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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • Rising and falling boats  0 comments
    Aug 9, 2011 9:31 AM | about stocks: CAT, DE, CMI
    The last few days have been interesting in the market. Note how stocks rise and fall in the same direction, in spite of strong or weak fundamentals. The recent volatility has been entirely technical in that sense - stocks have moved based on the dysfunctional federal government, economic worries, and out of control spending, to name just a few of the causes.

    Case in point: Consider three close competitors: Caterpillar (NYSE:CAT), Deere (NYSE:DE) and Cummins (NYSE:CMI). Some stats:

    Monday's close
    CAT     82.60
    DE       66.81
    CMI      83.31

    5-day high
    CAT   101.55
    DE       79.89
    CMI    105.04

    Three-month high:
    CAT   112.97
    DE       94,61
    CMI    118.72

    These drops in price between 27% and 30% off the high levels are remarkable consistent, not only for these three competitors but across the board for many other companies as well. So what should investors do when this kind of volatility occurs?

    Defensive strategies make sense in most kinds of markets, but espeically in extreme volatility like this. Frankly, this kind of market drop without any fundamental reasoning can present exceptional buying opportunities; these are bargain prices. The P/E for CAt is down to about 13, and for De and CMI all the way down to 10. 

    Of course buying in volatile markets is always difficult, because you cannot know if prices will fall any further. With this in mind, some alternative strategies make sense:

    1. Buy calls instead of stock. The call costs only a fraction of the price for 100 shares, and yet the call acts just like 100 shares of stock. So instead of putting $8,000 at risk, you may be able to find a suitable call just out of the money for around $400. That's all you have at risk and you might lose it all, but if stock does rebound, you are going to make a handsome profit, potentially very quickly.

    2. Buy an insurance put. If you already own shares, you probably are tempted to sell and cut your losses. But if you also believe the company is strong and will rebound, this is the worst time to sell. Buy one put just out of the money for each 100 shares you own; if the stock price declines further, the put will gain one point of intrinsic value for each point the stock loses.

    3. Buy more shares to average down your price. You have probably heard that it's a bad idea to put more money into a stock when you are losing money. Generally, this is true. But remember, this recent decline was a technical adjustment and had nothing to do with the fundamentals of any of these companies. If you truly believe the stock price is going to rise, buying more shares averages down your basis. For example, if you bought 100 shares of CAT at $103, buying another 100 shares at yesterday's close of $82.60 averages your basis at $92.80. This means you have to get 10 points rise in the stock to break even, versus 21 points with your original 100 shares.

    More than anything else, remember, don't panic. More money is lost in a downside panic than in any other kind of market. Just as with volatility to the upside, where some traders buy at the top, don't make the mistake of selling at the bottom. If you don't like any of the three steps above, think about another decision: hold tight and don't take any action. The market rewards patience and as long as you have faith in the fundamental value of the companies whose stock you own, holding on makes more sense than panic selling.
     

    Michael C. Thomsett is an instructor with the New York Institute of Finance, where he teaches five courses. He is also an investing and options and technical analysis author. He wrote the best-selling Getting Starting in Options (Wiley, http://tinyurl.com/22nmkf2), now in its 8th edition. Thomsett’s latest book is Trading with Candlesticks. (FT Press)
    Stocks: CAT, DE, CMI
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