Friday, April 11, 2008

A Lemon-Drop Cookie

Yesterday I gave a recipe on how to play stocks that have suffered at the hands of price-crushing news. I said that it was a highly speculative play but I forgot to give my reasons on why I felt that way. Usually when the stock drops on bad news, it has a tendency to keep falling. Sometimes the stock will rally back, luring investors into taking long positions, only to have it tank shortly thereafter. This can be a devastating trap. To avoid damage to your pocketbook, you need to be vigilant and watch the stock movement on a daily basis. You also need to have a firm stop/loss in place which is something that many investors don't do even though they know better. But if you paper trade this strategy, read the news, and watch the charts, you'll develop a feel for knowing when a trade set-up has increased profit potential. Also, it helps to select stocks in rising sectors or sectors that are at least not in decline. As the saying goes, a rising tide lifts all boats so it helps, too, if the overall market is trending upward.

At the end of yesterday's recipe I said that I would illustrate this strategy with an example. The chart of Integrated Device Technologies (IDTI), a semiconductor stock, is a good recent example. Here's its chart:

You can see the stock (along with the semiconductor sector) has been in serious decline, losing half of its value in six months, from last August to this January. The company reported third quarter earnings after the market closed on January 24th. Although their earnings were inline with estimates, their outlook for 2008 was lackluster, citing weaker demand for its products. Two analysts promptly downgraded the stock from a buy to a hold. You can see what effect all of this had news had on share price: the stock gapped down the next day on five times normal volume and remained at this level for several days. One analyst was quoted as saying that the bad news was already out there, and apparently investors started feeling the same way as the stock began to rise. Ten days after the drop, the stock broke its flush-out day high point. This was the day to take action. The following are two scenarios that could have been employed. (Note: All prices quoted are closing prices. Commissions and fees are not included.
Initial Investment: about $800
Buy Date: 2/8/08

1. Buy 100 shares of stock @ $8.02/share = $802 initial cost
Current price: $9.80/share ($980 total value)
Gain (unrealized): 22%

2. Buy 7 May 7.5 Calls @ $1.05/contract = $735 initial cost
Current price: $2.40/contract ($1680 total value)
Gain (unrealized): 129%

You can see that buying calls would have been much more profitable than if you had just bought the stock, which is usually the case. However, if the stock drops below $7.50 by the third Friday in May, you will lose all of your investment. This is the risk of buying options.

If I had just bought calls, I would probably do two things at this juncture. If I was still bullish on the stock (and there's no reason not to be since it's still trending upwards), I'd roll-out my calls by selling the ones I have now and buying new calls at a strike price of $10 several months out. The reason is that about a month near expiration, options begin losing value due to time decay. The August 10 call is now being offered at $0.90 which would give me a net profit of $1.50/contract should I elect to do this.

If, on the other hand, I had only bought the stock, my action today would be to buy some puts as protection. Buying one May 10 Put contract at $0.60 would lock-in my profit. If the stock declines, the rise in value of the put will protect my position. I could also buy the May 7.5 Put at a nickel. Although this would help reduce my loss should the stock tumble below $8/share, it wouldn't protect me entirely. (If an $8 strike price was offered, I'd buy that.)

There isn't time nor space to go into every trading strategy I mentioned yesterday. My goal was to show you how the trade sets-up and to give you a taste of how to profit when a lemon cookie does drop into your lap. Happy snacking!

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