For those of you that have signed up as members of my new trading service "The Trend Rider", you have probably heard me talk about Google's failed attempt to break it's resistance around $319.
I haven't had the... um, guts, to recommend the Bear Spread on Google. But what I will say here on the record is that I have been watching the stock try to break through $319 - $320. It has tried to break through 3 times and has failed.
Now I don't know if it will break out or break down, but this price range is a sensitive one. Meaning: if it can break out with big volume, it will probably trade much higher, but if it fails a fourth time, the point of resistance will be an even stronger one.
Also, energy has had a pretty nice run here. We could see energy prices backing off soon. If that happens, it will likely spark an upwards movement in the market which, depending on how strong the move is, could really help Google rally higher.
Again, I'm up in the air on this, otherwise I would have made a call.
If I had launched The Trend Rider 6 months ago, I would have owned the stock and I would definitely be recommending that you sell the calls on this thing again. I would even consider implementing an "Equity Collar" where you sell the calls and also buy the puts with the same expiration month. You would typically do both trades one series out of the money.
Selling the calls of course only reduces your downside by a small amount. It's a good way to make an extra few percentage points if the stock trades flat or higher. On the other hand if you want to LIMIT your downside, with some extra upside potential if you are slightly bearish on the stock, the "Equity Collar" is the way to go.
I'll give you an example and if you aren't familiar with the strategy maybe you can implement it in stocks that you own other than Google. This is what you would do if you own a stock that you think may trade lower, but you don't want to necessarily sell it for some reason such as a tax liability.
Google (Symbol-GOOG) is at $318.00 right now.
If you own the stock, the way you would implement this strategy would be to decide on the month that you want to be protected until, while keeping in mind that for the period that you are protected, you are also limiting your upside. If the stock rallies, you will have to sell it at the strike price of the calls that you sold.
Once you decide how long you want this protection you should implement the equity collar with options that expire at least a couple of months further out.
I'll clarify: Let's say that you think that between now and November Google may trade higher, but also it has a very good chance of taking a dive. You don't want to sell it today in October 2005 because you bought it in mid November 2004 and you want the long term tax benefit, which would net you a significantly larger after-tax profit.
- Sell the January $330 calls which are at $18.00 (notice that the $330 calls has a strike price ($330) that is 10 points "out of the money," which in this case is one "series" out of the money.) This means that I am selling someone the right to buy my Google stock at $330.
- Buy the January $310 puts which are at $16.00. When you do step one, you will take in $18.00 per call (remember: Options typically represent 100 shares of stock. If you own 1000 shares of Google, you would sell 10 calls, and buy 10 puts.) You will be using the money that is deposited in your account for selling those calls, to buy the puts which are at $16.00 which gives you a credit of $2.00. The puts are essentially free.
What you have done here is limited your downside risk to 8 points while giving your self the ability to make an additional 12 points (if you get "called away" at $330.)
The reason that we use an "equity collar" that expires a few months further out is incase the stock trades much higher than $330, the chances of your being called away from your stock position before your tax consequence becomes long-term, is significantly reduced.
The three possibilities:
- The stock trades over $330- If the stock is at least 25 cents over $330 at the time of expiration you will be "called away" (have to sell your Google at $330, 12 points higher than today's price.) This is a positive because it is better than selling the stock at today's price out of fear of the stock trading lower. Here you make an extra 102points and you will most likely avoid the short term tax consequence, which is your second positive.
- The stock trades under $310- If this happens, you own the puts which should be worth one point for every point that the stock has traded under $310. So if the stock trades to $290, your puts will be worth $20.00. (At this point, you can either use the put contract to sell your stock at $310 even though Google trades in the open market at $290, or you can simply sell the puts at the market price of $20. If your reasoning was to avoid the tax bite, the first choice would make more sense.) In other words, no matter how low Google trades, you are only exposed to 8 points on the downside.
- The stock trades between $310 and $330- If this happens you have a couple of options. You can let the options expire worthless which you would make a small 2 point profit on, which is the difference between the sell of the call at $18 and the purchase of the put at $16. The other option: if you don't feel the need for the equity collar any longer at any point, and the stock has traded a bit lower in the interim, your puts may have traded higher, and the calls may have traded lower. If so, you sell the puts that you own, and buy back the call that you sold, and make a profit on the difference.
No matter where the options are, you can always undo your implemented equity collar by buying back the calls that you sold, and selling the puts that you bought. You are never locked in.
That is what you might consider doing if you want to hold a stock that you think will trade lower. There are a few reasons for doing this believe it or not.
You should also consider getting in the habit of selling calls on all of your stock positions. Unless the market is similar to the markets of 1997-2000 selling calls is always a great idea. Sometimes it will work better than others but if you get in the habit of doing it constantly, your portfolio's over-all performance should improve significantly.
In today's market, the trend for a company reporting good earnings has been to pop, and then regress back down to the mean. When these stocks pop on good earnings you most likely are presented with a big opportunity to sell the calls and take in a big premium. Anyone who is not familiar with the strategy needs to become familiar with it immediately because they are really missing out.
Chief Investment Officer
Technical Analysis Millionaire