You hate the drillers. You think they are rolling over. You think I am dead wrong about my positive stance on the group. What do you do? One strategy would be to pick a couple of drilling stocks and short them. I just
detailed that process the other day.
I don't like to short stock. In an age when there are giant mergers everyday, I am afraid to short most common stocks except ones that would be impossible to be taken over. I also don't like to short concept stocks, and the drillers are concept stocks with earnings. (Double whammy for the shorts!) That means where they stop, nobody knows. If I can't quantify my losses ahead of time, I don't like to play. I like staying in business; it's comforting to know there is still an office at the end of my commute.
That's why puts were invented. Puts allow you to transfer the risk of the unlimited squeeze up on to the guy who sold you the put. You are stopped out. You can only lose your investment.
So let's go slowly. You hate
with a passion. (Traders, by the way, affectionately call this company SLOB for its Big Board symbol SLB.) You think it is 20 points overvalued and that it will be at $63 soon, but, of course, you don't know exactly when. You have a couple of options. You can buy a deep-in-the-money put, an in-the-money put, or an out-of-the-money put. Let's look at the prices and the risks and rewards of each.
My first question when I am about to buy options is always "when is the sell-off going to occur?" If I am sure that SLOB is rolling over, and sure that it will happen right now, I would be tempted to buy puts that might expire in just a few days. Take last week. A few days before Friday's expiration, the November 90 puts traded "flat" with the common, meaning that they would go up in value one-for-one with the stock's decline. Hey, good deal.
But that's what I call "putting a gun to your head." I hate doing that. I usually avoid this strategy unless I know of a near-term event worth betting on. I would rather go out to December or even January. That way if I am wrong I am not wiped out. If SLOB were to rally a quick six, in three days, I would lose my entire investment.
Again, the decision of which month is not an easy one. Do you pay a little more for the insurance that SLOB breaks within the January time frame rather than the December time frame? This is a guts issue. I usually err on giving myself more time. But in this case, the pricing of the "Jan 90s," almost $10, is too high for me. I start $4 in the hole. (Arithmetic: $90 minus $10 is $80 and the stock is at $84). In fact, all of the January SLOB puts are too expensive for my tastes.
But the "Christmas $90 puts" at about $8 look like a bargain. By the way, traders never say "Dec 90s" because that would lead to endless mistakes involving Digital Equipment. Important lesson: Just because a contract looks cheap doesn't mean it is available. If you want to short in size (more than 100 puts) you will need someone at a brokerage firm to help you get it done by positioning the stock. He will short the stock and sell you the put. He typically does not want to be betting against you.
So, we buy 100 of these puts for $8, laying out $80,000. If the stock goes down, beginning at $82 you will start making money. You won't be up immediately because the transaction costs and the bid and ask spread chew up your gains. If the stock goes to $80, you will be able to sell these puts for $10.
Once the stock starts going down past $80 you may want to buy 10,000 shares to close the position or sell the put to close the position. Either one does the trick. One involves more capital -- the stock purchase -- but gives you the flexibility to flip the common out again and start all over if SLOB rallies. (When you buy stock and exercise the put you have gotten rid of the position). So, if the stock goes to $79, say, you can sell the put for $11 and make $3 or $30,000, or you can buy the common and close out the position. If it rallies to $87, you can blow out of the SLOB and get short again with the put that you held on to.
Now, we don't have to buy the deeps. We can go to the "ats," and buy the X-Mas 85 puts at $5. That's my least favorite. You won't make any money unless the stock gets clocked below $80 (and even then, you just start making it). And if SLOB does nothing you get wiped out. Five bucks is a lot to lose. This is a sucker contract, but will be favored by your broker because he doesn't know squat about options and this one is the nearest to where the stock is.
Or you can go to the SLOB X-Mas 80 puts for about $2.50. This is my second favorite after the deeps, and if I were cash strapped it would be my choice because I could get good bang for the buck and not lose that much if I am wrong. I can buy 200 for half of what it costs to buy 100 deeps, and once the stock goes below $78 I've got a much better position, share-wise, than if I had bought the deeps.
In our original example we hate SLOB with a passion and think it is going down $20. If that level of conviction is intact, this out-of-the-money put is a much better "do" and I would skip the deeps because they don't have enough leverage. There is no contract "below" $80 in the Christmases, so I might also be tempted to buy some Jan 75 puts for $2.38, just for good measure.
Alternatively, let's say that I believe that the oil service group is no good, but I don't want to bet against anyone in particular for fear that the stock I "operate on" will be the one stock in the group that won't go down. Instead I would buy puts on the Oil Service Index. That way I capture a group move.
Unfortunately, an index requires a whole new skillset of valuation and trading. So I will save that lesson for next expiration.
(Writer's note: I am quite cognizant that I threw a ton at you in this piece. If you have never traded options, some of this will be over your head. I will revisit this concept many times until you get the hang of it. Others of our readers are probably saying "why listen to Cramer?" Okay, I'm humble about some things, not humble about others. I am a good options trader. I want you to be a good options trader. I have made a lot of money trading options. Most people I know have lost a lot of money trading options. They should stop doing what they are doing and start listening to me. The strategies I outline here are what works time and again. If you buy the SLOB X-Mas 90s and the stock shoots up ten, believe me, you will wish you bought the Nov 80s for 75 cents. I am not trying to tell you the direction of SLOB. Don't miss the symbolism: I am long SLOB. What I am saying is if you have conviction about the direction of something after you have done the homework, this is how I, as a seasoned option pro, would approach it. Does that mean they would buy that same contract at
Harvard Business School
and not the February 85s? Frankly, I don't give a rat's ass what they do there; I am in the business of making money, not getting A's from teachers who couldn't trade their way out of a Harvard Coop Bag.)
James J. Cramer is manager of a hedge fund and co-chairman of TheStreet.com. At time of publication, his fund is long Schlumberger. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to