Trading To Save A Position

This week and last, I find myself staring at many shares that are showing paper losses. Paper losses present a quandary for the covered call writer when the available option premiums just aren't enticing enough.

Barely a year ago a young woman, who probably knew nothing about stocks or options, made the same walk that countless college seniors before her had done, as she proudly received her diploma. Like others, she may have been thinking about the uncertain job market that awaited in the real and cruel world, but she had already helped to beat that cruel world.

Like most, she had friends and family in the audience that shared in the glow and probably reminisced all the way back to her birth, her infancy and all the years between those days and this one.

After that day, for all anyone knows, she may have joined other jobless and under-employed graduates around the country and is now occupying something here or there to protest educational debts and perceived societal inequities.

Although lots of people making that walk have their own truly unique stories, this graduate made her news even before her birth and gave rise to an investing strategy for me, years later.

And so it was more than 21 years ago that everyone was debating the very ethics of her actual birth and plans for her life.

No she wasn't going to be sacrificed at some Aztec altar, nor was her death intended as a sign of some covenant. It was also not part of an elaborate plan to pay back some childless drug baron in South America, in order to spare the lives of a village that didn't meet its cocaine harvest quotas. (As an aside, my advice to those farmers? The State Department and I both urge you to diversify.)

Her birth was engineered, following her father's reverse vasectomy procedure, in the hopes that her bone marrow would be a match for a then 16 year old child with a rare form of leukemia. All other hopes had been exhausted and the clock was ticking.

The probabilities were small. Being 40+ year old parent wannabes already puts you at a disadvantage. There's nothing like carefree teenaged sex to ensure a pregnancy. Once you get to 40 and have the stress of desperately wanting to procreate, you're already behind the eight ball.

Sure, most of the time the reverse plumbing procedure works, but add that into the mix along with the fact that you're hoping for a perfect match.

And then there's the march of time, as well. Nine months to create a child, then another year to be medically cleared for being a marrow donor is a long time, especially when cancer is involved.

It was a long shot and raised lots of heated opinions when the story broke before her birth. The story itself, despite all of the controversy, recruited more than 100,000 people to add their names to the bone marrow donor registry. That created lots of liquidity.

Just 10 years earlier, I had been a resident at Boston Children's Hospital, back in the early days of bone marrow transplantation. There was no certainty of a good outcome at that time. In fact, the certainty was in the other direction. On top of the horrific chemotherapy came months of isolation in the "laminar air flow" room, before and after the procedure. Long story short, the match was perfect and the older sister was there to watch her baby sister receive that diploma.

Alright, that's enough of a preamble. What does that have to do with stocks and investing?

There are essentially three outcomes you must be prepared for if you are an inveterate seller of options.

The most pleasing is the continued inflow of option premiums that are paid to you by those seeking to leverage their money and take the risk of losing it all. Bless those people.

The second, which is cited by the naysayers of the strategy is that you don't get to share in the profits beyond the strike price. Clearly, those people insist on participating in only those activities that follow the concept of having your cake and eating it, too. They also are the kind that must consistently ask the question "what have you done for me lately?" as they ignore the past stream of premiums all the times that the option contracts expired.

Finally, there is always the question of what to do if your stock takes a significant price hit, as if that only happens to the sellers of options. But the follow-up to that scenario is the question of how you handle paper losses and the selection of strike prices for upcoming cycles.

A few years ago, when portfolio values were plummeting, I decided to adopt the "Having a Child to Save a Life" investment strategy. Other than David Einhorn and John Paulson, who didn't get vanquished? Back in those days we didn't really talk about the 99% to 1% schism. But on paper, at least, the 1% probably got hit disproportionately, although they still would have stayed in that 1%.

I've used that strategy over and over again on individual stocks, although it certainly would have been easier to have been smart enough not to have bought them in the first place. As opposed to critics, I haven't been blessed with perfect vision and timing.

Face it, your choices are limited when faced with vast declines in your stock prices. It's not like reversing a vasectomy.

You could hope for an incredible climb back; you could dump your losers and try to pick "winners"; you could cash out or, if you have available cash you could add new positions or average down.

With an investing strategy based on collecting options premiums, it's difficult to stomach taking those premiums for strike prices that are well below your cost basis. There's a limit to how many strategic tax losses you really need. Worst of all, you would hate seeing those beaten down shares get exercised at beaten down strikes just as the market seems to be reversing course and heading back upward.

My choice, in general, is to average down, as long as I don't believe that the stock is irreparably broken. When averaging down, it is almost with a bomb shelter mentality of survival, except that no squirrels are skinned in the rebalancing of any portfolios.

Those sister shares, the new ones added to existing positions form the basis for the climb back. I've previously chronicled such climbs back with the shares of Green Mountain Coffee Roasters (GMCR) and Riverbed Technology (RVBD). I've just newly added the activity in GMCR, specifically following its first plummet in November 2011, after disappointing earnings. It took lots of children in that case, but I have a big heart and had dug a big hole.

I still have fond memories of a long ago held stock, LSI Logic (LSI). Just another one of those companies that I owned at one time, yet had no idea of what it is they made or provided.

I initially bought those shares for my kids' account and it became one of the first stocks on which I sold calls. With an initial purchase price of about $10, it just went down from there. I kept buying more shares and selling calls on those new shares. I would then use the premiums to buy even more, but cheaper shares.

Occasionally, in fact, more often than not, the new shares would be lost to assignment, with ensuing capital gains on both the shares and the options premium.

Then it would be time to buy even more shares to replace the ones lost.

Over and over again. And over. Until that day came that premiums offset the loss in shares, and the shares were eventually assigned. In that case, the net result was to break even. At the time, I was pleased to have gotten even that far, particularly since LSI never got anywhere near my original price point.

I never went back to that specific well, but the concept stuck and after a couple of years of dormancy, the time returned for its application, once the post March 2009 climb ran its course.

Instead of considering my lots on the basis of their average share cost, I considered them on the cost per lot. There was the old sickly child and the new healthy one. It was the healthy one that held out promise.

Instead of selling call options on the entire holding, I chose to sell call options, typically for in the money or near the money options on the new shares only. Those premiums were the basis for restoring life to the older shares. By selecting in the money options the prevailing thought is that shares may still decline in value, but by so doing you achieve a greater option premium and perhaps a greater chance of having your new shares assigned.

Of course, while doing that, you can still squeeze out some pennies from the original lot of shares by selling call options that are near their purchase price. If you're really the risk taking kind of investor, you can also try to collect whatever crumbs may be left on the table as the clock is ticking away.

Ultimately, the idea of just breaking even was inadequate. Now, although sometimes irrational, even after a large price drop, my anticipation is that through having lots of children I'll be able to return to a positive ROI on the original shares.

Where I differed from the parents from that ground breaking story 21 years ago is that I don't really care about the well being of my baby shares. They're around for that single purpose of contributing to the effort of reducing the paper loss of the older shares and restoring them to healthy profits.

When you do so, you have the advantage of knowing that your old and new shares are a perfect match. One share of Riverbed Technology is precisely the same as the next share.

I have no doubt that if that baby born 21 years ago had not been a perfect match, or if the bone marrow transplantation had failed, the parents would still have given unconditional love to their newborn child.

I wish I was that kind of person.

For me, it is all about the Aztec sacrifice or paying off the debt borne out of a bad harvest or stock selection.

Unfortunately, this is one of those weeks that I've needed to add lots of new children. I'll have high hopes for all of them, but am consigned to the fact that some of them, will be held hostage by the external factors that rock the markets, making them the investing equivalent of an imperfect match, but only because of timing. Goldman Sachs (GS), Mosaic (MOS), Direxion Bull 3x (FAS) fell into the category and now have siblings, as did MolyCorp (MCP) yesterday.

Instead of giving up on those "losers," there will be plenty of opportunity to dip into the equivalent of a modern medical miracle of bone marrow transplantation. At some point, the timing will be right, as long as patience can replace fear.

Stock options give new life and hope to live yet another day and battle against the dreaded paper loss.

Just as a child is the derivative of a parent and the organs, stem cells and marrow are a derivative of that child, there shouldn't be any qualm, fear or concern about using "instruments" that are so far removed from their origin to help sustain life or financial health.

L'Chaim.

Disclosure: I am long FAS, MCP, GMCR, MOS, GS, RVBD.

Comments

[George Acs]

I'm not certain if you response is directed toward me or the previous comment from ScottHB, but, of course, I agree with your points. Clearly there are times when there is no reasonable expectation for a recovery in an equally meaningful time frame.

Investing or investment decisions shouldn't be dictated purely by numbers, after all there are algorithms to do that, but has to include an expectation for a return that is at least as good as your next available alternative.

[ScottHB]

It seems a completely arbitrary choice to buy new lots of the same stock in order to "save" the original lot. You're just trading to make back paper losses so why not choose the best stocks in your playbook to do this with? Basically, you end up holding on to the original lot waiting for a price recovery while picking up pennies selling deeply OTM calls on it - potentially a "dead money" deal. Mightn't you get a better return out of the residual funds tied up in the original lot by selling and applying the money elsewhere?

This situation differs from "having a child to save a life" in that the second child provided a genetically unique hope for saving the first child. Stocks don't have DNA.

[George Acs]

You did miss an important piece. The piece.

That's the role of the new lot. The new lot, specifically its ITM or near the money premiums makes the recovery occur much more quickly.

It's hard to call the selection of shares in the same lot as being arbitrary. It starts with the diagnosis that the shares are not irreparable broken. Hard to see how the process itself is arbitrary. If they are, it's time to take advantage of the tax code and move on. What is arbitrary is perhaps selecting a different stock, which entails new risk.

In addition, presenting a strategy is not based on an arbitrary thought. It's based on quite a bit of implementation (and consistently comparing results to the S&P 500. I assess each transaction lot versus the S&P by comparing ROI for their respective time periods)

In this case it's staying with what you know because your experience gives you a greater degree of confidence that there will be ample recovery in share price, combined with ITM premiums and OTM premiums (which may or may not be deep)

Stocks don't have DNA? They are precise clones of one another Apple shares are all Apple shares, Microsoft like all other Microsoft. Nature should be as adept at the process.

[sean.parmelee]

His point is that you have to constantly re-evaluate your original investment thesis. If the decline is warranted based on new information, or if you realize you made a poor initial judgment, then chasing after what has turned out to be a bad investment is irrational. You'd do better to "make back" what you lost with a new, better investment.

[ScottHB]

George & Sean - Sean is correct. As I said "You're just trading to make back paper losses so why not choose the best stocks in your playbook to do this with?". This doesn't preclude working with the same stock as in the original lot. But you also have at least 30 or so other stocks that you routinely remain sufficiently informed of to also consider using for recovery in lieu of new lots of the original.

Of course you'll only continue to work with a stock that's not "irreparably broken" and take the tax write off on the original lot if it did break. But the notion of batching new lots with the original in terms of a recovery program for one particular stock is no different in effect than batching lots of an alternate stock with the original lot to engineer that same recovery.

Whether you use the same stock or one or more alternate stocks, the activity to recover the paper loss on the original lot is identical. You're simply making an offsetting profit following your usual procedure. The only difference is that it is not as natural to think of lots of differing stocks as a batch rather than multiple lots of the same stock. It seems likely you already made the money back working with another part of your portfolio - where's the "batch" in that?

I'm just saying that I don't see that targeting profits from one group of trades to counter the loss from any other specific trade has a financial benefit. It's like drinking a cup of water from a half-full barrel and then pouring two cups of water back in while trying to track which drops in the barrel came from cup that replaced what you drank.

So, the real question is: why hold on to the original lot? That money just remains marginalized in terms of income potential as long as you hold it for the production of deep OTM call premiums. If you expect the price to recover in a fairly short period then that's great - you're made whole without effort or transaction costs and don't need to consider buying cheaper lots to create a recovery program (though you may buy those lots as your best current option to turn a profit). Otherwise, you can cut your losses by garnering the maximum premium available for an ITM or NTM call and let the shares be assigned, returning as much cash to you as possible to put to more productive uses.

Essentially, it's a question of whether the money reinstated through price recovery on the original lot will exceed the profits available from actively working the remainder cash value instead. This comes down to time. For example, if the original lot is down about 10% and you produce an annualized return of roughly 30%, you pay an opportunity cost when the price recovery takes over 4 months.

[George Acs]

What that meant was that if your July $2.50 strike options were assigned, you would have received $2.50 for those newly purchased shares. However, you paid $2.75. That's a debit of $0.25. But that in turn is offset by the premium you would have received of $0.45. The net result of that series of transactions (Purchase shares, write call and then have shares assigned) would therefore be $0.20.

That $0.20 profit on that specific lot of shares is applied toward reducing your cost basis on the $5.10

[rmmdavis]

George, on the NOK example, I didn't quite understand how you got to the net $.20 deduction on the $5.10 cost basis. I'm new to this concept, so would appreciate a clarification. Thanks.

[George Acs]

"Your cost is your cost?" Then you fall into a very passive segment of the investing universe. Consigning yourself to a pre-destined outcome is fatalistic.

Limiting yourself to just having concerns about the justification for a drop and going on a diagnostic expedition is neither proactive nor reactive.

However, you then go on to make the point that I made in the article, as the caveat. The stock can't represent an irreparably broken holding. If it does, then it's nonsense to fantasize about it being able to return to a state of health.

Your statement about there being a more attractive place to invest is a truism for all investment decisions. Presumably one weighs the various options, including inaction, whenever committing funds. That process isn't limited to just assessing fallen shares and the decision to buy more, hold or sell.

On days like today (June 6, 2012) a 200 point gain justifies picking up beaten down sibling shares and selling those call options.

I may feel differently tomorrow about yesterday, but not about the overall path that the strategy takes you upon.

[Lucas Krupinski]

I think I have to disagree with the premise, in that I don't think anyone should be trading to "save" a position. Once you buy a stock, your cost is your cost, and you might as well forget about it. The only value of concern is what its worth now, and what its worth in the future. If it takes a precipitous fall, your concern should be if the fall was justified or not, and if the position is a good buy or not.

If it's not a good buy at the lower price, then there's not a real reason you should hold onto the shares you already own if the goal is just to not convert an unrealized loss into a realized loss. But if you think the news brought about an unjustifiable decline, and, say, the stock was attractively priced at $25/share, then $20/share represents a great deal for acquiring more.

But if there was a game changing announcement that caused the decline, the only questions at that point is are your now less valuable shares fairly priced, and is there a more attractive place that you'd rather have your money invested? If there's a more attractive investment out there, why tie up your money in a less attractive one, again, just to try to "save" it...

One of my favorite investment adages is "you don't have to make it back the way you lost it".

[stocknerd]

George, enjoy your articles and your sense of humor (I write comedy). Just a suggestion, edit it down some. This one did ramble. Also I think some investors get too cute and want to hedge hedges, put calls and use all the market's tools to make a trade. A simple buy and sell works just fine. You are a unique poster here. Rock on dude!

[George Acs]

I absolutely agree about the rambling. I'd be most happy if I could eliminate all of the stock related material to cut it down, but SeekingSecondBanana has a very small readership.

Thanks.

[liusing]

Good to learn this strategy, just that you got to have deep pocket and your money management won't get out of control.

[George Acs]

No, you don't necessarily need to have deep pockets.

If you sell covered calls or puts there is typically assignment of some portion of your shares, thereby freeing up cash and making it available for (re)-investment.

Additionally, you can also have a portion of your portfolio hedging against strong market moves , such as by buying VXX (and selling its calls) to protect against downturns. Market goes down, VXX shares get assigned and cash generated to purchase beaten down shares. See "Seeking Mediocrity" http://seekingalpha.co...

[smorgoun]

A good proof that your strategies work well for you is that you are not following any other contributor in SA... And thank you for the very practical articles.

Elaborating on "deep pockets" question:
- you mentioned previously that you are fully invested
- and now you "find myself staring at many shares that are showing paper losses"
Could you please explain more in detail, from your experience, how much (%) one should allocate to VXX or keep as free cash to be ready to buy more of losing shares for two-three consecutive periods, especially if more than half of portfolio is down?

Thank you...

[George Acs]

Well, I don't know if that's a good metric. I just may be very shallow. On Twitter, I refer to myself as "arrogant" because I follow very few people and rarely followed back. What gratified me is the quality/reputation of people that followed me on Twitter, although I've greatly cut down my activity there with a focus now elsewhere.

With regard to your question about allocation, I try to keep hedging kind of holdings such as VXX and ZSL to no more than 5% each. Sometimes that number slips upward insidiously, as it did for me with ZSL (see: When is Speculation not Speculative http://seekingalpha.co... )

I often flip flop between combinations like ZSL/AGQ and VXX/FAS alternately buying shares/selling calls or selling puts, following relatively simple algorithms.

Also, take a look at my article on retirement. It has a spreadsheet that lays out a sample portfolio (the numbers, however reflect share prices from May 2012, but you can alter them or add your own stocks)

http://seekingalpha.co...

[sethmcs]

Well George, the market will teach you whatever you don't know assuming that you are willing to pay the tuition. I have been trading stocks and options since the 80s made money and lost money. The money I lost was well spent because I learned at lot about how to play this game. I am managing a lot more money (my own) than I did back then.

[George Acs]

That can be an expensive way to learn a lesson and there's certainly no reason why everyone needs to personally re-invent the wheel.

AT the very least, my kids will be spared the need to repeat my own errors of omission and commission

[LitheInvestments]

A good question I ask myself when selling a position of paper losses "Would I buy here?" If the answers "no, it will likely experience more losses and I'd rather buy lower" then you should look into selling and cutting your loss..

[George Acs]

I was with you until you used the word "likely," when describing the direction a share will move if the answer to your question was "no"

How is it that you can find a high correlation between your opinion and the direction a stock's price will take? Where was that ability when you purchased the stock? Presumably, when you purchased it, the question was also "would I buy here?" yet then you find yourself asking the exact same question at a lower price. How do you know which time the answer is accurate?

We are all imperfect in our ability to know, so we should look for mechanisms to cushion that imperfection and actually remove it from the process.

[LitheInvestments]

I'll have to agree with you. A lot of us have an emotional reaction to panic and sell at the bottoms. It's a difficult tether between cutting losses short and insuring not to sell at bottoms due to an emotional panic reaction. flexibility with your account vs being too stubborn and not admitting you're wrong

[George Acs]

Fear, greed and the fear of missing out can be our worst enemies when seeking to make a decision that should be predicated on profits, losses and opportunities.

[bigalconehead]

I like your take on things. You're a bit irregular but aren't we all?
Good view on MCP and options.

[Mbrillo1]

I daresay that your broker is quite happy.
Are your commissions factored into your P&L?

[Ted Barac]

"The most pleasing is the continued inflow of option premiums that are paid to you by those seeking to leverage their money and take the risk of losing it all. Bless those people."

It's simplistic and wrong to assume that the buyers of call options are systematically on the wrong end of the trade (as you seem to imply). Many could just as easily say "The most pleasing is the continued flow of call options, afforded to you by covered call sellers who assume all of the stock's downside and giveaway most of the upside in exchange for a modest call premium. Bless those people."

As I discussed in the following article, determining who's on the right side of those trades all comes down to price and many misunderstand the risks and downside of covered calls and other option strategies: http://seekingalpha.co...

[FamGuy224]

Value, I read your article the other day and while I agree that options are complex, I was disappointed with your conclusion that we should leave option strategies to the hedge funds. I was hoping for advice or suggestions not just fear mongering. Call me delusional if you like but I prefer to believe what George has posited previously, that not all of us individual investors are idiots.

[George Acs]

That's neither the implication nor the intent.

The statement stands on its own. Option buyers do leverage their investment and they do take the risk of losing it all. No statement was made regarding their success. That was your own projection, or to use your own phrasing, simplistic and wrong.

In fact, your version is much more inflammatory. In my statement, the call buyer is credited with the ability to leverage his assets in return for taking the risk of losing it all.

In your version, you saddle the call seller with both the assumption of downside and then use the expression "giveaway" to represent what may be lost on their part.

Whereas my statement consisted of two objective statements of fact, yours included a very revealing bias.

[ibarkinthedark]

I agree. The Value Seeker article (link posted here by the author in a bush league effort to leverage his own “hits”) is “simplistic and wrong”. For one thing, in the entire article the author offers no evidence that he even understands the several components of option pricing. In fact, he demonstrates that he affirmatively doesn't understand the meaning of “intrinsic value”.

If Value Seeker has too "little knowledge” to understand options and how they work, perhaps he should do some reading. George's articles might be a good place to start.

[Modernist]

Trading for psychological comfort, defying the "sunk costs" fallacy

[George Acs]

Sounds like something that I might say and then just as quickly not even begin to comprehend..

Obeying the "sunk cost" tenet can have its place, but stocks, by and large are a totally different animal than the manner in which the tent is applied to business investments, gambling, etc..

Certainly there are some situations that just can't be expected to return to health and you have to move on resisting the urge to throw the good money after the bad.

But if a stock's long term pattern is one of ups and downs, why not go with the pattern?

Besides, instead of thinking of it as running after sunk costs, think of it as separate investments, judging each lot of shares on its own merits, until the good and bad they balance one another out

[sean.parmelee]

I think the quality of this article's advice depends on what your own tendencies are. If you're the type to forever throw good money after bad, and this article reads like justification to you, then no, it's not good advice because it reinforces one of your psychological issues. On the other hand, if you're the type to panic and constantly switch from one stock to another, this article is a good lesson in patience and contrarian investing. George's follow-up points about mean-reversion and oscillation are valid--we're not talking about one-time purchases that have an expiration. Averaging down works because oscillation is the norm, and a stock in a protracted downtrend is very likely to reverse course, however briefly.

[George Acs]

Averaging down does work, as you pointed out, but it can sometimes only take you so far, particularly if averaging causes you to overlook the unique properties of each share lot.

Although I don't listen very much to people that refer to charts or technical indicators, certain things to catch my attention, such as when people refer to a period of prices that are characterized by lower highs and lower lows.

In times like that, averaging down may still not get you quickly enough to that point that your position is no longer at a loss. For me, that's especially when writing calls on the lesser expensive lot pays literal dividends as you further reduce the cost basis one premium at a time.

[George Acs]

Thank you. The funny thing is that I'm absolutely terrinble with idiomatic expressions and adages. Still have nightmares about the part of the SATs.

[jeanewight]

I think you have a flair for writing and can create an apt metaphor as easily as slipping on a pair of old slippers.

[George Acs]

When your cost basis is that low it's as if you had already purchased an option.

The other point is that if a stock is irreparably broken there is an inherent problem.

But if you truly believe in the ability of NOK to survive, you can start by picking up additional shares at $2.75. The July $2.50 strike has a premium of $0.45, giving a net $0.20 deduction off of your $5.10 cost basis, if your shares are assigned. Depending on the number of shares you own, you might also see if writing an October 2012 call on your $5.10 shares, for an additional; $0.10 premium makes sense (depending on your faith in NOK and in what time frame)

If you were more optimistic you would write the July $3 call for a $0.19 premium, for about the same premium as the $2.50, but the added possibility of $0.25 in share gain. That, of course, comes with greater risk.

Although you refer to the option premiums as being "so little," the July $3 strike, for example is offering an ROI of about 7% on the $2.75 purchase.

By the way, you'd be hard pressed to find a baby with MS.

[Jfet]

My baby (Nokia) has MS, AIDS, and was born addicted to crack. What strategy can I do to rescue it to my original cost basis of $5.10 when the option premiums are so little?

[Valueplay98]

If you think NOK will go up - buy say the Oct 3.50 calls and sell twice as many at 4.50 (or 3-4$). Either trade won't cost much and should get you out at B/E (or close).