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The End Game to a Powerful Strategy Revealed

By Costas Bocelli September 26, 2012 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Today we’re going to forget about the riots in Spain.  There won’t be any mention of the massive general strike that shut Greece’s economy down yesterday.  We’re not even going to discuss the market ramifications of the Fed’s QE-Unlimited program.

Nope, today we’re going to focus on the primary reason we at IFII write The Tycoon Report -- offering financial education to help you become a better investor.

Over the past couple of years writing in The Tycoon Report, I’ve shared various options strategies and techniques that you can apply to your own investing goals.

And whether you’re an experienced options trader or a totally newbie investor who simply wants to learn more about the benefits of options, my responsibility is to share with you all my knowledge and experience from trading options professionally for nearly seven years.

So, today is going to be an options education lesson, and you’ll soon discover one specific way that options can benefit you.

I chose this particular week for this lesson is because I actually shared this powerful options strategy with you four months ago.  And the strategy involved the use of September dated options that just expired last Friday, September 21.

It was a repair strategy for your stocks using options.  It can be used in instances where you get caught holding the bag after an unexpected drop in the price of your stock -- usually a significant gap to the downside that gave you no chance to react.

Now that the position example has run its course over these four months, you’ll get to see the endgame and result, which should help you to understand and reinforce what this strategy is trying to accomplish. 

When I first shared this strategy with you, it was indeed timely and the future was unknown.  What I did know is how the strategy could benefit me and all the potential scenarios that could have resulted.

If you were to ever search for a text book example of how to structure and produce a successful outcome using this repair strategy, you may want to warm up your printer and save this as a case study.

A Whale of a Repair Strategy

In my Tycoon Report article dated May 17, 2012 -- One Simple Secret for Turning Losers into Winners -- our example focused on the recent plunge in JP Morgan Chase (Symbol: JPM).

The stock gapped down and heavy selling pressure ensued when the CEO abruptly revealed that the bank had suffered large proprietary trading losses.

If you have not read that previous article, please click on the article link and read it now.  And if you recall reading the article when it was first published, then I want you to also click on the article link and re-read it.

Don’t worry... I’ll wait until you finish it.

(Done yet?  No?  OK, no rush.  I've got time.)

Okay, now that you’ve done your homework, let’s move on.

If we owned 100 shares of stock in JPM around the time of the unfortunate announcement, we’re not all too happy with our investment.

When we looked at this mess that we were facing, the stock was trading 35.46, a drop of 13% alone from the gap move down.

 

We then weighed our choices:

We could simply take a quick, reactionary (and likely emotional) approach, and sell the stock at depressed levels.  But we pondered that, after a significant price decline, this might not be the best option.

We also considered holding the stock and letting the dust settle, which could be a better option.  We argued that the bank is still best in breed and most likely to recover because of its long term prospects of profitability.

What about the dollar cost averaging approach -- buying more shares, creating a larger position and more risk?  We talked about that particular option too, but we thought that could be too risky for the average investor, especially with all the uncertainty and unknown extent of the monetary damages.

So what to do?

If we’re going to hold the stock looking for it to recover, why not do something about it without incurring more risk?  So we reached into our investor tool kit and pulled out an options repair strategy, the 1x2 ratio Vertical Call spread.

We structured it with a realistic potential outcome by time and strike prices.  We properly position-sized the strategy by buying ONE slightly out-of-the-money Call and selling TWO higher strike out-of-the-money Calls against it (with the same expiration date) for every 100 shares of JPM stock that we owned.

We also did not commit more money or more risk to the existing position, since the repair strategy -- if structured properly -- is executed virtually for free, or even returns a small initial credit in many cases.

And, as a result, we crafted our repair strategy.

We bought 1 JPM September 37 Call and sold 2 JPM September 40 Calls for every 100 shares of stock that we owned.  We also executed the trade for a small credit of 0.04 -- or, we took in $4 for every ratio vertical spread.  (If we owned 1000 shares of JPM, then we would have bought 10 JPM Sep 37 Calls and sold 20 Sep 40 Calls against it and received a $40 credit.)

What we did is essentially create the potential for additional upside super charged gains if JPM traded back up above 37 at September expiration, while not adding any additional risk to our original stock position that we chose to hold.  However, the high octane we built-in is capped by the width of our spread, in this example, to 3 points.

The Textbook Endgame

Now let’s fast forward to the present and see how this repair strategy performed.

On expiration, September 21, JPM stock closed at 40.88 which triggered our September 40 calls to be assigned -- meaning that we had to deliver 200 shares of stock at 40.00.

We had 100 shares of long stock that we physically owned and had to deliver.  The other 100 shares are also covered.  Not by any stock, but by the 1 September 37 Call that our broker would automatically exercise on our behalf.  The result offsets the additional assignment while realizing the super charged maximum additional gain of $3 from our exercise of JPM stock at 37.00 per share.

Essentially, we are left with no residual position and have profited as if we sold out at 43.00 per share on September 21 instead of the stock’s closing price of 40.88.

This is indeed a textbook example of how you can use the ratio vertical spread as a stock repair strategy.

Options are very versatile and can be utilized in many different ways to offer you numerous benefits.  Some option strategies are relatively straightforward, while others like the ratio vertical spread can be more complex to understand.

Here at IFII, we offer several options education products that can suit your investment needs whether you’re in search for income, protection, growth or speculation.

Please visit our website at www.IFII.com or call 877-489-2666 to learn more about options.

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