What is your opinion about NetEase (NTES) - Get NetEase Inc. Report? I read the Aug. 12 story, "Net Stocks From China Showing Cracks," and any cracks just disappeared, as NTES recently broke out of the $52 resistance and is currently at about $58. I own 90 puts, 45 strike, December 2003 expiration at an average cost of $5.10. These are now down to $3. Also, what strategies would you recommend, to limit my losses? I'm hoping to get out at break-even or within a month of expiration, whichever is earlier. Thanks.
I have no opinion of Chinese Internet stocks in general, or NetEase in particular. (Given the specificity of the question, I'm required to remind readers that I'm not a registered investment adviser.)
Also, since receiving this question two weeks ago, NetEase has traded as high as $69 and is currently back down to $52.33. Even though it's obviously a moving target, it still provides a real example for addressing some basic concepts on how to deal with an open options position that has moved into the loss column.
I don't know if the reader has acted yet, but with the stock at $63, the December 45 put which he is long is worth about $2. The continued rise of the stock points to some advantages of using options, especially when trading high-beta issues such as Chinese dot-com companies. Buying options limits one's risk -- in this case, the maximum loss is whatever you pay for the puts.
Unlike shorting the underlying shares, in which your capital exposure and losses are both unlimited and increase at a constant rate as the share price rises, the maximum loss of a long put position is limited to its cost and the capital at risk, and it actually declines at a decreasing rate as the price of the underlying stock price rises.
In this sense, the reader has, by definition, limited the position's potential loss. But the downside of this inverse relationship between the stock price and being long the options' value is the very real possibility of losing 100% of the investment.
Salvage vs. Scrap
Any adjustments to get this position back to break-even would require balancing an increase in risk vs. limiting the profit potential; the third, most straightforward choice of action of simply accepting the loss. Some adjustments include buying more puts to lower the average cost, buying back the puts and switching to short calls, or creating a ratio or calendar spread. All of these will turn the position's theta -- or time decay -- back in your favor but will also increase your risk profile.
I think it would make the most sense to use a straight vertical spread to reduce the cost. For example, selling 90 of the December 40 puts, which are currently trading around $1.25, would not only reduce the current exposure by some 50%, but it also brings the absolute cost (and maximum loss) down to $3.85 a spread. It also retains the possibility for a profit; should NetEase fall below $40 prior to the December expiration, the spread will be worth $5 and allow you to salvage a profit of $1.15 a spread. Admittedly, hoping for the shares to drop 35% in the next two months is bit of a longshot. But is it any better than just selling the puts right now and accepting the loss? That I can't answer.
The bottom line is, no matter how many adjustments you make, profit and loss will always come down to being right.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to