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The Stock Market Parachute

What color is your parachute?

If your answer to that question is: "what parachute?" then we need to have a serious talk…

Anyone can jump out of a plane, you open the door and jump – this is not brain surgery.  The trick is not to die in the process!  Gravity is a nasty, royal bitch and has been successfully conquered by exactly none of the approximately 100Bn people who have ever livedOf the 94Bn people who have died, only one is even rumored to have come back so generally, when jumping out of planes, we find it advisable to employ some sort of safety device commonly known as a parachute.

Yet when we buy stocks and calls, why are we are tossing our money into the air and yelling "Fly, fly!" with no actual plan as to how to save our investments should that flying thing not work out?

Sage just wrote a wonderful article about hedging, this is akin to preparing for your jump by packing your chute, checking your straps and cords and making sure everything is in order before you go check to see if you will be the first person who ever actually flew (and if you’ve jumped out of a plane, you know you thought about it the first time).  So I urge you to read that article and take the advice to heart for the next time we try to make our money fly but this isn’t an article about that.  Today we have advice for the unprepared.

The prepared don’t need our help, they have a chute and a backup chute.  They’ve praciced on the ground and they’ve tandem jumped with an instructor and they’ve had a few practice runs with automatic chute deployments until they got comfortable determining how much freefall they could safely handle before pulling the cord.  Even with all this training and preparation, most reserve parachutes still have an automatic activation device (what we call a hard stop) which trigger before they fall below the safety zone (2,500 ft).

All this hard work and preparation keep all but around 30 of the 166,000 people who jump out of planes with parachutes each year from dying (no safety system is flawless) – this is a vast improvement over the 100% fatality rate for people who jump out of airplanes without a safety device.

So whether we didn’t have a chute at all, or whether it failed to deploy or whether, like me, we thought we were close enough to the ground last Friday and cut our primary chute away…  We are all in the same boat now so let’s take a nice, rational step back and assess the situation.

  1. We are falling.  Seems obvious but did you really accept that fact last week?  If so, what are we doing with long positions?
  2. We don’t know how far down the ground is.
  3. Global investors who jumped with us are falling hard and fast.
  4. We would like to try not to die (again, obvious but what are you doing about it?)

If your parachute fails to deploy at 2,500 feet, you would consider yourself lucky to walk away with 2 broken legs and a ruptured spleen right?  How about if you lost an arm?  A leg?  Some fingers???  It’s morbid but if you are looking at your virtual portfolio right now you have to think about it that way.  You’ve already broken a leg or two, are you prepared to risk loss of life and limb as well?

When an animal is caught in a trap it might chew it’s own leg off to escape, finding freedom at a cost preferable to death.  We can make a similar choice with our virtual portfolios today, cutting our losses and heading back home to lick our wounds.

Since we are not animals though, we can also think our way out of the situation.  As a tree skier, I can tell you that I have willingly sacrificed badly sprained arms (twice) and fingers (3) and one dislocated shoulder and one torn calf to protect my head and face at various times.  We all have to make decisions under stress and we have to balance out the risk/reward profile against the situation at hand (your face heading right for a redwood, for example).

So we are in freefall and we’re not sure where the ground is and we don’t wish to cut our losses and go home – what can we do?

Assuming you still like your positions and have a reasonable, rational, realistic expectation that they may come back we could spend a little money on a mattress play.  In a mattress play we will take a look at our total virtual portfolio (let’s say $50,000) and decide how much more we can stand to lose (lets say $5,000) before we opt to start chewing our legs off.

Take that $5,000 right now and start cushioning your landing.  If you hold 2,000 shares of stock with an average price of $25 each then a 10% drop in the market will cost you $2.50 per share.  If you hold options it is much trickier as you would need to determine your time value and volatility in addition to the directional move so we’ll stick to the more straightforward example.  What we do in either situation is start buying mattresses and stacking them on top of each other, the further we fall, the more mattresses we buy to cushion our landing.

You can protect your 2,000 shares of stock by purchasing 20 April  DIA $115 puts for (I’m guessing the open) $1.25, a $2,500 investment.  If the Dow drops 5% ($6 on the DIA) we can assume the $115 puts will be worth (ignoring time value) approximately what the $120 puts are worth now – $2.20.  Spending that $2,500 can net you a gain of $1,800 or more if the Dow continues to plunge.

Mattress number 2 comes in if we continue to fall.  In this situation I would look to buy 10 more Aor $114 puts when they hit $1.10 and mattress number 3 would be 10 Apr $113 puts, when and if the Apr $113 puts hit the same $1.10.  At each new level we should set a 20% trailing stop on the level(s) above it and, after 3 levels I prefer to roll out of the top position, take that basis off the table and put the profits into mattress number 4.

Just imagine that you are falling and falling and every 100 feet or so you figure it’s a good idea to buy another mattress.

We are not doing this to make money per se (although you can accidentally do well on these) but to protect the positions we have so we can afford to take our time reassessing them individually.  If the market turns up (Hallelujah!) then a 5% up move will put (roughly) $2.500 back in your virtual portfolio while we can assume that the $2.500 worth of DIA Apr $115 puts we bought at $1.25 would slip to the value of the $110 puts (.55) leaving you with a loss there of $1,490 – the cost of your virtual portfolio insurance.

Of course this is just one example and you should consult your professional financial advisor to determine which index fund would work best for your individual mix of plays.  I will be posting several more of these mattress plays for various indices up on the members site but you should seriously consider covering existing positions rather than taking on additional risk by trying to balance a heavily positive virtual portfolio by shorting or putting new stocks that have already dropped considerably.

 


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  1. Gordo

    Where’s the thread this morning?

  2. mrn

    Phil
    How do you think the Asia and dollar slide, along with oil’s prospects, are going to affect our gold positions – GFI and AUY? (Unfortunately I hold several other gold positions as well).

  3. arnie

    test

  4. juliet

    Where is everyone?

    j

  5. Thrilling Thursday Morning | Understanding The Stock Market

    [...] can be played in these low-volume markets. It’s tons of fun if you can keep up but our Mattress Plays, for example, long covers that used to change perhaps once of twice a month, are now being changed [...]

  6. Phil

    Mattress/Concreata – You should always look to roll up your longs for .50 or less per $1.  You should be able to get to the $89 puts for that price.  The idea is this always keeps you with at least a ..50 delta, meaning you would get at least a $1.50 gain on a 300-point drop.  Since you are 1/2 covered with the $88 puts, you know a 300-point drop will put them $2 in the money and that’s no problem at all.  A 600-point drop (to 8,300) would put your putters $5 in the money but you know you will gain at least $3 but, realistically, your downside delta improves as you go more in the money too.  So, with the 1/2 cover and a 300-point drop, you gain 25% on the long but your putters only get their money back (and, of course you sell Sept whatever).   In a 600-point drop you gain 50% and you have a 1/2 cover at $5 so you will roll them to 2x the Sept whatever is $2.50 (unless we think the market is going much lower) and your 50% gain will be well covered.  All those are the IFs – what matters is that you ALWAYS take advantage of the opportunity to roll up the long side.  This is, of course, all under the assumption that you have something on the bull side that is making money while this is going on! 

    Conc – here are a few posts in the past on DIA plays.  UR question may be answered here.  For all newbies, bookmark ‘em, read ‘em, read ‘em and paper trade ‘em.  They are frustrating in the beginning, but then things start making sense as to how to keep the losses to a minimum.
    http://www.philstockworld.com/2009/02/22/weekly-wrap-up-89/#comment-214448
    http://www.philstockworld.com/2009/03/05/thrill-ride-thursday/#comment-217107
    http://www.philstockworld.com/2008/07/24/thursday-morning-63/#comment-163599

  7. Phil

    Good morning!

    DIA Mattress/Ajay, All - This goes for any time you have a 1/2 cover and get "blown out" with a downside move. 

    We begin with 10 (this is an EXAMPLE AMOUNT) DIA June $108 puts at $6.80, 1/2 covered with 5 Feb $106 puts at $2.12 on Wednesday.

    On Thursday, the Dow drops 200 points and the Feb $106 puts shoot up to $3.  The June $108 puts jumped up to $7.75 so they are up $950 and the 5 Feb $106 puts are up $500 so this is nothing to panic over anyway. 

    Since we are completing a 2.5% move down and since we expect a bounce off 2.5% we want to SELL INTO THE INITIAL EXCITEMENT (which we ALWAYS try to do) and, CONTRARY TO YOUR INSTINCTS TO FREAK OUT OVER A 50% "LOSS" ON THE SOLD PUTS – we SELL another 1/2 (5) Feb $104 puts at $2, not moving to a full cover of 5 Feb $106 puts AND 5 Feb $104 puts.

    What have we done?  We have collected $1,000 selling 5 Feb puts that are $2 lower than the $106 puts, giving us a $2 better spread between our June puts and the Feb puts we’ve sold than the $106 puts.

    What is our plan?  We are HOPING we do get our bounce.  Keep in mind we have a $1,000 loss on the Feb $106 puts but we did just collect another $1,000 for selling the $104 puts.  If the market goes up, we’ve increased the Feb delta relative to our June longs from .35 (1/2 of .70) to .65 (the average of .53 and .77). 

    By adding 5 more shares we have now flipped our spread to BULLISH as our June delta is .65  so a bounce back will hurt the fully covered callers more than it will us.  Our hope is that we have a retrace that allows us to take out the Feb $106 puts at $2 (even) which would mean we effectively traded the Feb $106 puts for the Feb $104 puts at the same price and widened our spread for free.

    If, on the other hand, we are wrong and we break down from 2.5% then what is our plan?  We collected $2 ($1,000) on our original sale of the 5 Feb $106 puts and they are now at $3 ($1,500).  We collected another $2 ($1,000) from the sale of 5 Feb $104 puts ($1,000). 

    Our next move comes IF the $106 puts rise to $4.  At that point, we have obviously moved lower than we thought (and, since the Delta on the Feb $106 puts is .70, we can be pretty sure that it would be roughly 150 Dow points lower than we are now, so at about Dow 10,250.  By the way, if we are at 10,400 and you believe that 10,250 will not hold – THEN DON’T SELL THE ADDITIONAL 5 $104 PUTS IN THE FIRST PLACE!

    So, at 10,250 (roughly) the DIA 5 Feb $106 puts hit $4 ($2,000) and, at this point (assuming we don’t think 10,250 will hold), we then roll the Feb $106 puts lower, which is to say we buy them back for $2,000 and then sell 5 of whatever puts give us $2, which should be the Feb $102 puts, now $1.45 with a .38 delta so a 150-point move would add 1.5x delta or .57 to the $1.45 so about $2.03 at 10,250.

    What have we done?  On drop in the Dow from 10,700 to 10,250 (just about 5%), we have "rolled" our 1/2 cover of 5 DIA Feb $106 puts at $2 (collecting $1,000) to A) 5 Feb $104 puts at $2 (collecting $1,000) and B) buying back the 5 Feb $106 puts for $4 (paying $2,000) and selling 5 Feb $102 puts at $2 (collecting $1,000).

    We still have the $1,000, which is just about enough money to roll our 10 Feb $108 puts up to the Feb $110 puts and now we have covers of 5 Feb $104 puts and 5 Feb $102 puts, which averages to a $7 spread on what was, orginanally a net $5.75 position. 

    We can anticipate that the 10 June $108 puts, which have a .65 delta, would rise, on an additional 150-point drop, from $7.75 to roughly $8.75 ($8,750) and they would now (at Dow 10,250) be fully covered by 5 Feb $104 puts at about $3 ($1,500) and 5 Feb $102 puts at $2 ($1,000) for a net of $6,250, up from our original net of $5,700 so not much of a gain on paper until the premiums you sold start expiring.

    The key is you now have, at Dow 10,250, $5.50 of intrinsic value and, if the Dow heads lower, you can add 5 more June puts (at a lower strike, probably the $103 puts at $5.80) to increase your downside delta by 50%.  This also sets you up to cash out 5 of the June $108 puts when there finally is a bounce, taking the profitable top of your spread off the table and reducing your long delta by 1/3 or more instantly when the market turns. 

    Roughly every 200 points further the Dow drops, you can add 5 more June puts at a $2 lower strike than you added last time and each time you add 5, you set a stop on the next highest 5 puts you have to lock in the gains.  This is a strategy that can cover you well to a 1,000-point drop (10%) at which point you would have 10 June $108 puts, 5 June $103 puts, 5 June $101 puts and 5 June $99 puts with the Dow at 9,700.  The 10 June $108 puts would be worth at least $11 and you would have a stop on them at $10.50 (a .50 trailing stop), taking $10,500 off the table on a turn, which is close to 2x what you began with. 

    That would still leave you with 15 June puts between $103 and $99 covered with 10 Feb puts at $104 and $102, probably about Delta neutral and you would have a stop on your 5 $103 puts, probably at $7.50 at $7, taking another $3,500 off the table and flipping the spread bullish withe the Dow recovering from a 1,000-point drop.

    Of course, many, many things can happen in between but it’s good to have a plan for the extremes because, hopefully, it keeps these little day-to-day moves in perspective.

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