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In stocks, as in comedy, timing is everything. If you've been investing long enough, you know that momentum is powerful, but seems to possess a sense of dark humor when you place a trade. No doubt you've seen a stock rise or fall and decide to get in as soon as possible only to watch it plateau or reverse direction soon after.
Attempting to go against momentum is even more risky. For example, the phrase "never try to catch a falling knife" sticks with you after you've made that mistake once.
Luckily, options eliminate most of the risk involved in making such decisions. Using derivatives to leverage stock positions can let you speculate on price movement while risking a bare minimum of capital.
Right now, we see a classic case of this momentum dilemma with Ford (NYSE: F). The stock has fallen more than 10% already this week and was off 15% in September.
This week's sell-off came on news that management lowered guidance, with full-year profits cut from $7 billion to $8 billion down to just $6 billion. Management cited several reasons, including $1 billion in warranty and recall costs; a larger-than-expected loss in the South American and Russia's geopolitical drama.
The news isn't all bad, though.
The Relative Strength Index (RSI) had reading near 21, which put the stock in oversold territory (30 and below) and suggests a reversal could occur in the near future.
Ford trades at just 9 times trailing earnings and 12 times this year's earnings, well below the S&P 500 average of 18. Its 3.4% dividend should help put a floor under prices, as well.
For 2015, Zacks estimates the company will earn $1.89 per share. Using the current price-to-earnings (P/E) multiple, that would place the fair value of the stock near $17 -- 16.5% above current prices.
The options strategy we're going to employ today with Ford is called a strap, which is similar to a straddle. A straddle involves buying both a put option and a call option with the intention of profiting from either a rise or fall in the underlying stock. A strap focuses more on the bullish side by purchasing twice as many long calls as puts with the same strike price and expiration date.
This creates an unlimited profit, limited risk scenario that also profits from volatility.
Recommended Trade Setup:
-- Buy two F Jan 15 Calls
-- Buy one F Jan 15 Put
-- Enter trade at a net debit of $2.50 ($250 per contract) or less
The strap can be profitable whether the stock continues to fall or if it reverses direction and begins to climb again. Neither direction has a limit, so profits aren't capped.
This trade has unequal breakpoints because we have more long calls than puts.
Our upper breakeven is $16.25. At that price, our calls would be worth $1.25 each for a total of $2.50, thus canceling out our initial cost. The lower breakeven point is $12.50 ($15 strike minus $2.50 net debit). In percentage terms, the stock must fall 14% or gain 11% in order to break even.
If Ford reverses up and trades to $17 by expiration on Jan. 17, the calls would be worth $2 ($200 per contract) each for a total of $4 ($400 per contract). Subtracting out net cost of $250 and we're left with a total profit of $150 -- a 60% gain.
If Ford continues to fall and doesn't recover by expiration, we can still make a profit. Our two calls will expire worthless, but our put becomes profitable once the stock drops below our breakeven of $12.50. So if the stock is worth $12 at expiration, our put would be worth $3 ($300 per contract). That leaves us with a profit of $50 for a 20% gain.
A loss will occur if the stock expires while the price is between our $12.50 and $16.25 breakevens. The maximum loss we could incur is limited to our net premium of $250. To compare the trade to simply buying Ford's stock, we would need to purchase 100 shares at its current price near $14.60 for a total outlay of $1,460. Unlike our option strategy, however, we have no downside protection.
A strap is a great way to speculate on price movement in a stock that's experiencing rapid changes. Our downside is limited while the upside is unlimited, giving us a lower risk trade with plenty of profit potential.
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