We've all been there before. You find a stock that interests you. You put it on your watch list. You do your homework. You choose an entry point and make a limit order.
You then watch in disappointment as your limit is missed and the stock surges forward.
I recently experienced this with Cummins Inc. (CMI). As you know, this stock was pummeled in 2012. Showing promise at the beginning of the year, the stock then went on to shed over 30% of its market cap. This was consistent with other parts-makers and industrials levered to China.
In July, I took interest in the stock. Despite the weakness in China and emerging markets, I wished to enter a position due to valuation and also due to the fact that I believed the sector to be at a bottom.
Towards the end of July, I placed an order at the limit price of $90.00. The stock dipped to $90.48 and then surged upwards, some 17%. Have I missed the party? Not necessarily.
This morning I placed some options trades including a call spread and a short put. Here's how I did it.
- I purchased the January $110 calls (@ $4.40)
- I sold the higher strike January $125 calls (@ $0.90)
- I also sold a January $90 put (@ 3.60)
As you see, I received a net credit of $0.10 per contract; more than enough to cover commissions.
Essentially I am on a free roll; if the stock trades in a range of 90 to 110 for the next 4 months, I walk away from the trades. If, however, the stock continues to rise as hedge funds rotate into the sector (as some have observed) then it's all profit up until $125, where my gains are capped.
On the low end, so long as my interest in entering the position at $90 remains, I have no inherent additional downside risk.
The risk/reward analysis must be driven first by a well researched entry point for the stock. This represents your only risk, and if you have done your homework, there is no additional risk.