Rather than talk about how Google fell again (down 3.97%), Apple fell again (down 1.57%), the retailers fell (RTH down 1.83%), the Bank Index dropped 4.11%, the Dow dropped 108 points and the NASDAQ dropped 30 points [Aside: the good news is FXI broke bullish], we decided to give a blow-by-blow of a trade that still managed to make money, despite an initial screw-up! We hope it will prove educational.
When you see how we trade and how Phil trades, you will certainly spot differences, but you will also see a most important commonality: We have trading styles that works for us; we each have a plan, and we stick to our respective plans – even when everything goes horribly wrong! The trade we will discuss here is a bull put spread trade that we issued on December 23rd.
December 23rd: The NASDAQ climbed 51 points to close 9 points shy of 2,700. The Dow rose over 200 points to close at 13,450 and the NYSE Euronext had risen aggressively over the previous three trading days to close at $89 per share, having risen $2.10 for the day.
Since the stock was overextended in the short-term, a pullback was not out of the question. We didn’t want to chase the stock higher so we employed a bull put spread using strikes 85 and 80. The trade was filled as follows:
Jan08 short put strike 85, Credit = $1.64 per share
Jan 08 long put strike 80, Debit = $0.71 per share
Net credit = $0.93 per share, Risk = $4.07 per share
It appeared as if we had no sooner entered the trade then the stock took a U-turn. Have you ever bought a stock and had it drop the next day, and the next day, and the day after and the day after that? We know the feeling! By January 18th NYX had dropped almost 20%.
As our french friends would say "Quel Desastre!" Disaster indeed! But like our favorite french investigator, Hercule Poirot, we resolved to find an answer to the puzzling mystery which was "How to produce a profit from a seeming disaster?"
Thankfully we have been in this situation in the past. How many can honestly stand up and say they never picked the wrong direction before? (Our hands are down!). We can confidently say that even when picking the wrong direction initially, we can still transform losing trades into profitable trades and that’s what we did.
On January 18th, we sold our January 08 long put for $8.00 per share, banking a gain of $7.29 on that option alone. If you ever thought to yourself "Should I enter a naked put or spend a little on a long put way out of the money", this example should provide the answer. Although the stock was at $89 at the time we entered the long put at strike 80 and only cost us $0.71, it gained in value over 1000% and ended up saving our trade in the end.
We had little choice but to take assignment on the short put at strike 85. In the assignment process we pocketed the short put credit of $1.64 over expiration weekend. We were now the proud owners of NYX at $85 per share with the stock trading around $72 per share. Seems bad but remember our cost basis was NOT $85 per share. We had banked $7.29 from the long put sale and we had banked $1.64 from the short put (during expiration weekend assignment).
In short we had a cost basis of $76.07. Not great admittedly. It was still higher than where the stock was…but much better than $85 per share! We weren’t done yet. Although NYX was way outside its lower Bollinger Band, this was the time when a global market meltdown was hitting news headlines, when recession fears were rampant, when the credit crisis was panicking traders. We decided to protect our stock with a long put in March at strike 70, which cost us $4.85 per share. That increased our cost basis to $80.92. This bought us protection for a few months and time for the stock to settle or reverse direction.
By January 29th, the stock had indeed reversed: it had risen almost as fast as it had initially fallen. But we noted to members that the stock was hitting resistance levels and thought the prudent action was to enter a short call against our stock position. We wanted to make sure that if the stock did keep rising that we would still make money on the overall position so we took in a credit of $1.21 per share at strike 85. That reduced our cost basis down to $79.71.
As it turned out, the stock kept rising and soon we were left with a big decision. With earnings due to be announced before the market opened on Tuesday February 5th, do we hold the position or take profits? Do we potentially hold out for a gain of just over $5 per share or risk almost $10 in the process? The answer was clear. As we have seen on many occassions this earnings season, earnings can move a stock wildly up or down. Certainly, earnings could be phenomenal on Tuesday morning, but it could also send the stock crashing back down to $70. With 20:20 hindsight it will all seem SO obvious, but ahead of the call it’s not worth gambling. It’s much easier to trade the stock after earnings is announced. Moreover, there is a lesson that we adhere to strongly which is when we totally screw up, we are happy to get our money back and making a profit is a happy bonus. In this case we bought back our short call for $2.23, sold our long put for $1.64, thereby capturing remaining premium in it, and we sold our stock for $82.08, which resulted in an overall profit of $1.78 per share.
It wasn’t pretty, but it was approximately twice the original bull put spread target profit and only took an extra few weeks to bank. We had made money despite the market moving completely against our original expectations. In this tough market, we are not particularly proud of getting our direction wrong but we hope that by seeing how we squeezed out a profit, perhaps it will help you in your trading.
We wish you a Tremendous Tuesday!
