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I started actively trading about a year ago and started learning the tricks of the trade from authors featured on websites like Seeking Alpha and reading tons of magazine articles and investment books. I quickly learned that I was at a serious disadvantage to the big brokerage firms who employ full-time graduate level talent with seemingly limitless resources to research the equities we trade. Most articles conveyed that I should only invest in index-based mutual funds and ETFs to reduce the amount of volatility my account would experience by investing in individual companies. Then I read about these very risky instruments called options and futures contracts - they should only be traded by highly experienced and savvy investors who completely understand the risk they are taking. I picked up all of these valuable lessons in a "...For Dummies" book, but one tidbit of information overpowered the rest of the book. Every cloud had a silver lining.

Take the "small investor disadvantage" for example. The little guy actually has an advantage with the ability to jump in and out of a trade with a significant percentage of his capital. He could additionally ride along while an institutional investor moves the price of a stock when purchasing or selling a large position.

Investing in a portfolio of mixed asset classes using index funds and ETFs is an appropriate strategy for a beginning investor who doesn't have the adequate skills or time to actively manage his account. What many investment gurus won't tell you is that it's also appropriate to set aside a small portion of capital for speculation (depending on risk tolerance, time horizon and investment goals). Many folks are wired to take some risk with their money; just take a look at the casino and lottery industry for example. I learned that by setting aside 20% of my account in speculative investments, I can strive to pick up the skills and experience of the savvy investor. Sure, I will take some knocks on the head in the process, but with proper money management, I can perhaps learn the lessons that will increase my chances for success in the future.

Finally, using leverage to increase rates of return can be very risky, whether it is through the use of margin or trading with options. This is indeed the case with strategies like selling naked calls or puts. But there are also conservative strategies that make use of option contracts that can add a considerable amount to the investor's bottom line. These are the silver linings that really stuck with me.

Enter the Covered Call

The most basic and most widely used (and some might say "boring") strategy combining the flexibility of listed options with stock ownership is the covered call. An investor sells a call option contract against an equivalent number of purchased shares of the underlying stock. The strategy is conservative because if the underlying stock is assigned to a call option buyer, then the brokerage firm just removes the shares from the seller's account. However, there is considerable risk in this strategy because it involves the ownership of hundred(s) of shares of said underlying stock. If the stock tanks, the investor will close out the position with a loss. The silver lining in this scenario is that the covered call writer cushions the loss with the option premium sold through the call contracts. Sounds good to me, but I still need to manage all of that risk.

  • Risk Control #1: Research the underlying stock and purchase the company that I would be happy to own long term.
  • Risk Control #2: Do not blindly chase after the highest premium; the company may have a very strong reason the implied volatility is so high (which is probably bad).
  • Risk Control #3: Skip the stock or ETF that has any of the following red flags (your flags may vary) - biotech/pharma company, any Chinese company, earnings announcement prior to expiration, special news announcements prior to expiration, special dividend announcements and any leveraged ETFs.
  • Risk Control #4: Look for an in-the-money strike price that will provide enough premium to earn a profit and provide some downside protection.

This list expands and grows as I encounter one of those hard knocks on the head. The Chinese company and special dividend announcement, which oddly enough involved another Chinese company, were not part of my original list of red flags. The newest addition to the list is exposing my capital to the biotech/pharmaceutical company. That company was Targacept (NASDAQ:TRGT).

Tangling with Targacept

Last Sunday, my favorite covered call screener uncovered spectacular premiums on Nov. 19 Targacept call options. Immediately thinking about risk control #2, I decided to take a quick look at the TRGT chart on FINVIZ.com. The page displayed a chart that was building upward trendline support for a month following a long downtrend. The stats were nothing spectacular, but the news was very intriguing.

On Oct 16th, Adam Feuerstein reported that Targacept revealed some outstanding results from its phase IIb study of the antidepression drug TC-5214. The drug demonstrated a 6-point improvement on the Hamilton Rating Scale for Depression (HAM-D), when a score of 2-3 points improvement was considered successful. Mr. Feuerstein spoke with Targacept CEO Don DeBethizy, who said, "The data are pretty amazing. I think people expected the [TC-5214] data to be good, but we were careful not to hype it in advance. One thing I've learned with age is to recognize that you don't need to do that when the data are that good." I didn't know anything about the drug business (red flag), but I was reading about an ecstatic CEO talking about a blockbuster test result of a new drug which was enough for me to run the numbers on the covered call strategy.

  • TRGT Price: $18.69
  • Nov 19 $17.50 Premium: $4.50
  • Breakeven Price: $18.69-$4.50 = $14.19
  • Downside Protection: 24%
  • Profit if Flat/Exercised: $17.50-$14.19 = $3.31
  • Annualized Return: 539%

Risk Control #1: Failed, because I didn't understand the company or the drug business. Analysts were predicting losses next year but the recent news wasn't priced in. Either way, I wasn't crazy about owning this stock long term and would be happy to have this stock called away in two weeks.

Risk Control #2: I didn't consider this a failure because I thought I spotted the smoking gun behind the crazy implied volatility. It was good news and I thought the news was going to push the price up, so this was a calculated risk.

Risk Control #3: It passed only because I missed a critical piece of information on the list of TRGT-related news items. On Nov 3rd, Business Wire ran a story about AstraZeneca and Targacept preparing to announce the first top line phase 3 results for TC-5214. I simply missed it, and had I read the story, I may have taken pause before going through with this buy-write.

Risk Control #4: I had a $17.50 strike premium giving me 24% of downside protection! This stock could go down to $14.19 before I started losing money. With commissions and fees, my breakeven was actually $14.24 and I would set a stop at $14.25.

Bottom line: I had a stock that was trending up with support around the $17 level with potentially fantastic news about a new drug in late stage testing to treat depression. I was only going to be in the trade for two weeks with 24% of downside protection. I had enough money in the speculative portion of my portfolio to buy 200 shares and sell two $17.50 call options. I was looking at a potential return of $645 on a $2850 investment in two weeks. I knew I was swinging for the fences, but I pulled the trigger.

The day after I wrote the covered call on two Targacept contracts, the company reported a failure of the TC-5214 drug in Phase III testing. The stock gapped down pre-market and plummeted 60% on the news to close at $7.61. This was a crushing blow and I quickly bought back the nearly worthless option contracts at $0.04. I then placed a tight trailing stop on the stock and eventually sold the shares at $7.86. My $2850 investment lost $1275 after commissions.

Humble Pie and Tough Lessons Learned

1. Discipline. This was more of a lesson not captured from my previous trading experiences that lead me to implement Risk Control #1. I did not understand the business and therefore I had no business playing with this stock. I should have listened to my own rule and passed on this trade.

2. Stay away from the biotech/pharma industry. This rule immediately went on my list of red flags following this disaster. It primarily stems from the reason I just mentioned about owning stock in the businesses you know. Drug testing announcements are like earnings announcements on steroids. I don't write covered calls prior to earnings so it stands to reason that I stay away from biotech and pharma companies, period.

3. Stop swinging for the fences. This is honestly a no-brainer; I can easily find covered calls on mid- to large-cap stocks that will net me 2-3% per month with plenty of downside protection. This sounds like a small rate of return, but if the trader can apply the strategy consistently it will stand a good chance of beating the market averages.

I recently experienced some success writing a covered call on Silvercorp Metals (NYSE:SVM) that produced an annualized return of 205%. I ended up a little too sure of myself going into the Targacept trade on the heels of that success in Silvercorp. It all goes back to that thing called discipline. If you're a beginning investor like me, perhaps you can find a lesson in this story that could save you some hard earned money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Learning A Tough Lesson With Targacept