Trading Strategies: November 2007 Archives
Here's a scenario for you...
You've just bought a smokin' hot stock (ticker REDHOT) for $100/share, but you're a little nervous. If you're like me, buying REDHOT shares today means REDHOT almost certainly will trade lower tomorrow. Worse yet, will REDHOT tank? Will you lose all your money? JUMPING JEHOSEPHAT!!
Down to Business...
When you go to sell shares of a stock and you select your order type, you may notice "Stop Market" or "Stop Limit" order types. The concept behind "Stop Loss" or "Stop" sell orders is this: if the stock price drops to the activation price, a sell order is triggered automatically. By using a stop loss sell order you can, with some pre-planning, protect your capital in the event of a stock price drop (even if you aren't in front of your PC watching quotes all day). Here's a situation where that might prove valuable...
You buy 100 shares of REDHOT for $100 / share because you're looking to make some crazy cash, but if the stock doesn't rise right away you're packin' your REDHOT bags. You decide that if REDHOT drops to $98 / share, you want to sell your stock automatically for whatever the market is willing to pay at that moment. After purchasing the shares, you immediately place a "Stop Market" sell order to sell all your shares if the stock drops to an activation price of $98.
Incidentally, REDHOT cools down and falls from $100/share to $92/share the next day. That means that the stock traded at your activation price, which means your sell order got triggered. Maybe your 100 shares sold for $97.98/share.
In this example, here's what happened in money terms:
Initial buy: 100 shares x $100/share = $10,000 invested
Sale executed: 100 shares x $97.98 = $9,798 left; => loss of ($10,000 - $9,798) = $202.
Value with no stop loss order: 100 shares x $92/share = $9200; => paper loss of ($10,000 - $9,200) = $800.
Not great, but not bad. The stock didn't rise right away and instead it tanked, costing you $202 instead of a more depressing $800.
Sounds like a dream come true?
Not so fast!
Depending on the type of investment you're making, using stop loss orders may not make the most sense. One "stop loss" rule I keep in mind isn't right all the time, but I think it's reasonable:
If you're making what you consider to be a risky (quick? super-growth?) stock trade, consider using a stop loss order. If you're smack-dab in the middle of a long-term value investment, stop loss orders might not be most sensible way to go.
Why do I like that general rule?
If I'm in the middle of a long term value investment, chances are I've put some thought into how much I think a stock is worth. I'm owning the stock in the first place because I trust my judgment that the stock is headed higher. If the stock has reached a point where I'm concerned it may drop lower (in other words, maybe it's reached a valuation I find fair or even rich), why sell lower when I could sell now for more profit? Thanks, Grandpa Stan.
Time for another example. Suppose I own a stock with ticker BESTVAL. BESTVAL is trading at $50/share, and I had purchased the stock at $42/share. I figure $50/share is a high valuation, and I'm afraid BESTVAL is going to drop soon. Since profit is the name of the game, logic tells me to sell BESTVAL at the highest available price (buy low and sell high, right?). By entering a stop loss order with an activation price of let's say $48 / share, I could end up selling the stock at a price that's 4% lower than the current price. What gives? I'll take my $50/share, thank you very much.
Conclusion
How you approach your trades is 100% up to you, but you may want to consider these examples when making some order type selection decisions.
Happy investing!
Full disclosure: BESTVAL and REDHOT are not real stock tickers. So, yeah...
(P.S. for more information on order types, check out the wikipedia page on stock orders)
Options trading can be a powerful tool for either the speculator/trader or the risk avoider. In this entry I'm going to provide you with a situation where you might want to buy (and later sell) put options. As always, perform your own comprehensive research before making ANY investment decisions; do not make decisions based solely on content you gather at this site.
Quick Intro
Options can come in different flavors, notably puts or calls. Options contracts represent the right, but not the obligation, to buy or sell a security by a certain date for a certain price. For more in-depth info on options, check out the wikipedia options entry.
A put option provides the option contract holder the right, but not the obligation, to sell 100 shares of a security at a certain price. How might you use put options to bring home some extra clams?
Put Option Example #1
You want to make profit off of a stock that you believe is going to sink soon. Let's give that stock the ticker HOTSTOX. You're not comfortable selling short. If you sell short and the stock rises (maybe you're out enjoying fresh air instead of closely monitoring the streaming ticker?), the downside of your investment is limitless. AKA you could owe a hell of a lot of money to your brokerage. Alternatively if you buy a put option, the most you can lose is what you put in.
Wait a minute... how could owning (and then selling) put options make you money if the stock sinks? Good question. I mean, why would a put have any value at all?
Suppose you owned a stock that was trading for $30/share. If someone offered to buy that stock from you for $50, that's a pretty good deal for you. You'd be pocketing a premium bonus of $20/share (on top of the $30 it's worth) all in one profitable swoop. Not too shabby.
So the ability to sell your shares for a certain price might be worth something to you. At a very basic level, that's one way I like to think of puts. The ability to sell stock at a certain price -- if I want to -- is worth something to me. If I were to pay $20 to sell my shares tomorrow at $50, I'd break even, so that doesn't sound too attractive. But there is some price where it might be worth it to me. That's one thing to consider when figuring out how much put options are worth to you. Some refer to that difference as the intrinsic value of an option.
So now you see that put options are worth something to someone, here's an example of putting ... puts to use for you:
Suppose HOTSTOX is trading for $54/share, and here we are in early November. You strongly believe HOTSTOX will drop by at least a few points by December. You browse over to the HOTSTOX options listing on Yahoo! Finance to discover that DEC 55 puts (i.e., put options that expire in December and give you the right to sell 100 HOTSTOX shares for $55/share) are trading for $3.20. Note that this $3.20 amount describes cost per share. Since each options contract applies to 100 shares...
# of shares per contract: 100
option price per share: $3.20
total option contract price to you: 100 shares x $3.20 / share = $320 [+ commission]
You bite your upper lip and place a limit order to buy 1 put option contract for $3.20. You sleep well that night.
The next day an OPEC bigwig stubs his toe while getting on a boat in the Persian Gulf, and HOTSTOX drops from $54 all the way down to $51. You still hold the right to sell shares of HOTSTOX at $55, so the difference there just got bigger. You check the options pricing for HOTSTOX and notice that the same put options you bought yesterday for $3.20 are trading for $5.00* now. You jump up and down for joy and place a limit sell order for your put option $5.00. Your profit on the transaction?
purchase price: $320 per contract (remember, 100 shares per contract)So that's one example of how you might buy and sell a put in order to collect some serious cabbage (+56% in that example). Keep in mind that gains might not happen that quickly; gains might not be that sharply; and gains might not happen at all.
sales price: $500 per contract
net change: $500 - $320 = $180! (minus some $ for commissions)
Also, remember that in this case you have to sell at some point in order to make money. Picking a selling point might be tough, but you've got to come up with something that works for you. I'd advise against buying/selling any securities/options/etc. until you've come up with a selling plan that you can stick to.
Good luck!
Full disclosure: HOTSTOX is not a real stock ticker, so I definitely don't own any position in HOTSTOX. Proceed with caution when trading any securities, especially options.
* Note that an options contract price takes into account other things in addition to intrinsic value. Visit the wikipedia options page mentioned above for more information on options.
