By: Costas Bocelli — September 10, 2020
Before You Double Down on the Tech Wreck, Do THIS Instead…
F.O.M.O. The “fear of missing out”…
That’s what usually sucks most investors in right before a blowoff top.
And that’s exactly what happened after stocks just posted the best gains for the month in August in decades.
The S&P 500 Index declined -7%.
The Dow Jones Industrial Average fell -6%.
But where the pain was felt the most was within the technology-heavy NASDAQ Composite.
The NASDAQ Composite plunged -10% over the same three-day period.
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That marked the quickest correction (loss of 10% or greater) from an all-time high in the history of the NASDAQ.
The “Naz” has been the hottest index.
It's where you’ll find all those mega- cap technology growth stocks that have been driving big returns.
It’s been a heavily crowded trade, too.
Every Tom, Dick, and Jane with an e-broker account has been piling into these high-flying tech stocks.
So the conditions were ripe for a steep sell-off.
You see, right before the three-day slide that began in earnest on Thursday, September 3rd, the RSI, a popular momentum indicator, was above 80. (Above the price chart.)
That’s a level that screams OVERBOUGHT in the marketplace.
Now, there are several ways to work off the excess bullishness.
One way is for markets to consolidate or trade sideways for a period of time. That’s the most benign scenario.
The other way is for prices to decline.
Now, there are varying degrees to a market pullback.
This one happened to be a doozy -- particularly for those who arrived late to the party and bought in right at the top.
It’s always the F.O.M.O. crowd who take the worst of it.
Take Apple (AAPL) as a prime example.
AAPL is the most valuable and widely followed, publicly traded stock that just split its stock 4 for 1 on September 1st.
Before the split, it was a $500 stock.
Post-split, it turned into a $100 stock.
That made AAPL much more accessible to Tom, Dick, and Jane.
And like flies attracted to a bug zapper, all those investors piled in.
What came next?… zzzzzt!
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AAPL traded as high as $138 per share just before the three-day tech-led train wreck.
The stock made a low of $111, or a -20% decline from the peak.
As of yesterday morning, it was rebounding off of the lows at around $116 per share.
So those in the “F.O.M.O.” crowd who bought in near the top and didn’t get out are stuck in a major way.
I think we can all agree that it’s hardly a great feeling when a stock you own drops that much straight into your face.
But one of the most common trading pitfalls is “falling in love with a stock”.
If that happens, and if your “loved one” happens to turn sour, your first instinct could be to…
DOUBLE DOWN, right?
Doubling down is a double-edged sword.
On the one hand, it lowers the cost basis of the investment. You can buy more stock at a lower price and average down.
On the other hand, it increases your risk. You’ve essentially created a bigger position and exposed yourself to even greater losses to the downside.
Throwing good money after bad can make a bad situation worse.
I can’t tell you how many investors have gone broke by doubling down after a stock just suffered a steep decline.
So if you happen to be one of those investors tempted (or hell bent) on recouping a loss, then I’ve got the perfect solution. It will help get you “whole again” or even turn a profit without adding any more risk.
It’s a powerful technique that incorporates options along with your existing stock position.
Think of it as a "stock repair" strategy.
This repair strategy harnesses everything that’s great about options while also taking advantage of their benefits.
It’s called a Ratio Vertical Spread.
Don’t let the complicated name fool you. The strategy is quite simple and easy to learn. It's particularly useful when a long stock position has sold off, like AAPL just did.
And when you’re reluctant to sell and hopeful the share price will rebound.
Best of all, the technique carries minimal risk and, if structured properly, it can be put on for free or at a very minimal cost.
In fact, the example we’ll use to repair an AAPL stock position actually allows you to collect a cash payment.
Now how cool is that?!
When used as a repair strategy for a long stock position, the ratio vertical spread simply entails buying ONE slightly out-of-the-money Call and selling TWO higher-strike out-of-the-money Calls against it.
You’ll want to do this in the same expiration date (preferably 2-6 months out) while maintaining the proper ratio. The proper ratio is: For every 100 shares of long stock you wish to repair, you'll buy one Call option at the lower strike, and sell two Call options at the higher strike.
That essentially leaves you with a bull call vertical spread, plus an added higher-strike Call contract which you've sold. Even though you’re short that extra Call option contract, you’re still completely covered by the long stock position. So the total position is fully hedged.
So let’s take a look at Apple (AAPL).
As I mentioned, the stock was trading around $116 per share as of yesterday morning.
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In the case of AAPL, for every 100 shares of stock, you could look to buy one November 120 Call and sell two November 130 Calls to create the ratio vertical spread. With the stock recently trading around $116, the trade can be put on at no additional cost to gain the leverage.
In fact, the option trade sets up for a $2.40 credit! In other words, you get to collect $240 for every 100 shares of stock that needs repairing.
What this essentially does is give you additional upside potential (although limited) without having to pay for it, because you finance the vertical spread cost by selling that extra Call option contract. At the current prices, it sets up as credit, so you get paid.
The idea is that if the stock does indeed recover and trade higher, the option structure will act like a double stock position in between the two option strikes, magnifying your gains.
If the optimal result materializes, you’ll find that your repair strategy will have you exit the position as if you sold the stock at $140 per share, which would be above the recent all-time high of $138. The optimal price objective would be $130 -- or higher -- at expiration (November 20th).
So that means you’ll want the stock to trade above the short Call strike, which is your maximum profit gain and likely your position exit. At that point, not only have you picked up all the gains from the long stock position, but you’ll pick up the difference between the two option strikes for an additional gain.
Now, if the stock doesn't rally back up... well, then you’re essentially in the same position as when you put on the trade.
But you'll have incurred no additional losses from the option trade, because you’ll have laid out nothing to buy the 1x2 ratio spread. And you get to keep the $240 to boot.
You will face an opportunity cost, though.
Should the stock really take off and soar even higher, beyond the higher strike where you sold the Calls, your gains will be capped at that point and your stock position will be called away.
But hey, remember: This is a repair strategy. You use it when you find it hard to cut a position loose, feel stuck, or have the urge to double down.
Until next time!