You’ll see us use the phrase “defined risk” when we talk about stock alternatives into uncertain events. Usually that takes the form of an options structure that is easily recognizable as far as how much can be lost or gained. Straight up profit/loss profiles like risking 1 to make 3 on a call spread. Other times the structure has a little more nuance like a call calendar where you know exactly what you are risking but depending on how everything plays out the potential reward is less easily explained as it can just be a profit or a loss near term while the short leg of the calendar is still extant, or it wide open profit potential once the short option portion expires. A third scenario you’ll see us mention in long alternative scenarios is one where you could potentially be put the stock (when the structure includes a short put). These usually take the form of a risk reversal (selling a downside put to buy an upside call) or a risk reversal call spread (selling a put to buy an upside call spread).
Into a (really) uncertain event a few weeks ago we took a look at a risk reversal call spread in FireEye (FEYE) a once hot stock that has taken a complete dirt nap in 2016:[caption id="attachment_65951" align="aligncenter" width="597"] FEYE 2 year from LiveVol Pro[/caption]
What got us looking at FEYE was that some of the other prior hot stocks of 2015 (like DDD, FIT, etc) that had fallen on hard times in 2016 had seen some renewed interest recently. FireEye, with an earnings event as a catalyst, fit the bill of as something that could see some renewed interest (or a short squeeze) if they were at all able to deliver. And that last point is key because it would be idiotic to go out and buy the stock into an event like that with the hopes of a short squeeze. Therefore we detailed a call spread risk reversal that defined a realistic range to the downside before one was put the stock, and upside potential in case the stock went higher. Here was the trade idea from August 4th:
Bullish position in lieu of 100 shares of stock at $17:
Sell the Sept 14 Put to Buy the Sept 17 / 21 call spread for 70 cents
- Sell to open 1 Sept 14 put at 40 cents
- Buy to open 1 Sept 17 call for 1.55
- Sell to open 1 Sept 21 call at 45 cents
So what happened? The stock got killed on earnings. And went straight to the short put strike of 14. It is now about 14.60 and the short put will likely expire worthless. So we picked a bad stock to highlight, but picked a good put on the downside to define the range. But there was one thing we did really wrong here that I wanted to go over for educational purposes, something than can be applied elsewhere in your trading:
On a trade like this it’s best to find something near zero cost. If this trade was a zero cost, (or small debit or credit) then a move to 14.60 and the put expiring worthless is like a free shot. Sure there’s risk involved of being put the stock, and there’s margin involved with being short that put, but the most likely scenario when selling a downside put and buying an upside call or call spread is that it all expires worthless. And that was the main mistake here. This trade cost .70, will likely end up costing .70 when it expires. So it was risking 70c in most scenarios, and risking being put the stock below 14, for the potential for making up to 3.30 above. A better structure would have found strikes above that equaled the .40 of the short put and resulted in a zero cost trade. That would mean less of a chance of being right on the upside call spread (if it was higher strikes and therefore more out of the money) but the entire reasoning behind the idea is playing for a serious gap higher. And by being less aggressive on near the money on the upside, it would have rid the trade of the most likely scenario, which is losing what was paid.
So the trade worked as intended in that the decline of over $3 is not realized, but it will still end up most likely losing 70c. A better idea would have been to have found a zero cost risk reversal call spread where an upside gap is in play but a decline like this would have cost nothing. That’s a good lesson that can be applied elsewhere.