As earnings season kicks off, we all know disappointments lie ahead, to be followed by painful selloffs.Blowups always generate the same inevitable questions. And AutoZone ( AZO), Electronic Arts ( ERTS) and General Motors ( GM) have inspired a flurry of reader emails seeking guidance on either how to minimize the damage or how to seize opportunity.
The position now controls 2,000 shares, double the existing long stock position between the price of $30 and $35 for no additional risk. Now, because the long stock and long calls are all covered, there is an equal number of $35 calls sold short, and the maximum profit is achieved and capped at $35 and above. Establishing the proper spread for even money can be a challenge, but high implied volatility, which usually occurs in the wake of a blowup, will help make the numbers more attractive. Again, this strategy should be used as a means of reducing losses in a relatively short period of time, not completely eliminating them. Do not get bogged down by a CPR position. For a more complete explanation on how this strategy is constructed and works, please read this
past article . playing the dumpers ," but it requires exact entry and exit points, and a nimble trading touch. One mistake many investors make is to use call options as the vehicle for catching the bounce. I do not believe this is the right approach. It may seem to limit your downside risk in case another bombshell falls, but in reality it leaves you exposed to a much more insidious sort of pain.
Just as the initial move creates that burst of volatility, the fallout in the days immediately following a blowup are usually characterized by a slow drip or decrease in options value as volatilities return to a more normalized level. Buying options the day after a blowup is akin to holding a radiated material with a quick half-life: It could certainly come back to life, but it's more likely you'll experience some serious premium decay. If you are looking for a bounce, a better bet would be to sell put options. This strategy takes advantage of both the increased implied volatility and the fact that the stock needs to only stabilize, not necessarily rally, for the position to yield a profit.
rule to wait 30 days after a blowup before even contemplating buying the stock. When stocks blow up, the best attitude to take, no matter what your opinion on the company, is that it will take time for prices to normalize, but normalize they will. In the meantime, avoid buying options with overly inflated prices.