OPTIONS
Split It Three Ways
Split Synthetic Stock Positions
by Roger Ison, Ph.D.
Use this flexible but little-known strategy to buy stock inexpensively, deploy cash more effectively, and diversify your portfolio.
Suppose that a stock you follow, Abcd Inc. [ABCD], has just taken a substantial price hit. It's really beaten down. Its sector has had some news that made investors nervous, and now there are some negative analyst comments about the company itself. But you know this company. You watch it, you understand its business, and in your judgment, these shares are now an excellent deal. On its merits, ABCD is a stock you'd like to own. This feels like an opportunity, but what is the best way to act on it?
YOUR CHOICES
- Buy the stock? You could buy the stock outright. But you might have to ride out a further decline, and it's hard to predict when the stock will recover. Your money will be tied up for an uncertain period if you buy now. Yet this is a sound company, and the recovery might be sharp and substantial when it comes. If you don't invest now, you could miss a big move up. It's a dilemma.
- Use options? You could write some puts striking below the current stock price. That way, you pocket some money immediately. If the stock declines further, it will be put to you at an even lower price, which would be a good thing, since you've already determined that this is a stock you'd like to own.
You won't buy the stock if it lingers near its current price, because the puts won't be exercised; but neither will your money be tied up in a sluggish stock. Meanwhile, cash that would otherwise have gone to purchasing shares can at least earn a little interest with the put strategy. Unfortunately, this approach still runs the risk of missing that big move up sometime in the future.
Or you could buy calls. Buying calls avoids the downside risk, but at-the-money calls will be relatively expensive; their implied volatility will be high because the stock has just made a significant move. And if it takes a while for the negative issues to resolve, your money will waste away in time decay as the options expire worthless. Calls striking farther out-of-the-money would be less expensive in absolute dollar terms, but there is even less chance you will profit from them until the stock truly recovers.
FIGURE 1: SPLIT SYNTHETIC STOCK POSITION. Write three December 20 puts and buy two December 27.5 calls.
...Continued in the April 2003 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the April 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.
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