short life. If you own the stock you could hang on and wait for the next earnings report or whatever. But you don’t want the option to expire. Sell it and then buy back in at a higher strike price; or wait for weakness and buy back in at the same strike price—just out another month or two; or take your money elsewhere.

The point is this: if you wouldn’t buy the stock or option at a certain price, and you do in fact own it, then sell it at that point where you wouldn’t buy it. That sell point is your best-guess summation.

A variation of this point is using the “percent to double” or points to double rule which I’ve written about in the Wall Street Money Machine. We use the “%Dbl” to determine if buying an option is a good deal. Many brokers can get access to the on-line computer services which have this program. It’s a computer model whose “bottom line” tells us how much a stock would have to move for us to double our money on a particular option. I like low percentage movements (under 10%)—take a quick profit and get out.

Let’s say a stock is $82. The $90 strike price on the call option is $2.50 and the percent to double is 6%. The stock (at this particular point in time) would have to go up almost $5 for our $2.50 to double to $5. (6% of $82 = about $5). If the stock has an upward trend or good news, et cetera, then this could be a great play. Remember, your $2.50 option doesn’t have to go up double for you to make a nice profit. A 50c move would be nice, especially if it’s in a few days.

The point though, in this chapter is not to determine when to get in, but when to get out. If the stock and option have an upward move, check the %Dbl. If it’s high, say 13%, then you should sell. Think of it: you probably wouldn’t buy an option with a 13% to double. Back to our example: If the stock has moved to $88 and our $2.50 option is $4, and at this point (time remaining and other factors involved) it would require a $10 move to take the $4.50 to $9 then you may want to sell for the $4.50.

You’ll probably get your biggest profits shortly after you’ve bought in at a really low price, then get out on a quick up-tick in the stock.

There are four major strategies for determining when to get out of options. I’ll cover these as I blend in specific formulas on option plays. We’ll look at:

- Peaks

- Slams (“Dead Cat Bounce”)

- 90 degree angles

- Covered Calls

- Selling Calls

- Selling Puts

- Stock Splits

A quick explanation would be in order. A stock option gives you a chance to purchase or sell an underlying stock. It’s not a pure gamble in that you can actually act on the underlying security. Small movements in the underlying stock can produce, on a percentage basis, drastic moves in the option. I’ve seen a stock move up $3 and an option on that stock move up $2.50. You ask, so what? Well the stock went from $74 to $77. The $70 call option went from $5.25 to $7.75. Talk about a great proxy investment. The same can happen with puts.

Investors buy options for:

1.    Maximum bang for your buck—the expiration month and various strike prices should be ana­lyzed.

2.    Quick return on your money.

Again, we’re not here to discuss entrance strategies. You can read about those elsewhere. I only bring this up as a lead in to the next point. Is time a friend or foe? If we want to get out at not just a nice profit, but at the best possible profit, we need to explore this question.

An option may be comprised of two parts: intrinsic value and time value. Intrinsic value is that portion of the option which is in the money. Time value is that portion of the option which is out of the money. For example, if the stock is $26 and the $25 call options are going for $1.75, $1 of the $1.75 is intrinsic value and the 75cent of the $1.75 purchase price is time value. 75cent pays for one week or two months, or whatever time is left before the expiration date.

The reason I said “may” at the beginning of the last paragraph is that the option may be all time value. If you’re after the $30 strike price, and the stock is at $26, and the option is 50cent, the whole 50cent is time value. Time value could be called extrinsic value as it is extrinsic to the value of the stock.

At first, time is a friend. Your 75cent has purchased you a month and a half—six weeks. If the stock rises, the option value increases. You could sell at anytime. If you had pur­chased a call option with a $30 strike price, the op­tion value in­creases up to a point. If the stock goes above $30, you’ve made a nice play and you can get out at a nice profit.

If, however, the stock moves toward $30 and you’ve seen a nice run up in your option, but then the stock stalls, you may want to be careful. Time becomes the enemy. The option (stock) needs time to move up, and more specifically, move to the strike price, or it may become worthless.

Look at the chart. Note the dates. Note how in the last few days before the expiration date the stock is still going up a little but the option goes nowhere and then down. Time runs out. We’re purchasing the November $30 call options for 50cent.

Do you see how fast the time value deteriorates when there is no time left? As you look at this chart you can obviously see several exit points where you could have made a nice profit. Also note: the time value of in the money calls also evaporates as you get near the expiration date. Look at the chart. This is the $35 call option. The stock starts at $26.

Sometimes we, “tongue in cheek,” refer to time value as fluff. When there is ample time before the expiration date, the time value portion of the option premium is large. In the above example it was 75cent back on October 20, but only 25cent two days before the November 19 expiration date.

There comes a time when you get less bang for your buck. I would have sold this option at a double or triple. Be careful.

If it gets to be No­vember 10 and the stock takes a two dollar dip, the value can erode very quickly.

When the stock has less time to re­cover it may not regain its previous value. A lot of money can be made in the expiration week but only for someone with a stout heart. I hope you see how easily the “friend” can quickly turn to “foe.”

If you choose to purchase puts on the way down, do everything in reverse. Wait for the stock to peak out, check for other news, including where the market in general is heading (don’t fight trends), and buy a put. Sell it as the stock decreases in value. On a $25 stock, purchase the $22.50 put or even consider the $25 or $20. The $25 put will cost more because it’s in the money, but you have some insurance. The $20 (or lower) strike price will cost less because it’s way out of the money. Pick an exit point that you’re comfortable with and upon selling the put, watch for the true bottom (or support level) to sell the put, then jump back in with a call option and ride it back up. Keep the cycle going.

I took the Wall Street Workshop in October of 1995. I bought options in a few companies and was ahead at the end of the year by a little over $9,000. You know, this year has been thrilling. My gains thus far in 1996 exceed $86,000! All of your courses have been wonderful, but your Wall Street Workshop has been the most rewarding financially. Thank you.

Sandi—Bellevue, Washington