No. of Recommendations: 11

It is sometimes difficult to describe all the reasons and thoughts behind a trade. It is also sometimes a little scary to post a trade with the thought that someone might piggyback and lose money because of a post. We all know the loss would not be the responsibility of the person making the post, but ...

A second problem is with posting trades is that people are usually much more eager to share success stories than bad trades. Bad trades are often more instructive, but they are less fun to talk about.

A third problem is that most are just plain not very interesting. My most common trades are selling naked puts and waiting for them to expire worthless.

Even with all the problems, however, I think sharing trades is something not done often enough and I will join you in requesting more people share trades. (You may have to to some searching, but there have been several trades shared on this board over time.)

To start things off, I will share a sequence of trades on Sycamore (SCMR) I have been doing.

First a little background on the stock. The are into fiber optics, an area that was being clobbered when I initiated the position 2/6/01. The stock had a very high PE ratio, but it was also in the process of transitioning from losses to profits. Normally that would make a high PE ratio much less meaningful, but with the slowdown of sales in the area it appeared quite likely that they would be dipping back in the red for a while. I read some information on one of their products, a dense wave division multiplexor, and though it was an impressive product. I also saw that the company, unlike some others, had plenty of cash to cover losses for some time, and had no significant debt. I also saw that short interest was not very high, so any significant short squeeze was quite unlikely. Even though I thought the stock would go down, I though implied volatility was too high, making option premiums too high. Finally, I had some margin debt at the time, so any cash I could apply to that debt would effectively pay me a higher interest rate than the "risk free" rate used in option pricing.

To top things off, shortly before I established positions someone on this board commented that only an idiot would short a stock and sell naked puts on it. I took that as an omen and/or challenge.

I established a position with three sales on 2/6/01:

I sold 800 shares of the stock at 29.25 for $23,400
I sold 9 strike 35 June 2001 puts at 10.75 for $9,675
I sold 3 strike 50 January 2003 LEAPS puts at 28 1/8 for $8,437.50
In total, I received $41,512.50 less commissions

If, as I expected, the stock went down I could expect to get assigned on all the options, giving me a liability of $46,500. The net impact would be that I would be long 400 shares for approximately $5,000 or $12.50 per share. That didn't sound bad for a stock that was selling for over $29. Selling deep in the money puts did mean that on a decline early exercise was a real possibility, but that did not appear to be a reason for any significant concern.

If, on the other had, the stock did rally my short stock position was protected up to approximately $40/share from the premiums I received. My expectation, if the stock got over $35, was that implied volatility would decrease dramatically allowing me to close all positions for a minor profit. If IV did not decrease enough I would be able to roll the June 35 puts up to a higher strike and collect some additional time premiums for limited additional protection.

Remembering option arithmetic, selling a stock short and selling a put is a synthetic naked call. Instead of shorting 800 shares and writing 12 puts, I could have had an essentailly identical position selling 4 naked puts and 8 naked calls. Don't ask me for a good reason for not choosing that alternative because there isn't one.

Because of the high IV on the options, the delta on them was lower than you might have expected simply comparing the stock price to the strike prices. Overall the position had a delta of a little below negative 100.

As it turned out, I was very right about the price of the stock dropping and quite wrong about the magnatude of the drop. As the stock kept dropping my delta kept going up. By the time the stock got down around $7 per share, my delta was approaching positive 400.

On the way down, I considered selling some additional (real or synthetic) naked calls to hedge against further downside on the stock. I decided against doing so because I still thought it was a good company, naked calls still scare me more than naked puts even though I believe that they really are not that much more dangerous, and I considered the $5,000 at had at risk on the downside was within my comfort range. If I were a purer option player as opposed to a mixed stock and options player I almost certainly would have made some kind of adjustment well before the stock reached $7.

Around $7 per share the stock started to show a little strength, probably what would be called "support" in TA circles. On 4/3/01 I covered my 800 short shares at $7.6875 per share, or $6,150. Obviously I had transitioned into a pure directional position, raising delta from ~400 to ~1200. The next day, 4/4/01, I was assigned 6 of the June 35 contracts, so I bought 600 shares for $35 each, of $21,000. After these two transactions my position consisted of:

$14,362.50 cash credit
3 short June 2001 strike 35 puts
3 short Jan. 2003 strike 50 LEAPS puts
600 long shares SCMR

My delta was still around 1200. Note that I would far rather be assigned shares than buy back the options because I avoid the bid/ask spread penalty.

As it turns out, my timing was pretty good. The stock continued to climb to about the $10 level. It then started to drop again. On Tuesday, 4/17/01, at about $9.00 I became a little less complacent about the 1200 delta. I also was assigned the 3 LEAPS puts, so I bought 300 shares for $15,000. I decided to "exchange" the 900 shares I now owned for May puts at 7.50. I got $8.99 per share, or $8,091 for the stock and $0.60 per share, or $540, for the options. As of Tuesday night my position consisted of

$7,993.50 cash credit
3 short June 2001 strike 35 puts
9 short May 2001 strike $7.50 puts

In case you slept through Wednesday and Thursday, my choice to lower my delta risk on Tuesday looks like a pretty bad piece of time at this point. Still, given the amount of time before May and June expirations, I am not uncomfortable with the decision. Someone forgot to tell me that Chipzilla (Intel) profits would look "good" and Mr. Greenspan was going to lower interest rates.

Assuming I make no further adjustments to my position, the most likely outcomes in order of likelihood are:

(1) The May puts will expire worthless and I will be assigned on the June puts, causing me to buy 300 shares for $10,500. Given the $7,993.50 credit I still have, that will make the net cost of the shares $2,506.50 or $8.35 per share.

(2) I will be assigned on both the May and the June puts, causing me to buy 1,200 shares for a total of $17,250. Once again subtracting out the credit that would be $9,257.50 or $7.71 per share. Right now with the stock around $11.00/share that looks pretty good, but if I am assigned on the May puts the stock price will have dropped to the point it will look bad.

(3) If, by some miracle, I am not assigned on any of the contracts I will pocket the $7,993.50 credit I currently have. Stranger things have been known to happen, but somehow I doubt that it will happen this time.

I am certainly not ruling out any further adjustments, but I do not plan any more at this time. If I do adjust, it will most likely be done by selling 3 calls.

I have not included transaction fees in the above calculations. With 8 transactions at $25 each, they total $200. Between the interest I would have paid on the margin debt I had before I initiated these position, and the interest I have received on the credit balance I have had because of these positions, I have more than covered the transaction fees.

As an aside, some of you may think the size of these transactions represents bigger-league trading than it acutally is. Even though the post contains numbers like $23,400 and $46,500 those numbers were not representative of my risk. On the downside, my biggest risk came when the stock was about $10/share and I had a delta of about 1,200 and a gamma of about 0. If the stock had gone to zero I would have lost $12,000. However, the chance of a company with a lot of cash (and a very low burn rate) in a high-growth industry going to zero within a few months are pretty remote. On the upside, when I initiated the position I had a theoretically unlimited upside risk. However, by selling in the money puts I gave myself a cushion to protect me from a 34% increase in the stock price in a troubled industry in a bear market, even without making any adjustments. The risk was real, and I do not want to discount it, but it was a risk I felt comfortable assuming. On course, I would have done really well (had a profit of soughly $17,000) if I had simply shorted the stock and not sold the puts, but that risk would have been too high for my comfort level.

Finally, I am not trying to present this as a great of even a particularly good series of transactions. There is still a significant chance I will have a loss when all positions are closed. I might like to think of "closing the short stock position going into a rally in the stock" as skillful trading, but in reality there was a lot more luck than skill. In posting this I hope to generate some feedback, particularly suggestions of ways I might have made better adjustments. Some of you know I am not too shy about being critical of other people's trades, so don't worry about being critical of mine.

Good Luck,
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When Life Gives You Lemons
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