Alternatives to Selling a Position

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Make sure you read the disclaimer listed in the frame of this site. Here's the TL/DR:  You are responsible for your actions, and I am not.

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One of the rules that I have for my stock positions is that the stock must be sold, at least in part, if it closes below the 21 day moving average ( simple or exponential ).  If the stock drops below the 50-day it triggers another sell, and a close of two days below the 50d generally is an exit signal.  Certainly, a close below the 65d will have me running for cash in the position, as I never see stocks at the 65d (until I do, of course ....)

Some use other moving averages to take profits, others simply exit if they see a behavioral change, that is, "...it's been above the 21d for the last 3 months so I'll lock in profits now..." or something to this effect.

The challenge here is that the markets shake out positions from time to time.  For long-term traders who want to hold stocks that are true market leaders (TML), the key is to developing a methodology to keep holding these when the inevitable shakeout occurs.

The rest of this note will focus on an option strategy to lock in a significant portion of unrealized profits, and will present various decision points to evaluate on possibly improving upon the initial transaction.  The goal here is to hold a "Stage 2 Stock" (https://www.swing-trade-stocks.com/stock-market-stages.html) as long as possible.

You Bought Well, and the Stock has Increased a Significant Amount

Stocks that are TMLs have massive gains over their Stage 2 life.  Do the research.  Part of this process  is a downside:  they often "pause", and even pull back, and traditional rules such as "sell if the stock closes 2 days under the 50 SMA" or "sell if the stock closes any time below the 65d EMA" can trigger you out of the position.  While you may have gains at these levels, you may miss some of the recovery and subsequent move upwards, resulting in missed opportunities.

Here's an example that should help this make sense.

• You were bullish on PINS and you placed an order back in September 2020 and it was filled at $37.44.
  
  
• PINS grows over time, and here on February 26, 2021, PINS has grown to $80.54.  You have a significant gain:   ($80.54 - $37.44) = $43.10 and on a percentage basis, this is $43.10 / $37.44 = 115%.
  
  
• PINS starts to increase in daily trading range, causing it to become more volatile and test key moving averages (KMAs).  You do not want to sell PINS, as you still have a bullish outlook over the longer term, but your rules could force you to liquidate the position if the stock heads downward.
  
  
• KMAs are:  21dEMA:  $80.46, 50dSMA: $74.58, and 65dEMA: $72.41

The question at this point is whether to take partial profits or to hold on to the position.  In this example you're up over 100%, so you have a lot of cushion, right?  If your "exit at all costs" rule is the 65d EMA then exiting around $72.41 would net you a ($72.41 - $37.44)/$37.44 = 93% return.  Not bad.

In context of a graphic profit and loss (P&L) graph, here's the chart:

Click on the image to enlarge

In the image above the x-axis is price and the y-axis is profit (or loss).  The blue line is the profit-loss for the position, and it goes all the way down to zero (not shown) as well as out to infinity (also not shown :o).  As price varies, the blue line reflects the gain on the account, if you have 100 shares.

You can see that the vertical line at the "last" price of 80.54 produces a gain of ($80.54 - $37.44) = $43.10 per share, and if you have 100 shares, you have a paper gain of $4,310 on the original investment of $3,744.  You can see this by looking at the y-axis.  

I've added two vertical lines.  The first, in orange, intersects the blue line at the 50d SMA of $74.58.  The other, in red, is the 65d EMA and it intersects the blue line at $72.41.  You can infer from the y-axis that you'll still be up quite a bit if you sold at the 65d EMA, as I calculated above.

The other thing to note in the graphic is the dark black area vs. the gray area.  The black area shows the expected range of PINS, as measured through 3/19/21.  All things being equal, this black area shows the higher-probability occurrence that PINS will be in this range as of the close on 3/19.  You can see that there is a non-zero chance of taking out the lower 65d EMA, and then some.

Let's presume you set a stop loss at the 65d EMA (or just below, whatever).  Let's also presume it gets hit.  The obvious downside is that once you lock this profit in, you're out.   You will have to wait for the next setup to reenter the stock, and this could take some time.   In addition, you'll miss the recovery (if one occurs).

There is another approach.

Revisiting the "Married Put"

When we own at least 100 shares of a stock we unlock the potential to transact options with respect to that stock position.  A well-known conservative options strategy is called a "Covered Call" or "Buy-Write", and essentially, we purchase 100-share increments of a stock (the "underlying") and also sell a call contract against the underlying shares.  A lesser-known options strategy is the "Married Put", where we buy the stock (again, the "underlying") and at some point in the future (generally), we buy a put.  If you are new to options lingo when you buy a put you have a right, but not an obligation, to sell the underlying stock at the put strike.  Options have an expiration date ("option expiration", or OE), and your right to sell the put is valid all the way up to the OE date.

In the example of PINS above presume that we are sitting on a really sweet paper profit.  Also assume that we don't want to sell the position as our outlook for PINS is bullish, but we're encountering some increased volatility.

Can the Married Put (MP) strategy help here?  Of course it can, or I wouldn't be writing about it.

Like everything else though, there are pros and cons.  Only you can decide in the alternatives analysis on what path you want to take.

If we're willing to give up all of our paper gains down to the 65d EMA because of our strategy rules, it would make sense to buy an insurance policy on PINS that protects us at the 65d and lower.  This way, we get to hold PINS, at least until options expiration, and ensure that at a minimum we achieve this gain in our portfolio.

• Options on PINS bracket the 65d EMA ( $72.41 ) at $70 and $75.  Let's take a closer look at the $75 strike, as it covers both the 50d as well as 65d moving averages.

The next decision point is how far out do we want the insurance policy to be valid?  I like at least 90-day increments, to give the market time to wiggle and because earnings are about every 13 weeks, which is 91 days.  There is nothing wrong with going out further, but the insurance policy costs more.

• I note that Estimize (www.estimize.com) has PINS earnings release on 5/20/21, before market open (BMO), so we want to go out at least this far.

When I open the option chains on PINS, I see the following:

Click on the image to enlarge

A few things are apparent to me from this:

1. PINS trades weekly options.  You can see this in orange.  We may use this information later.
   
   
2. There is a monthly expiration of PINS options one day after ER in May.  We *could* choose this date, but I'd rather go a bit beyond the ER date to allow things to settle, one way or another.
   
   
3. The $75 strike for the June 18 OE Put will cost $9.35 (Ask) or $8.50 (Bid), or somewhere in the middle if we were to place this trade as soon as markets open on 3/1.  For analysis purposes I like to use the worse-case (most conservative), and since I am buying the insurance, the highest cost of the $75-strike put is $9.35.  This means that I'll pay $935 per 100 shares of stock that I want to protect.
   
   
4. Over under the "Open Int" column, this is the open interest that exists as of today at that strike and OE.  Since this is in the 1000's, we are safe -- the option is liquid, should I want to sell it back in the future.  This is a good thing to see.

Let's presume that I'm willing to buy the 6/18/21 $75 put for $9.35.  This adds to my stock basis (which was $37.44), so the new stock basis is $37.44 + $9.35 = $46.79.  This seems like an expensive hit:  $9.35/$37.44 = 25% so it appears that I'm giving up a good percentage of my gains to pay for this insurance.

Well, truthfully, yes, insurance costs.  Just like it does for your car, house, etc.  You don't get protection for nothing.

This being said, let's look closely at what this does for us.  Here's the profit/loss graph:

Click on the image to enlarge

At the bottom of the image I've circled the cost of the option ($9.35), the put strike ($75), the original cost of the stock ($37.44), and the option expiration date (18 June 21).  This is simply to draw your eye to these inputs.

Two curves are shown, one is yellow, which is the profit curve as of placing the trade, and the blue curve, which is the final value of the transaction as of 6/18/21.  The blue curve is the WORSE CASE scenario for this strategy, and reveals a couple of key things:

1. The blue line is flat from $75 and below (to the left).  This is because we are 100% protected in our gains up to $75 up to 6/18/21.  Put another way, no matter what happens to PINS on the downside, a drop below $75 will not result in any gains less than $2,821 per 100 shares owned.  If PINS goes to $50, we still get to sell our 100 shares at $75 because of the put option.
   
   
2. If PINS collapses to $0 (unlikely) the $6,565 Max Profit on the Put (see the lower right corner) reflects the value of the option on 6/18/21.  This is $7,500 - $935 = $6,565.  We paid 12% ($935 / $7,500) for the option and in this worse-case scenario, our return on option is nearly 700% ($6,565 / $935).
   
   
3. The blue line rises linearly from $75.01 to the right.  This is because we have not capped our upside -- if PINS goes "to the moon" we will go "to the moon" with it.  Our gains are unlimited, and you can see this again in the lower-right with the Max Profit on the stock position being infinity.
   

What the setup does is that no matter what, we are guaranteeing a minimum profit of 60.3% for any price movement below $75.  This is easily calculated as:

Total cost of stock:  $3,744

Total cost of option: $935

Total cost:  Stock + Option = $4,679

Stock value @ $75:  $7,500

Option value @ $75 on 6/18/21:  $7,500 - $7,500 = $0

Total value @ $75 on 6/18/21:  $0 + $7,500 = $7,500

Profit @ $75:  Total Value - Total Cost = $7,500 - $4,679 = $2,821

% Return @ $75 = Total Profit / Total Cost = $2,821 / $4,679 = 60.3%

If the stock drops below the 65d EMA and remains there through 6/18, there is nothing to worry about.  Let's presume that the stock drops to $50:

Total cost of stock:  $3,744

Total cost of option: $935

Total cost:  Stock + Option = $4,679

Stock value @ $50:  $5,000

Option value @ $50 on 6/18/21:  $7,500 - $5,000 = $2,500

Total value @ $50 on 6/18/21:  $2,500 + $5,000 = $7500

Profit @ $50:  Total Value - Total Cost = $7,500 - $4,679 = $2,821

% Return @ $50 = Total Profit / Total Cost = $2,821 / $4,679 = 60.3%

Let's presume that the stock goes to $100 as of 6/18:

Total cost of stock:  $3,744

Total cost of option: $935

Total cost:  Stock + Option = $4,679

Stock value @ $100:  $10,000

Option value @ $100 on 6/18/21:  $7,500 - $7,500 = $0

Total value @ $100 on 6/18/21:  $0 + $10,000 = $10,000

Profit @ $100:  Total Value - Total Cost = $10,000  - $4,679 = $5,321

% Return @ $100 = Total Profit / Total Cost = $5,321 / $4,679 = 113.7%

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Given all of this, what is the downside?

"Downside" is relative.  We bought insurance, and we have to pay for it.

The "downside" is that if we were truly buy-and-hold, with no regard to risk management (exiting when our rules say to exit), then we will always underperform buy-and-hold with a married put strategy.  This is because the put option costs money, and this subtracts from profits.

This is really the only negative in the entire process.

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In the end, there are a number of positives here:

1. If the stock drops below our sell point (wherever that is), we have the psychological confidence that we are fully protected if we placed the put strike at or above this level.  This confidence exists through the life of the option contract.
   
   
2. If there is an ER event during the period the put is active (e.g. before 6/18/21), we are fully protected and do not limit our upside.  We simply do not care about ER and are happy to hold across ER.
   
   
3. If, as in the case of PINS, there is a huge earnings blowout and PINS jumps up a huge amount, we can still sell the put before OE and recover a portion of what we paid for the put.  This is NOT factored into the discussion above but would add to the overall gains for the position.  If you don't understand this, ask, as it's important.

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A variant here is to raise the MP purchase of the put to being at-the-money (e.g., $80-strike), or even making it an in-the-money (ITM) put (e.g. $85, $90, $95, etc.).  While you pay 1:1 for the amount between the strike and the current price (e.g., if you are buying the $85 put strike, and the price of the underlying is $80.54, you will pay $85 - $80.54 = $4.46 for this (Intrinsic Value) plus the time value (Extrinsic Value) of the option (currently around $9.89 as I write this).  There are advantages to this too.

The next post will look at how to improve on the Married Put by selling short-term out-of-the money (OTM) calls on PINS.  I will show that even with decaying volatility (which means premiums received from the sale of the OTM calls go downward), it is possible to push the minimum gain received above from 60.3% to over 90%, over the same period (March to June) with very conservative strike selections.

Please do not hesitate to ask questions.

Regards,

pgd