fumbling through the market – today collars

Published on 8 Nov 2008 at 2:11 am. No Comments.
Filed under Investing.

As previously stated I know very little of the stock market but it has become an interest of mine lately after discovering different plays that are possible. It’s similar to poker in that you try to make the best decision possible with limited information. However there are more ways to hedge your bets. As I learn new things I am sharing them here in hopes to spark some interest in someone else but mostly for the clicks on those ads you see on the right 🙂

On 10/29/08 I made a speculative play on Las Vegas Sands (LVS). I bought 200 shares and got in at an average price of $8.75. As I discussed in my post about Apple I immediately sold a call option to hedge my position. I sold 1 Jan $10 option at $3.40 and then waited to see what happened. On 10/30 the stock started to run on some news and moved through my $10 execute price. I decided I thought the stock was going to go much higher so I bought that option back at $4.30. This was a loss of about $110 after fees. This was fine cause I was up a lot more on the holding at that point. The stock continued to soar and at one point on Halloween I was up nearly 100% on the position. This was where my first mistake occurred. If you are up almost 100% on a position (specially in 2 days) take profits! At the very least put in a trailing stop to ride any additional rush and then taking profits on the next pullback. 100% is very rare. I would suggest considering profits anywhere over 20%, I’m happy with 10+.

So I didn’t take profits and I had no hedge on the down side. News came out that LVS was in big trouble financially and in after hours trading it dropped from $11.75 to $7.94. It continued to sell off and I jumped ship at $7.72, booking a loss of around $220.

Total loss of $330 on what should have been a $1500+ trade.

What did I learn?
1. Don’t be greedy, take profits – use trailing stops to lock in profits while still riding a rush.
2. Consider hedging your bets with things like Collars

Here’s an example:

Over the course of Halloween I bought into 400 shares of YHOO ending up with an average price of $12.98. YHOO is sitting on a lot of cash and was in the works with Google for a search advertising deal and there were always the Microsoft buyout rumors. I was however not sure how the election may or may not affect the market. My guess was that an Obama win was already cooked in and that the relief of it just being over would cause a little run. To hedge my position I sold 2 Jan $15 calls for $1.70. The stock looked really solid Monday so when it pulled back a little around 2pm I bought back the calls for $1.63, not quite covering the fees.

Well the Google deal fell through and Jerry Yang started talking about how Microsoft should buy YHOO. The stock soared to almost $15. I know Microsoft needs a better search in order to compete with Google so I thought the deal might happen. I consulted a good friend who knows much more about these matters as to how I should play a possible Microsoft bid. Should I sell the rumors, sell the announcement or wait for the bid and sell then. He responded that he thought YHOO was done and there was no MS deal. He turned out to be right on with this call, but I didn’t believe him, however I trusted his judgment. So instead of selling the stock on 11/06/08 I sold 2 Jan $15 calls for $2.30 each and 2 Dec $15 calls for $1.70 each. I thought this had me fully hedged on the down side, but I was wrong, it could have been better.

Microsoft comes out and says exactly what my friend had already told me, there is no deal, we offered, they weren’t interested, we moved on. (I still think Microsoft wants the search, they just aren’t in any rush and hold all the cards right now).

I had no stop loss on YHOO and it trades down from the previous close of $13.95 to $12.45 before the market even opens.

It’s looking ugly so immediately dump 200 shares at $12.20 netting a loss of about $160

Having uncovered short call options out there makes me nervous so I immediately buy back the Jan $15 calls for $1.25. I sold those calls for a total of $460 so buying them back for $250 made me about $200, subtract the $160 from sale of the shares and I snuck out about even on a diving stock. I decided to hold my Dec $15 call and the underlying shares to see where YHOO went.

The Collar:

If I had done one other thing on 11/06 this could have gone much better. When I sold those calls for $460 around 11am I could have immediately bought 2 Jan $14 put options for $2.23 each ($446 total). What this would have provided is a collar on YHOO guaranteeing that at expiration in Jan I would have the option to sell YHOO for at least $14 and maybe $15. Why would I do this? Well at that point on 11/6 YHOO was trading at $14.41. I was already up $586 ($572 on the stock and $14 on the difference between the call options and put options). That’s an 11% return and locking that in would have been nice. At this point I could have just stopped watching YHOO till Jan. The worst case would have been that YHOO was trading between $14 and $15 at expiration making both options worthless and my net gain only what I had gained in the stock price from $12.98, which would have still been about 10%

Now lets see how 11/07 would have played out with the collar in place:

When the stock opened at $12.45 I would have been feeling very good about those put options I bought, knowing that come Jan I could always sell my stock for $14. So I wouldn’t have been in a hurry to do anything and could have sat in wait to see how things played out.

Turns out YHOO didn’t dump much past where I sold off, but the options prices did continue to move. By around 3pm the Jan $15 call option had leveled off at 1.05, the Jan $14 put option had leveled off at $3.30 and YHOO was trading at $12.18.

What I could have then done is:
Buy back the call options $460 – $210 = $250 profit
Sell the put options $660 – $446 = $214 profit

At this point I am holding YHOO which I can sell at $12.18 for a loss of $160 making the whole trade on those 200 shares worth about $300 or 11% without waiting till Jan. Or I can hold YHOO and keep the $450 profit I just made on the options. Without the collar I snuck out in a panic and basically covered the fees, with the collar I would have been comfortable watching where the stock went and could have made $450 on the day while holding a stock that seemed to be trading sideways.

Collars are best when:
– You think a stock is going to move big in one direction or another, but you don’t know which (rumors that prove to be false or true, earnings that are vastly different than expected, etc)

– Safest when the put price is above your average per share price. Buy into a position and put in a standard hidden stop loss, if it moves up a little go ahead and collar it and lock in a little profit and possible a big one if the stock moves alot.

– When the premium difference between the call you are selling and the put you are buying is big enough to book a decent immediate profit.

One thing to notice about this collar was that it was basically free to setup as the money I received from selling the calls was larger than what I spent on the puts and the difference covered the fees. This was mostly because the price had already risen and I was collaring the stock to lock in that profit but still have options if it moved big one way or another. This meant I could have locked in a 10%+ guaranteed return, with no possible downside for free, and still have other more profitable outs if it moved a large amount one way or another.. How can you go wrong with that?

I’m going to be looking to collar a lot more stocks in the near future in this volatile market. They provide a known limit to any losses/gains and at the same time still allow you to take advantage of large moves in the market.

There is another play called a straddle where you don’t have to hold the underlying stock and thus requires much less capital to execute. It has its own drawbacks however and I will discuss a straddle play in another post. And buy a boat.

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