Saturday, November 15, 2008

Protecting Positions

Last weekend I wrote about the use of stops in general and in high volatility markets such as those we are currently facing. A reader pointed out that I didn't know what I was talking about since it was his view that stops don't work in high volatility markets and the only thing worthwhile to protect positions was the protective put. First, I want to point out that at the worst, it is far better to have a stop than to have nothing to protect the downside. I agree with the most recent critic that stops are more difficult in highly volatile markets and as I indicated last week, more latitude is necessary in placing them than in less volatile situations.

Truth be told, I am a great believer in protective puts as well. In fact, I just spoke about them a couple of weeks ago at the Trader's Library event, went into great detail about them in my book, "Trade Your Way to Wealth," and have previously written articles about them here and elsewhere. For those who may be unfamiliar with options, a put option is a contract in which the buyer of the put obtains the right (but has no obligation) to force someone to buy his stock at a predetermined price (the strike price) anytime until the put expires. In exchange, the buyer of the put pays the seller of the put a premium. In return for the premium, the seller of the put has the obligation to buy the stock at the strike price if assigned (put) to him anytime before expiration. For example, suppose I owned XYZ, an optionable stock which I bought at $30 a share. I could buy a put at a $25 or $30 strike price that expires a month or two or maybe even a year from now. The longer away the expiration, the more expensive the premium would be and the higher the strike price I bought, the more expensive it would also be. In the example, suppose I bought the $30 strike price with an expiration 4 months out and the premium was $5 a share. Now, no matter how far the stock might fall, I could force someone to pay me $30 a share if I exercised my put any time before expiration. Naturally, if I did that, I would be out the $5 a share, but I would be able to sell the stock, itself, for exactly what I had paid (less commissions on the stock and on the purchase of the puts).

One thing for which I suspect the critic of stops failed to account is the relative cost of puts. At times like the present, for example, where the implied volatility is very high, options are very expensive. Buying options may not be the wisest things to do at times when volatilities are extremely high. To look at a real life present day example (as of close on Wednesday, November 12, 2008), DUG closed at $45.26. Suppose we bought 100 shares at the close and also bought the at the money $45 protective puts. We could have bought the Jan 45 puts for $11.90 a share. Now we would be able to force someone to buy our stock for $45 a share anytime between now and the third Friday in January for $45. It would have cost us $11.90 a share to obtain that protection so come the third Friday in January, the stock would have to be up $11.90 a share (+ $0.26 since the stock would lose 26 cents a share if we sold it for $45 a share) plus commissions for us to break even. That is one choice we could have made and it is a legitimate one. However, we should be aware that the premium we are paying is quite high because of the high current implied volatility. On the other hand, we might have chosen to place a stop loss below the uptrend line on the stock at $37. If the stock dipped to $37, our position would be closed and if closed around the $37 mark, we would have lost $8.26, a number significantly less than the cost of the put premium. Of course, one problem with stops is that there is no guarantee that we will get the stop price if it is hit.

The stop simply means that our stock will be sold if the stock price hits or goes below the amount at which the stop is set. If, for example, the stock gapped down at the open to let's say $20, our $37 stop would be hit but we would probably only get around $20 a share. With the put in our example, no matter what the stock price, we could still assign it for $45 if we had paid the $11.90 a share premium. The real point is to look at the alternatives available to us. Sometimes the stop is the better choice, sometimes the protective put.

The fellow who decided I was so foolish to discuss stops last week and took the position that anyone with a brain should only buy protective puts also failed to acknowledge that many stocks are not optionable and if one holds a position in such an issue, buying a protective put is an alternative that simply does not exist.

Returning to the subject of a seminar, although there has been a fair amount of interest, I have decided not to do one for pay. Instead, I am going to do a free event for those who have been one-on-one coaching students. I will contact those individuals privately. I also am offering those who indicated an interest in the seminar the opportunity to have a private coaching session for the same price as I offered the seminar (i.e. $2,100 for paid subscribers and $2,500 for non-paying Newsletter subscribers). This offer is open ONLY to those who have already written evidencing a desire and willingness to participate in the seminar. Please contact Earleen at MarketFN (866-756-2656 ext. 1) if you would like the private coaching and she has agreed to put you in direct contact with me. The private coaching sessions are designed to address the specific individual's needs and goals and are geared to his or her level of knowledge and experience. I sincerely believe these sessions are even more valuable than a general seminar and they have been quite popular in the past. Other than free seminars for previous coaching students which I hope to do on an annual or biennial basis, I do not expect to do any other seminars now or in the foreseeable future.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

12 comments:

jegan said...

Re: "One thing for which I suspect the critic of stops failed to account is the relative cost of puts." and the difficulty in establishing stops.

Thank you for stating these issues. I don;t know how many articles I've read that advise 'protective puts', when they are in essence plain too expensive. As to stops, true, you can blast right through a stop and sell low, only to watch your stock ramp right up again past yesterday's price. That's the problem with a whipsaw market that can swing 1000 points in one day.

Although there are no easy answers, I'd like to point out my personal experience with AAPL and RIMM. I got tired of stopping out on these two, only to watch them ramp past the stop price and end higher. So, I decided, based on the fundamentals (which are good for both companies), the production of new products, and an up-coming Xmas season. I am presently down 35% on APPL and about 40% on RIMM, even though I bought them at 'bargain basis' prices.

Two lessons to be learned (1) There is no such thing as 'can't get any cheaper' and (2) use stops.

jegan ;-)

milt said...

This is great info!..I will quote from it in my thesis about hedge fund operators. I also learned a lot about hedge fund trading strategies from 2 other great books. Hedge Fund Trading Secrets Revealed..by Robert Dorfman..and Confessions of a Street Addict of course by Jim Cramer..written before he got really famous..both are riveting and very informative. You should check them out if you like reading behind the scenes stuff about hedge fund and what methods they use..….. my winning ratio is now better than ever.

Bill Kraft, MarketFN.com said...

Great points, jegan. I don't believe anyone has found the perfect way. As in so much of life, trading decisions often involve compromise.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks, Milt. Glad to hear you liked it.
Bill Kraft

Anonymous said...

Bill, There is a fellow marketing a system based on buying a protective put as soon as one buys the stock witht the strike price sometimes higher than the cost of the stock or ATM. My feeling is that his means you have to get too much of a gain, usually 8-10%, before the breakeven price is reached and you would do better simply taking a profit there. I realize if you do that you are unprotected if the stock goes against, which is why you have a protective sto- which does work in most markets. Have you ever tested the results of the two approaches or do you have a current opinion on which is better??

Earl

Anonymous said...

Bill,

I've read that if "stops" are used, those sell orders can be "seen" by the individuals with the access to this market information.

If this is in fact true, doesn't that give an edge to those who have access to this information and the capital to push a stock price down just to take out those stops?

Thanks!

SP

Stosh said...

You could also sell your put out if and when the stock dropped to 37 as if you had put a stop there then you would have lost less money probably

Bill Kraft, MarketFN.com said...

Hi SP. Yes, stops are visible to the market makers. Generally they swear they don't drop a market to hit the stops but I have often seen a dip down to the level where stops would be expected and then a reversal. Of course on the heavily traded issues it is unlikely that market makers would drop a very liquid option just to get your stop. May be more likely on illiquid ones.
Bill Kraft

Bill Kraft, MarketFN.com said...

Hi Earl. I discuss those issues in some detail in "Trade Your Way to Wealth." I sometimes put on collars where I buy the at the money put and sell the out of the money call and then trade in and out of the calls as the stock moves up and down. In that fashion, I keep the protection and try to take regular profits on the calls. So much is dependent on the individual, his risk tolerance and time available to watch and follow the market.
Bill Kraft

Bill Kraft, MarketFN.com said...

Agreed, Stosh. There are definitely a lot of ways to do things as I wrote in a Newsletter article entitled "Lots of Ways to Skin a Cat" some time ago. Unfortunately, some readers took the title literally and thought I was actually there skinning cats (which I'm not). As an aside, that phrase came from Mark Twain in "Connecticut Yankee in King Arthur's Court."
Bill Kraft

jegan said...

Re: Stops being visible:

Could it also just be that most people place their stops at obvious points (pivots or just below resistance).. Everyone knows this. It would seem to be a good pre-set buyin point. (If price drops below $$$, and then moves back up on volume, buy!)...

Thx for the info.... jegan

Bill Kraft, MarketFN.com said...

Absolutely true, jegan. Most stops are in the obvious places around supports and resistances.
Bill Kraft