I don’t make it a habit of talking about trades that I still have active positions in, so I’m writing the first half of this post ahead of time.
I don’t currently have the ability to short a stock. While I have the funds necessary to open a margin account, they are currently spread across three brokers. First there was the “I need an IRA” broker, followed by the “Hey everyone else uses them!” broker, and most recently the “Can you believe we pay $10 per trade for that other broker?!” broker. Yes it’s a mess, I agree. But the end result is no shorting. The best I can do is inverse ETFs, which is hardly a precision instrument.
But of course there’s an alternative to shorting stock: buying put options.
As of this writing I have read six – yes, six! – books on options and futures. And the weirder trade combinations (“Iron Condor” anyone?) still bend my brain into n-dimensional shapes. But I get the basics. Unfortunately, these books are good at telling you the “what” but not the “why” or “how”.
I don’t give a put what a Long Put Butterfly is. Just tell me where to put my put and how to make money at it!
But slowly it’s coming together. Here’s what I’ve learned (and tell me if I’m wrong!):
– Buying simple puts and calls limit your risk. All you can lose is what you paid for them.
– The numbers move faster. A couple of dollars on the underlying stock movement can double your investment. Or render it worthless.
– Don’t spend more on a call or put than you would normally risk in a stock trade. If you’re willing to risk $300 on a stock trade with an investment of $3000, then don’t buy $3000 worth of call contracts. Buy $300 worth of contracts.
– In-the-money strike prices are more expensive (because they have intrinsic value already). But they more closely track the underlying stock price than an out-of-the-money strike. There’s no waiting around for your price to get hit before seeing any action.
– Options enter a time warp when they’ve got less than 30 days to expiration. You experience time decay, which is like tooth decay except your teeth don’t expire worthless. And no amount of brushing will make your OTM put profitable. So when buying a simple call or put option, pick longer expiration dates (which are also more expensive than shorter expirations).
So with much hand-wringing and double-checking and chart-gazing, I purchased a put option this morning. Yes, I risked a whopping $160, fully prepared to lose it all for the experience. A day at Six Flags Magic Mountain would have been cheaper and possibly more thrilling, but I can’t do that sitting in front of my computer screen.
I bought a single put contract (“aw isn’t that cute! One contract!” you’re thinking) on Questar Corporation (STR). Here’s my shorting logic: the utilities sector is currently the worst-performing sector. Questar has had a string of down days. And – bonus! – they’ll be reporting earnings tomorrow after the closing bell. So this is a fundamentals/technicals/earnings-surprise play.
Total crap-shoot in other words, but with a certain logic to it.
My trade has an in-the-money strike price of $25, and the previous day’s close was $24.09. It opened down at $23.98. My breakeven point on the underlying stock price is roughly $23.77 (I had to fudge the charts a little to figure it out), and my investment doubles (again, roughly) if the stock falls to $21.70. I have a trailing stop of roughly 2 x ATR above the low, but this really only comes into play if I’m profitable and the stock starts heading back upward (remember I’m shorting with a put). If STR doesn’t have a sucky earnings report, then the trailing stop won’t matter. Also, I have calendared a date just before the 30-day expiration date to sell the puppy if it’s in-the-money.
Yesterday Questar announced their earnings: they missed their EPS estimates by $0.03, and also missed revenue estimates. Yet the stock is actually UP from where I bought the put option. WTF? Probably because the day before their earnings announcement, they also announced an increase in their dividend by $0.02. Yesterday was a sizable up day and today is a down day. So there’s hope that the stock is heading in the right direction (downward). But it certainly wasn’t the dramatic movement I’d hoped for. Perhaps the takeaway from this is don’t buy put options on stocks that pay dividends.
P.S. Amazing what a little research can show you, once you’ve figured out the right question to ask. This article points out that stocks that pay dividends usually see their price fall as they get closer to the payout date, and so the premiums on put options get more expensive. But that’s good for me! I’ll report back later.