There’s many articles written on how to “repair a broken stock” out there. Click here for a good recent example from The Motley Fool. They instruct you to buy one ITM call (one for each 100 shares you’re long), and sell 2 OTM calls. The only problem with this strategy is that it still leaves you with lots of downside risk. The above mentioned article states if the underlying goes down all options expire and you lost just your commissions, try again and unfortunately your underlying’s value has lost even more.
I like to protect myself a little more than that to the downside, even if I’m bullish (why else would I own the stock?). The easiest way to protect a stock from downside risk is to buy a put. Buying a put makes me short theta which I hate. I feel there is only one thing that is guaranteed in the market, time will pass. I want to be long Theta whenever possible. So, how do I offset the cost of my put and get short theta?
First I want to make my predictions as to where the underlying will go. Second, and equally important, I predict what IV will do.
Looking at the daily and weekly charts (click any picture to enlarge) with volume profile, I’m predicting PCP will stay in a range with support at 102 and resistance at 120. Earning are on 7/22/10 and historically, it has not made major moves after earnings. Volatility has also been in a range for some time and historically, Vol drops but not much after earnings.
Using the above predictions, I want to create a trade that profits if PCP stays in a range, and if Vol stays the same or drops.
Here’s the trade.
- I own 100 shares of PCP, currently trading at $107.79. (My price is $121.40)
- +1 Sep $105 put.
- +4 Sep $120 call.
- -5 Sep $110 call.
The P&L looks like this for the long stock (obviously) below:
The P&L looks like this after I added the options, below: Notice that this trade is ‘profitable’ in the range that I anticipate. If the underlying stays in the range as I predict, my trade that is currently around -$1,400 will be -$300. Then in Sep, I can put on a similar trade again as long as my predictions have not changed. I now have a limited risk trade that I can manage or stop out if PCP should rally hard. Synthetically, you’ve created a broken wing butterfly (long stock and long put is long call +1 $105call / –5 $110 call / +4 $120 call).
Also, the Vega is pretty neutral. At first glance at the chart of Vega it looks exactly the opposite of what you want. It’s short Vega to the downside and Long Vega to the upside, however, with further examination, you’ll notice the largest value for Vega is +/- only $26. See below:
As usual, I’ll keep you posted as to adjustments and management.
* Here’s an idea for discussion based on the above. You can use this strategy to put on a bearish synthetic broken wing butterfly and own shares of your favorite dividend paying stock.