When Stocks Become Sinkholes

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.

To Resuscitate, Not Resurrect

As a devoted options columnist, I am obviously a firm believer in the benefits of embracing options in your daily trading life. That said, I also recognize their limitations and always warn they do not offer miracle cures or immediate financial salvation.

So anyone who has seen a position obliterated must first understand that options can do only so much to redeem a position gone bad. Options can give a second wind to positions that still have a pulse, but do not expect them to perform a resurrection. In fact, in the case of a blowup, many professional traders would opt to take the loss and move along to a new opportunity.

The thinking is there are better places to deploy time and capital than fighting what will likely be a losing battle. In fact, when applied to a losing situation, options have the power to make you even more wrong and cause even more pain than if you had just let the position die.

That said, there are some standard operating procedures for at least trying to briefly stabilize before making an honorable retreat. One of the most popular techniques is often referred to as a current portfolio repair (CPR) strategy, which consists of adding a 1-by-2 ratio call spread to the existing holding. The goal is to increase your long exposure at little or no additional risk or cost.

For example, assume you own 1,000 shares of XYZ, which is currently trading at $30 per share. (The cost basis is inconsequential.) You would buy up to 10 of the $30 calls and sell up to 20 of the $35 calls for even money.

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.

Picking Through the Rubble

When a stock blows up, the worst injuries are suffered by those who are short options or who have positions with a negative gamma. This is because the drop in stock price usually results in an immediate mushroom cloud of near-term implied volatility. But those who are clear of the implied volatility blast area can take advantage of some serious opportunities for profiting.

The usual play is to assume the move is overdone and look for bounce. This can be a very effective scalping technique, which Ken Wolff, a RealMoney contributor, describes as " 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.

Kicking Dirt in the Hole

A completely different approach I used to take, and one Street Insight contributor Adam Warner employs, is to sell calls on the morning a stock blows up. The reasoning behind this is straightforward. You are once again taking advantage of inflated option premiums, and usually a stock will take some time before mounting a sustainable rally after a blowup. So even if the stock does get a small bounce in the day or two after the initial decline, the options will usually see a commensurate decrease in the implied volatility, which should keep any losses to a minimum.

A rule of thumb used by Warner is to use the first day's high as a mental stop; if the stock trades above that day's opening range, he will close the position. Selling calls after a stock has cratered may only offer limited gains, but the percentage of profitability is fairly high. It follows Jim Cramer's 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.

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 steve.smith@thestreet.com.

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