SURVIVING THE GAME
OCTOBER 7, 2008
2008 - 2

This is another newsletter, rushed out to try and help during these extreme market conditions. Today marked yet another serious down day on North American markets in particular. I spoke with several readers today, which has prompted this letter.

The point I am trying to make today is that there are several options for you in these current market conditions. You may be in one of three situations. 1) You are sitting with high cash levels, riding this out – congratulations to you and/or your advisor. 2) You are a long-term investor, still fully invested, suffering losses and riding this out – this to shall pass. 3) You are somewhere between 100% cash and 100% invested, losing some or a lot of money, worried as heck and looking to do something…whatever something may be! My concern is for those of you in situation number three. What to do?

This is meant to show readers that they have many options, not just buy, sell or hold.

I am going to give an example using RIM, Research in Motion for those not familiar with this equity. This is a classic example of a market darling that has fallen on hard times. It closed today at $60.93, -$5.07 today alone. This was a $150 stock in June this year. RIM hasn’t seen $60 since June 2007. What happened? If I knew, I would be writing this from my new yacht parked in Monaco. Was I in this? No. As recently as last month this stock was touted by many as a screaming buy at $100. Their new products were an Apple killer….blah, blah, blah. Well, things haven’t panned out that way. IF, I had been fortunate enough to be in RIM, I would have been stopped out of my final 1/3 position around $100.00. The example I am giving is for someone who is either holding the stock currently, long or short term, or someone looking to enter the market here.

RIM
$60.93 -$5.07

Options:

A) Buy stock here ( or hold your current position ) If I was holding 200 shares, I would sell ½ here and follow this option. If this is your choice, here is my advice. There is no way to know if $60 is the low or not. If you buy here, buy only a maximum of ½ your desired position. I would be using a stop around $45 as that is slightly below the price that RIM had it’s breakout towards $150.00. Place a buy-stop order to purchase the other ½ position at $100, this shows that the recovery is for real and you have some breathing space between your entry points and stops. You are now 100% long at an average of$80.00. I would then hold trailing stops of $10 on ½ position and $20 on second ½ from recent highs. If it goes up, great. If it collapses again, your out with a small profit, on to the next trade. This is the simplest way to trade RIM. Very easy to execute, very easy to figure out how much you will make or lose.

Profit/Loss based on 200 share position ( bought in 100 share increments at $60 and then $100 )

Closing price Gain Loss

$40 -$2100
$50 -$1100
$60 -$100
$68 $700
$80 $1900
$90 $2900
$100 $3900
$110 $5900
$120 $7900
ETC

B) Covered call option writes. This the most conservative, most often used trading strategy to enhance gains and offer some downside protection. This entails purchasing the stock here at $61.00, and simultaneously selling 1 call option for each 100 shares purchased. For the sake of time I will make the assumption that we do not reach $100 per share before mid-March 2009 ( five months from now ), therefore you only ever purchase ½ your position which is 100 shares. After purchasing the 100 shares at $100, you then sell one March 2009 RIM $68 call option at $11.00 which equates to $1100.00. This is now your position. You own 100 shares at $61, you have collected $1100 from an unknown, unnamed option buyer. That equates to $11 per share. Your actual purchase price is now $50 per share, not $60. What happens now? Here is the breakdown.

Closing Price Gain Loss

$40 -$1000
$50 $0
$60 $1000
$68 $1800
$80 $1800
$90 $1800
$100 $1800
ETC

As you can see, compared to simply being long the stock, you are substantially ahead at all price points unless we rally above $80.00. At that point you have given up the potential gains above $80 for the safety of not losing anything until we drop below $50 and essentially being paid if the stock is flat or even declines slightly. For those not familiar with options, the final result of this is that if RIM rallies above $68 by mid-March, you will be selling your 100 shares to someone at $68 per share. You get to keep the $1100 collected at initial sale. That is how we arrive at a profit of $1800. $700 gain on stock ( boughtt at $61, sold at $68 ) plus $1100 gain on option.


C) Ratio call write. Similar strategy as above but involves potential risk of loss if stock explodes to upside. Here is how it works. Purchase 100 shares here at $61.00 Instead of selling 1 March 2009 $68 call at $1100, you sell 2 March 2009 $80 calls at $740 each. What happens next? You own the 100 shares, you have collected $1480 from selling your 2 options. Therefore, your actual purchase price is reduced from $61 per share to $46.20 per share. You are also obligated to sell your 100 shares at $80 if we are above $80 in mid-March 2009. As a kicker, you start to lose on the second option you hold if RIM rallies above $87.40. Bearing in mind at $87.40 per share you have already pocketed $2640 profit on your 100 shares and 1st $80 call. Here is the breakdown.

Closing Price Gain Loss

$40 -$620
$50 $380
$60 $1380
$68 $2180
$80 $3380
$87.40 $2640
$90 $2380
$100 $1380
$110 $380
$120 -$620

Again, this does not show buying the second 100 shares at $100, this will alter the profit/loss above $100. It reduces the loss with RIM at $120 from a loss of $620 to a gain of $1380. As you can see, this strategy offers even greater downside protection than option B. It also has substantially higher profits compared to option A and B unless we rally above $85. Again, you are sacrificing potential profits way up there for cold hard cash now, downside protection and much higher profits if we are flat to slightly higher.


D) Here is one most of you have probably never dreamed of. Instead of buying any stock, just sell Put options !!! Here is how it works. At the close today, the RIM March $58 put closed at $11.00 That means if you sell 1 option, you get $1100. You are now obligated to purchase 100 shares of RIM at $58 per share in mid-March if we are below $58.00. BUT, you get to keep the $1100 no matter what. That means that you have effectively bought the 100 shares at $47.00 per share no matter what the price is. If we are above $58, you pocket the $1100. If we are at $40, you are now long at $47 and losing $7 per share or $700. Here is the breakdown
Closing Price Gain Loss

$40 -$700
$50 $300
$58 $1100
$60 $1100
$68 $1100
$80 $1100
ETC

As you can see, this is great strategy for a slightly down to up market. Unlike option C, there is no risk of loss on a huge rally but your gain is limited to the $1100. This is the ideal strategy for someone who really wants to own RIM for the long term.

E) One final example ( there are many more ) Combine option C and D together. This is really cool. Here is how it works. Buy 100 shares here at $61. Sell 2 RIM March 2009 $80 calls at $740 each AND sell 1 RIM March 2009 $58 put at $1100. You now own 100 shares, have collected $2540 in option premium ( cash ). You are effectively now long 100 shares of RIM at $35.60 per share and we are at $61 per share. You are obligated to buy another 100 shares at $58 if we are below $58 in mid-March, you are also obligated to sell your 100 shares at $80 if we are above $80 in mid-March. Obviously only one of those can happen, we cannot be below $58 and above $80 at the same time. And remember, we also have the 2nd March 2009 $80 call we sold. Clear as mud I bet. Here is the breakdown.


Closing Price Gain Loss

$40 -$1360
$50 $640
$60 $2440
$68 $3240
$80 $4440
$90 $3440
$100 $2440
$110 $1440
$120 $440

Again, this does not show buying the second 100 shares of RIM at $100. That increases the profit above $100 by $100 per $1 eg. At $120 the profit is now $2440. This is hardly a common strategy employed by your average investor. Most investors, their brokers, friends, family and shrinks would all consider this an insane thing to do. BUT, look at the numbers for yourself…..does it seem insane to you??


I will wrap it up here. I just wanted to open Pandora’s Trading Box a crack and let you see what is inside. This is but one example of how to do essentially the same thing…buy RIM, but with numerous different possible outcomes. I personally am not in RIM and would not get long here, not yet. These examples are for someone in RIM now or considering getting in soon.
The markets are NUTS. The Fed is scrambling to save the free world from itself. If I were heavy into only equities I would liquidate ½ and stand back. You can always get back in. There is a chance, slim as I see it, that we may fall another 20% or more before seeing the bottom of this decline. If they can’t get the credit markets to loosen up, watch out! I honestly think we are close to the bottom but I am more comfortable getting in on the way back up than standing in front of the freight train headed south.


Options Guy
Editor
Surviving The Game
optionsguy@shaw.ca