25 April 2007 – Normally I don’t speak much of option plays as my investment course, maalamalama, focuses on long term plays that will yield phenomenal gains by identifying low risk- high reward opportunities. Occasionally, I will purchase options merely for the chance of supplementing the total returns of my portfolios when the same low risk- high reward scenarios present themselves. Two options that I currently hold recently took a turn for the better. These plays are puts on GM and calls on BIDU. Below you can see the BIDU chart. !!BIDU@@ Given the near 30% drop in BIDU’s stock price, I thought BIDU presented a good risk-reward setup for a strong bounce. Therefore when BIDU showed some level of support at its 200 SMA of about $98 a share, I purchased calls on the stock. I was aggressive in purchasing May 100 calls as the stock really looked poised for a bounce. Yestereday, I sold half my position for 50% gains. The promising development yesterday is that BIDU broke through its 50 day SMA resisitance level of 101.62. The danger in buying this option now is that it has a tight frame until expiration, is already up 50%, and earnings will be released this Thursday. If earnings are positive, then this option play will increase significantly more. However, if earnings are less than eye catching, this option play could quickly fall out of favor. It’s always risky to buy any type of option before an earnings announcement so I may even decide to unload the rest of my options before the earnings announcement depending on how the stock trades on Wednesday.
With GM, if you look at its chart !!GM@@
I decided to purchase Jun 30 Puts at $1.30 a contract a couple of weeks ago due to the low risk – high reward scenario. My thinking behind making this transaction was as follows. I admittedly missed out on some potential huge gains by not playing put options on subprime lenders during the subprime lending fallout. However, I don’t believe that the fallout is yet over,and accordingly, I searched for ways to still capitalize on the continuing fallout. GM was a company with four factors working against them:
(1) significant subprime lending exposure;
(2) cloudy, convoluted direction and statements from management (never a positive thing);
(3) a business on the downturn; and
(4) a clearly formed bearish wedge in the midst of a downtrend.
These 4 factors, on top of a strong possibility of a downturn in the near future in the U.S. markets in general all added up to a low risk- high reward scenario for GM puts. This week, GM broke sharply below its 50-day SMA support line of $31.37 a share, again a good sign for a continuation of its downfall in share price. Admittedly, during the past week and a half of holding these puts, I was down about 20% several times in my position, and am now, only up a modest 14%, but the outlook looks bright for this play to be a solid winner as well.
So as those who follow my blog know that I don’t aggressively trade options and only engage in option plays when the time is right, here are my rules for engaging in option plays.
(1) Always look for a low risk-high reward setup, just as you would when buying a stock or asset class or regional market. If this doesn’t exist, stop considering entering any option contracts.
(2) Once you have found this, always look for a sign (the easy indicators to use on option plays are support, resistance, or a break through of share price at the 50-day and 200-day SMAs) that the stock is ready to break one way or another. Given that this is the case, I rarely buy options more than two months out as I’m looking to take profits or cut losses in a short time frame.
(3) Finally, don’t get greedy. Typically, I like to be in & out of option plays in a time frame no longer than two weeks. This is why I look for a sign that the stock is ready to break one way or another. I don’t like holding on to options for any length of time. Occasionally I’ll stretch this time frame to three weeks. Why? The longer you wait, the more can go wrong.
Also, as occasionally happens, if within 3 days, I find myself sitting on a 60% or 70% profit, more times than not, I’ll take this profit. Again, many times I’ve been too early in taking profits, perhaps settling on a 70% profit when a 150% profit was possible. However, I believe the way to consistently ensure that option plays supplement, instead of drag down, the overall returns of your portfolio, is to be disciplined about taking gains. People always tend to remember the instances where they took gains too early on options but don’t remember the instances when taking that 70% gain was smart because had they waited another couple of days, they would have had to take a loss on the position.
Always remember, that option trading is an art just as is stock investing, and I would argue, a much more difficult art to master than stock trading. So never jump in without any experience and if it’s not your game, no shame in sitting on the sidelines. Plenty of wealth can be built with straightforward long positions if you learn the stock investing game properly.
[tags]how to profit from options, options strategies, BIDU, GM[/tags]
J.S. Kim is the founder and Managing Director of maalamalama, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.