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Strategies & Market Trends : Options for Newbies -(Help Me Obi-Wan-Kenobe) -- Ignore unavailable to you. Want to Upgrade?

To: PoetTrader who wrote (2103)	6/19/2001 10:27:30 PM
From: Dan Duchardt	Read Replies (2) \| Respond to of 2241

Poet, I'm too new to know exactly how a protective put works...perhaps you could illustrate on the cien situation Perhaps this reply is a bit late in the CIEN journey, but it has become a good example of how a protective put can be used to limit risk. From your earlier post on June 7, the scenario was buying CIEN at 61.50 and selling a JUL70 call for 3.30, making your net investment 58.20. It is conceivable that by rolling down to lower strikes as CIEN has pulled back you might have lowered that net investment a bit, it is probably still well above CIEN's current price of 36.75. As I am sure you are aware, CCs are an excellent way to increase profits in a gradually rising market, and to reduce the cost of ownership of a stock at the expense of putting a cap on potential gains, but CCs still leave you at risk of losing your entire net investment. A protective put is a way to limit your potential loss. In this CIEN example, it would have been possible to buy a JUL50 put on June 7 for about $2. That would have increased the net investment to 60.20 leaving room for a potential gain of 9.80 (70-60.20) while protecting the downside. Even if CIEN goes to zero, the put gives you the right to sell your CIEN stock to a put writer at 50.00 per share, limiting your loss to 10.20. For another $2 you could have bought a JUL55 put reducing the potential gain to 7.80, but limiting the loss to 7.20. Spending 60% to 125% of your call premium for the protection may not have seemed like a wise choice, but it illustrates the principle of put protection. Had you been fortunate enough for CIEN to move above 65 fairly quickly, you might have waited for the move and spent less than $1 for that JUL50 out or less than $3 for the JUL55. Unfortunately, the cost of protective puts are generally not all that attractive at the time you write the calls. But they can become attractive when a position makes a nice move into the money. Probably the best thing that could have been done in this CIEN case was to stop out of the position early, taking a smaller net loss than you would have suffered had you only gone long the stock. That is of course said with the advantage of perfect hindsight, and none of us have that luxury when we are opening positions. A protective put early on limits upside, but sure looks good when a stock dumps. Another thing that could have been done here was to write a lower strike call, and settle for a lower upside potential. The JUL60 calls could have been sold for about 7 making the initial investment 54.50 and limiting the gain to 5.50. That is still 10% in about 6 weeks, which is not bad. Buying the JUL50 put under those circumstances would have been more attractive, but you were still then looking at a potential loss of 6.50 with the upside potential reduced to 3.50. The grim truth about CCs, IMHO, is that when a stock takes a nasty tumble a CC can be worse than outright stock ownership. If you have the discipline to exit a bad CC position, it reduces your loss compared to outright stock, but if you think you are in the stock long term and are going to write CCs every month you can easily get "trapped". With a net investment of only 54.50 (writing the JUL60 calls), it is not very comfortable to be thinking in terms of writing calls with strikes below 55 in the coming months, since being called out means taking a loss. But with stock prices in the 30s, even strike 55 calls have too small a premium to be worth selling. The higher strikes have no value. In any account that will allow it, with the downside risk as high as it remains but with stocks like CIEN beaten so far down already a much better risk to reward than CCs is buying LEAPS. On June 7 you could have purchased a 2002JAN60 call for around 15.50. Had CIEN gone up since then you could have enjoyed unlimited upside gains. With it down this far you might be thinking that it never will come back and you could stop out with only about an $11 loss, or that it will come back big in 2002 and roll out to 2003JAN 60 for an additional $6, or even better the 2004JAN50 for about $10 . You can also open calendar spreads with LEAPs or farthest out month options playing the analogous role of the long stock in a CC.. Much of the conversation over at the CC thread Subject 12574 has moved in this direction. Instead of buying CIEN for 61.50 on June 7, you could have bought 2002JAN30 calls for 34.50 and still written the JUL70 calls for 3.30, making the net investment 31.20. If you were called out, you would have to deliver stock at 70, but you could exercise the long call and buy stock at 30 to take in 40, an 8.80 gain on a 31.20 investment, 28%. As it stands now the 2002JAN30 is worth 13.20. That is still a big loss if CIEN does not bounce, but not nearly as bad as owning the stock and with some reasonable roll out alternatives. If you are of a mind to hang on long term, the thought of possibly losing another 13 for a net loss of about half the original stock price is a lot more attractive than possibly losing another 36. You could also add protective puts to this scenario. Having spent $2 for a protective JUL50 put would be looking mighty good right now since that put is increasing in value faster than the long call is losing value as CIEN falls. You could actually make money on the position if CIEN completely folds!!! That is a big advantage over owning the stock as part of a CC. This may be going a bit past "newbie" territory for some, but hopefully it illustrates that while simple CC writing is not always an easy road to riches, there are related option strategies that can improve the odds, as well as illustrating how a protective put can be great insurance against a CC disaster. Dan