If Volatility Has You Feeling 'Upside Down,' Here Are Some Options
The volatility is enough that many traders, especially newer traders, may find themselves in an unfamiliar and potentially uncomfortable position of: "The Upside Down."
Sure, a bunch of middle schoolers from "Stranger Things" managed to survive "The Upside Down" for three seasons, but I bet they'd struggle in the current markets. If you find yourself in a position with an unfortunate cost basis, but aren't looking to take the loss, you do have other approaches to consider beyond the old sitting on your hands.
I see two primary approaches to consider: Repair or hedge (a.k.a. - stop the bleeding). Here, I'm going to focus on the repair idea, and a subset within the strategy.
Repair strategies will focus around lowering your cost basis or break-even point. There are several approaches, but I want to take a quick look at the two most common: The covered call vs. the ratio call spread. These aren't the only two approaches, but if you are unfamiliar with repair strategies, this is where I would begin.
Let's approach this assuming we hold 100 shares of a stock, and go through a real-life example. I'll use Advanced Micro Devices (AMD) . With the stock sitting around $30, trading down $5 from recent highs, it is probably an actual situation for some traders.
Let's assume we picked up 100 shares last week at $32. That $3,200 investment has declined to $3,000. Furthermore, the stock looks vulnerable below $29.25, so we have some concerns about additional downside. Here are some ways to approach the position.
Covered call: An investor could sell a call against her 100 shares. In exchange for a premium, the investor sells the right to someone else to buy the stock from her at an agreed price (the strike) for a set period of time (option expiration). If the option is exercised, the stock will be called away (sold at the agreed price). If the stock is not called at expiration, the investor will keep her shares.
In either scenario, the investor will keep the premium. In this example, the investor might consider selling the Oct. 18 $32 for $1.48. This would generate $148 in income and lower the net risk to $30.52 per share. If the stock is called, the investor will receive the same $3,200 she paid for 100 shares and will keep the $148 premium. If the stock is not called, the investor keeps the premium plus the stock. The maximum loss is $3,052.
Ratio call spread: Think of this as selling a covered call, then using the proceeds to buy a call spread. In this case, the investor could buy 1 Oct. 18 $30 call for $2.34 and sell 2 Oct. 18 $32 calls for $1.48 each, or $2.96 total. The investor would receive $62 in premium. While the investor does not receive as much premium, the $30 long call creates an interesting wrinkle.
Our cost basis only drops to $31.38 in this scenario vs. $30.52 in the covered call scenario, but our break even is actually $30.69. Why? Well, it's that long call. If AMD finishes at $30.69 on Oct. 18, then our short $32 calls will expire worthless while the long $30 call will have a value of 69 cents.
Therefore, the current price $30.69 plus the gain of 69 cents on the $30 call, plus the premium received of $62 equals $32, the same as our initial entry. However, if AMD rises to $32, then the investor will break even on the initial stock purchase, gain $200 thanks to the long call, and still have the $62 premium.
Therefore, the upside is now $262 in this scenario vs. $148 in the covered call scenario.
Overall, it comes down to your bullishness and view on the stock. The covered call will pay more income ($148 vs. $62) and lower your break even ($30.52 vs. $30.69). The ratio call spread pays less income, but raises upside potential ($262 vs $148) without changing the break even price too much (17 cents). One isn't necessarily superior to the other. The decision should come down to a trader's risk tolerance, time frame, and view on the stock and/or overall market.
At the time of publication, Timothy Collins had no position in the securities mentioned.