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Time To Trade Options!

Although I am a committed long term index investor I do sometimes wonder what else can be done. For the most part I admit that I know nothing about any company’s fundamentals and never keep up with the news (except for my own business). It would be foolish to think that I know more than other active investors who trade the market daily.

But once in a while I wonder if they have different preferences or they are about to change their minds. There are well-documented and widespread actions that many investors use to lose money, so the people on the other side of those trades must be making money. Or there may be opportunities that are simply overlooked because they don’t fit the usual expectations.

A couple of years ago I went after one such opportunity by putting $1000 into a Mortgage Investment Corporation that’s been paying a steady 5% interest since then. That has been less than the return on government bonds until last year, when the MIC outperformed by 2%. It doesn’t trade openly so it doesn’t carry the risk of capital losses, but it does have a fixed term so I can’t withdraw the cash for 3 more years. So far that’s looking like a reasonable but not exceptional performance.

Option Trading

Now it’s time for something new. Earlier I tracked the hypothetical performance of a long/short trade with Apple and Blackberry. At the time I didn’t do anything with my idea which is too bad because the timing of the original posts and the two follow-ups was uncannily good (the timing was just luck of course). A lot of profit would have been made on that idea already so it’s not as attractive now but I’m willing to put in $100 to see what happens.

I’m trying this in the new Questrade RRSP account I opened so shorting isn’t available. In any case I wouldn’t want to take the risk of shorting on something like this. Instead I looked at options. By buying Call options for Blackberry above the current price, and Put options for Apple below the current price, I can profit a bit if the prices get closer together. If one or both stocks actually pass the strike price of the options that could turn into a large gain.

The Trade

To do this with $100 I needed to split that in two, take off $10 for the commission on each trade, and then buy one option contract at a price of $0.40 or less for each stock (since it is for 100 shares that costs me $40). I had been tracking a few options on a watchlist while waiting for Questrade to receive the form that allows options trading, so I ended up buying Apple July 20th puts at $275 (1 contract for $47) and Blackberry June 22 calls at $25 (2 contracts for $18 total). I realized later that I could have bought Blackberry calls at $20 for a cost of about $35 and stayed within the maximum I’m willing to throw away on this.

This is on a day when Apple closed at $427.37 and Blackberry closed at $14.78. I timed the Blackberry options to be after an earnings release in case that turns out to be really good. For Apple the timing didn’t work out as well so they are probably a little before an earnings release. If they come out with results in April and July that are similar to what they did in January, the stock price might take a beating. On the other hand they might find ways to beat expectations a bit this year and bring the stock price back up.

The Results?

Even if the basic idea is right there are a lot of risks in this execution including the trading commissions ($20+ to buy and sell a contract), the limited time frame (more distant options are more expensive), and the high chances that one of both options will be a total loss (if held until expiration and the stock price never reaches the strike price). Those risks are why options have to have a high payoff if they turn out to be useful.

I don’t expect much from this. If the strike price is actually hit each contract would be worth $100 for every $1 that the stock price goes past the strike price (plus or minus a bit for the remaining time, volatility, and transaction costs). That isn’t very likely but it is possible. Even if it doesn’t get there the value could rise or fall by several times the initial cost as I saw when some of the options on my watch list doubled in price from one week to the next.

I’m not doing this because I know better than the market. I have no secret information that tells me Apple stock will close at $198.76 in 3 months (although I would like to see that now). Instead I think that the market has become irrational, driven by emotions and past performance. Some of that has been burned off and counter-trends may happen now. If it turns out well the result may be a few times what I put in. If it doesn’t, I know the maximum loss from the start.

If I see any future situations where the market hype seems to be reaching an extreme I may put a little bit into those and see what happens. I don’t expect to do this regularly because it takes a combination of unusual market hype and me actually noticing that something is happening.

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