Different Ways to Play a Short
Stockscores.com Perspectives for the week ending September 23, 2006
|
| Upcoming Events |
Stockscores Seminars in Alberta, Club Meeting in Toronto
Stockscores Seminars - The Stockscores Approach to Trading
Edmonton Tuesday Sept 26
Calgary Wednesday and Thursday Sept 27 and 28
Free to attend, learn valuable insight on how to uncover and trade opportunities in the stock market using the Stockscores Approach.
Click here to register for any of these events
Stockscores Club - Toronto
Meeting this Thursday
Details found here
|
|
In this week's issue:
There is more to making a good trade than picking the right stock. Investors are often too focused on the entry in to the trade and fail to realize that to be successful, you have to manage risk and manage emotion effectively. If you understand the risk of the trade and the risk of losing your rational mind when the market starts to move, you can tailor the trade entry and exit strategy to best suit the situation.
One of the services that we provide to our Pro members is ongoing training using our Live Trading Room (chat room). Typically, I do a couple of educational discussions in the chat each week. The aim is to show how to apply the Stockscores Approach in real market conditions.
For example, on Tuesday Sept 13th we had a discussion on how to trade a Strategy called Breaking Uptrends. This is a shorting strategy that looks for stocks that are breaking their upward trend lines. Breaking Uptrends is one of the preset Market Scans available to Pro members of Stockscores.com.
During that discussion, we found a stock that looked like a good short sell. The chart of Walgreens (WAG) was breaking its upward trend line and trading abnormal volume on the break of support. The trade idea was to short sell the stock with a stop loss at the high before the breakdown, $51.60. On the short set up day, the stock closed at $49.31. Here is how the chart looked on the 13th:
We considered two ways to enter this trade.
Trade Scenario 1
First, a simple short sell of the stock with a stop at $51.60. This presented a risk per share of $2.29 with the potential for more risk if the stock were to gap up through resistance. While not a likely event, this is an added risk of short selling the stock.
Assuming a risk tolerance of $1000, the trade would have a 400 share short position requiring a capital outlay of $9,862 since short orders require the investor to post 50% of the trade position as collateral in addition to the amount of the shares sold.
Trade Scenario 2
Purchasing a Put option was another way to speculate on a downward price move in the WAG stock. What Put option to purchase was something that we discussed during the lesson. With this particular chart pattern set up, we shouldn't need a lot of time till expiry as this strategy tends to find stocks that will roll over within a month so I opted to purchase Put options with an October expiry. Strike price was the next question, I consider the Oct $50 and Oct $55 Puts.
The Oct $50 Puts were trading for $1.70 on the 13th of September. Since the stock closed at $49.31, this meant that there was $0.69 of intrinsic value in the option and we were paying $1.01 for time value. This option had a Delta of -.5309 which meant that a $1 drop in the stock price should bring a $0.53 increase in the price of this Put option.
The Oct $55 Puts were trading for $5.80. This option had $5.69 of intrinsic value and $0.11 of time value. The Delta of this option was -0.8591 meaning that a $1 drop in the price of WAG stock should bring a $0.86 increase in the price of the Put.
Based on this, I decided that the Oct $55 Puts were a better deal since very little of the option premium was time value. Time value decays over time so minimizing this in the option price is best for this kind of strategy.
The final decision in the option scenario was how many contracts to purchase given our risk tolerance of $1000. You can potentially lose 100% of your investment with an option position but in this case, dividing the option price in to the $1000 risk tolerance would not be the appropriate way to determine risk tolerance.
The reason is this. Our intention is to consider the trade a bad one if the stock moves up through resistance at $51.60 a share. Therefore, we should plan to exit the option if the stock hits $51.60. Since the Oct $55 Puts will still have $3.40 of intrinsic value at this price of the stock, we are exposed to about $2.40 of risk at the stop loss point. We will probably have a bit of time value left in the option premium so I predicted that the option would be worth $3.80 at the stop loss price (given the option delta of -0.8591). That meant there was $2 per contract risk in the trade making a 5 contract position have about $1000 in risk. Total capital requirement for this trade was $2900.
The Result
Here is a chart showing how WAG shares performed in the days that followed initiation of this trade:
The stock fell to $46.28 on Thursday of this week and the $Oct 55 Puts closed at $8.30.
The person who traded the stock short gained about $3 a share on 400 shares shorted, giving a profit of about $1200 on about $9,900 capital. This represented a percentage return of 12% in 8 days which is about 548% annualized. A nice trade.
The option position gained $2.50 through the same period, giving the option holder a profit of $1250 on invested capital of $2900 or a 43% return which is about 1962% annualized. An even nicer trade!
Summary
What is the best way to take advantage of the opportunity found with the Breaking Downtrends strategy? There are a few things to consider in answering this question.
First, how much capital do you have to work with? The dollar value return was about the same for both strategies but shorting the stock took more capital to generate this dollar value return. The option strategy provides leverage that improves the percentage return on the invested capital.
Liquidity is the next consideration. The stock likely trades with a tighter spread between bid and ask than the option. This spread affects the transaction cost of the trade and may make the option trade more expensive if the options are not very liquid. That was not too much of a concern on this trade as the options are quite liquid.
Risk is an important consideration. If you know that your trading decisions can be affected by emotion, you may want to trade the options. This trade required that you set a stop loss point at $51.60. If the trade had not worked and had instead come up and through $51.60 then you would have had to exit the trade at a loss. This is a hard thing to do for most traders but the discipline is essential to trading success. If you don't have discipline, the dollar value risk exposure of the short trade versus the option is higher. You can only lose the price you pay for the option but the stock could mount a much larger loss over time if the stock had continued higher and higher.
The final consideration is getting the order filled. A short sale requires that your broker have enough inventory of the stock to lend some to you to short sell. The purchase of the Put option does not have this requirement; you simply buy the Put without consideration for inventory or whether the stock's last trade was an up tick (which may be the case with a short sale order).
This is a more sophisticated application of a strategy than many of you may be used to but it exemplifies the importance of considering more than just the trade entry. You have to think about where to exit the trade if you are wrong, risk tolerance and emotional control. These factors will help to determine how to best execute the trade.
Back To Top
I applied the Breaking Uptrends strategy using the Stockscores Market Scan this week and found a couple of candidates. With this strategy, it is very important to plan to lose. If the stock hits a new high rather than go lower, you have cover the short and take the small loss. This will happen on some trades but when this strategy works you tend to get a nice reward pay off for the risk you have to take.Back To Top
1. MENT
The tops on MENT has not been rising as fast as the bottoms lately, an indication that the stock is losing its upward momentum. On Friday, the stock suffered from some selling pressure and broke its upward trend line which has been intact since this time last year. Since this stock has just hit resistance on the long term chart I think the selling pressure won't be too strong, perhaps taking the stock down to $12.50. However, there are options available on the stock that will leverage the return of this short trade.
Back To Top
2. COKE
COKE broke its upward trend line on Friday after barely making a new high, setting up a double top pattern. $55 is a reasonable downside target in the short term provided resistance is not broken at $63.
Back To Top
References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
Back To Top
|
