Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
PUTTING IT TO BETTER USE
If I want to accumulate a stock over time and am willing to buy on weakness, is hedging shares with protective puts the best means to do this? Or would a short put strategy be a better approach?
That’s a wonderful question. In the first scenario, by buying or “marrying” a put in conjunction with shares, you as a trader have guaranteed yourself limited losses and guard the stock against a bearish downside catastrophe. As someone who also wishes to buy on such weakness, as long as your outlook on the stock hasn’t changed, the small resulting loss compared to the kind suffered by a bull simply holding shares will mean you’re in a stronger position to average in or accumulate on weakness and capitalize on attractive value for a longer-term commitment.
With a married put, the trader always maintains control of their maximum risk exposure while allowing for unlimited upside, and after factoring in the cost of the put. These benefits, of course, aren’t free, as the trader is paying for protection, which increases the cost basis of the stock position. This can prove expensive if the stock isn’t dropping strongly enough to make the put worthwhile. Worse yet is if multiple put purchases over the course of a few months prove unnecessary and thus add up to being expensive protection, or if shares simply aren’t rising enough in price to offset the cost of the put(s).
As you noted, buying on weakness can also be pursued by selling or shorting a put in lieu of a married put strategy. In this method, the trader is willing to accept assignment of shares, which means getting long at the strike price of the put minus the premium taken in from the sale. Many refer to this play as a “targeted purchase.” This terminology applies as the trader is happy, initially at least, to buy shares at a known discount price if shares were to drop through the strike and assignment to occur.
If the stock remains above the strike, the premium is kept and the trader can look to roll out to the next calendar month and repeat the process if his or her outlook remains intact. The collection of premiums without receiving assignment helps reduce the purchase price when shares wind up below the strike and assignment results using this strategy.
Upon assignment, often the trader will buy a put to protect the new stock position and establish a married put. But until a put is purchased to hedge shares, the trader is exposed to substantial risk. The stock could be well below the targeted purchase price upon receiving assignment, as fast bearish moves and/or price gaps are a real possibility. Thus, considering a bull put spread as a means to initiate a targeted purchase, while taking in fewer cents initially, may make better sense over the long haul.
So which strategy is better? Aside from the risk/reward differences and our view of favoring a bull put spread over the naked short put, traders need to have a firm grasp of their expectations for the stock as well as the pricing of premiums. As the saying goes, there is a time and place for everything. If protection is fair to cheap and expectations are for shares to be traded higher, the married put becomes more attractive. Conversely, if premiums are rich and the trader’s immediate technical outlook is less certain, selling a vertical as part of a targeted purchase becomes a stronger candidate for positioning.
LEAPS OF FAITH
Following Netflix’s late October 2011 earnings disappointment, shares cemented the stock’s out-of-favor position with growth traders. But with NFLX’s rapid drop in excess of 70% from its highs and the company still the dominant player in the to-your-doorstep or streaming video market, what are your thoughts on buying a LEAPS call as a way to position for some upside?
It’s not my place to give recommendations on a particular stock. What I can say is that despite your prognosis of shares, a long call strategy with a long-term contract needs to assess liquidity and implied volatility. Separately or combined, both factors can have a substantial negative impact on profitability.
But the good news? Liquidity in NFLX LEAPs is reasonable with bid/ask spreads for individual contracts in the 2% to 3% range. The bad news is with most of the surrounding money options priced in the high teens into the 20s, the spread means there’s slippage risk on entering and exiting.
As of this writing in the first half of December and shares bid into the mid-70s on takeover “Amazon-for-Netflix” chatter, premiums in the surrounding money calls are priced around 25% to 30% of the underlying share price with implieds near 70%. The pricing is unexceptional. However, on a dollar basis for a wasting asset such as a long call position, which could be worthless in about a year, the situation is reason enough to consider spreading the risk with a sale such as with a calendar, horizontal, or vertical spread.
If a takeover were to occur, the “unexceptional” pricing of a long call in NFLX needs to weigh the impact of a deal and what that contract (or aforementioned spreads) might look like should a buyout be announced. Even if a premium deal is agreed upon, a near-the-money, let alone an out-of-the money call, could see its value disintegrate to zero due to an implied volatility implosion or the option’s intrinsic worth adding up to less than the extrinsic value paid for the contract. And with that kind of storyline, there’s no room for sequels, for better or worse.