Thursday, November 8, 2012

MS: Anatomy of a Hedge

The investment company Morgan Stanley (MS) broke below its 20-day low late Wednesday, triggering a thorough ambiguous bear signal in the context of the chart.

Whenever I see a trading signal, one of my jobs as a trader is to decide how much credence to give it, and if I have my doubts, to determine whether there's a way I can take the trade while hedging against the risk.

MS has been trading sideways since mid-September in a range running form $18.57 down to $16.30. Tuesday's breakout came a mere 33 cents above the range floor. It's the third test of the breakout level, so I consider it to be a point of substantial resistance.

Three references that inform my discussion.
I'll focus on the last three days of trading.

Day 1 -- Tuesday -- saw MS reach a high of $18..24, which is 2.8% above the prior day's close. It broke past a 10-day high in reaching that level.

On Day 2 -- Wednesday -- MS gapped down at the open and hit a low of $16.63, or 8.6% below the prior day's close. Perhaps it was a case of post-election blues, traders fearful of the president's second term running for the exits.

On Day 3 -- Thursday -- I started to deal with the breakout, which came to late the prior day for me to impose my mandatory 30-minute waiting period before trading. The downside momentum had clearly slowed, with the trading staying near the lower end of the prior day's range.

This is a challenging decision. The Day 2 range was so wide, clearly a lot of the selling has already happened. And the Day 3 trading basically is going nowhere, confirming my assessment that the big decline is yesterday's news.

Yet, it's not uncommon for a stock to plummet, pause, and then work its way further down. But, the pause can also be a prelude to a reversal, sending the price up toward the ceiling of the sideways range.

There is no way to know.

One legitimate response would be for a trader shrug and move on to the next prospect. But MS is a highly liquid stock, trading 22.6 million shares a day -- the bluest of the blue chips. It's not every day that a company in the Top 10 volume leaders gives a trading signal.

 A second would be to sigh and wait for a move to begin in either direction. But Wednesday's sudden quantum leap shows that often there is no "begin" to a move. The move happens in the after- or pre-market trading, and a private trader can only deal with the consequences.

So I chose a third course of action, which is to take the trade, but hedge the position so that losses from a contrary move are limited and profit is possible even above my entry point into a bear position.

I structured the position as a bear call spread, meaning that I sold call options expiring in December at a strike price nearer the current price, and then bought calls with a strike further away from the current price.

A companion structure to the bear call spread is the bull put spread. As a class, they're called vertical spreads.

Since the bought calls cost less than my premium from selling the short calls, I get immediate cash that I can keep if I hold the position until the options expire.

In this case, I sold the $17 calls for $76 per 100-share contract, bought the $18 calls for $40 per contract, and as a result had a net premium of $36 per contract.

By selling the $17 call, I'm promising to deliver 100 shares of MS at that price on demand. Now, I don't own MS and will need to pony up $1,700 plus commissions to fulfill each contract.

That's a fairly large hit. So to ease the potential pain, I turn around and buy an $18 call option. That puts me in the driver's seat. I can demand that the guy I bought them from sell 100 shares of MS to me for a share price $18.

So for each contract, if I'm called out on the call I'm sold, I'll call out myself on the call I bought, and I'll only have to pay $100. Much nicer. Especially when I consider that I already got $36 net for opening the position. So my actual cost is $64.

Of course, my entry price on MS was $16.66, and that's where the position gets interesting in terms of channel breakouts. In normal trading -- buying shares or options -- $16.66 would be my break-even point -- above that I lose, below, I gain.

Not a good situation if there's a 50% chance that the price will indeed reverse to the upside.

My bear call spread, however, puts the break=even point at expiration at $17.36, meaning that if MS is trading even $1.30 above my entry point on Dec. 30, I'm still profitable.

My profit, at its maximum, comes about at the strike price for the option I sold, and it stays the same at expiration anywhere below that level. Anywhere below $17, the option I sold won't be exercised because the owner can buy the stock on the open market at a cheaper price than he can from me by using the option.

That's the trade-off. I limited my loss to $64 per contract, but I've limited my gain to what I got when I set up the position, $36 per contract.

Under my trading rules, if the stock does continue on to the downside, then I'll add to the position. And since the downtrend would be then be established, I would buy puts, with no limit on profit.

If it instead reverses, then I'll hang on to the bear call spread in the hopes that the price will  be below my break-even level six weeks from now. If yes, I've made money. If not, then I take my loss and move on.

How do I calculate potential profit on a trade where someone pays me?

I do it on the basis of my maximum risk. If my risk is $64 per contract -- the loss limit described above -- and my maximum possible gain is $36, then the yield is 56% plus change. That's a very nice return for a six-week investment.

I've gone into such detail because the MS chart is a clear example of a situation that calls for a hedged response to a trading signal. Such vertical option spreads are, anymore, my preferred method of establishing an initial position.

MS next publishes earnings on Jan. 14. The stock goes ex-dividend in January for a quarterly payout yielding 1.21% at today's prices.

Decision for my account: I took the trade, as described above.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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