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Dissecting the Use of a Trade Idea


Consider the source, consider the strategy, evaluate the stock.


When it comes to stock market predictions, few are shy about playing the game. After all, it doesn't cost anything to take a stab at the future -- and if incorrect, the prognosticators simply ignore the prediction. When correct, they milk it for all it's worth.

It's not only stocks, but prognosticators exist in all financial fields. Options are no exception. Many individuals and firms claim results ranging from reasonable to unbelievable.

It's difficult for anyone to know how to evaluate the claims of those making predictions, but it's not a good idea to blindly follow.

Recently, Adam Warner (The Daily Options Report) reported on a trade suggestion made by a professional institutional equity trading and research firm. It's a perfectly reasonable suggestion, and one that normally goes un-noticed, unless the trade idea appeals to you.

But I can't let this one go without a comment. I suppose the reason is to reinforce the notion that trade suggestions are merely that: suggestions. No matter the source, the strategy suggested may be well thought out, or naive. It may be well suited to you, or totally inappropriate. It's always your responsibility, as the consumer, to carefully consider the suggestion before acting on it.

Here's an abbreviated excerpt of the recommendation (taken from Daily Option's Report):

Given our view that PALM has a solid downside floor and number of catalysts that could drive shares sharply higher toward our $20 target price, we highlight May 2010 risk reversals that entail selling 10 strike puts at $1.70 to buy 12 strike calls for $1.55 and net $0.15 credit. Note that these prices are estimated, based on the pre]market trading in PALM at $10.80. This position commits to getting long stock at the equivalent of $9.85, a level that we consider to be compelling value, and provides levered participation to the upside through the upcoming catalysts that we anticipate.

Here are my thoughts:

1. A "risk reversal" involves buying one call and selling one put.

2. Selling the May 10 put and collecting $1.70 is very attractive for the bullish trader.

  • If this idea turns out to be a loser, and if the traders are assigned an exercise notice, they owns PALM shares at $8.30. That's a lot more attractive than paying $9.85 per share.

  • If the stock remains above $10 per share, the puts will eventually expire worthless. The profit is $170 on an investment of $830 - and that's just over a 20% return on investment for a five-month trade.

3. Using the put proceeds of $170 to pay for the call options ($155 each) is a great way to own the call for no out-of-pocket cost. The true "cost" of the trade is taking the risk of owning shares at $9.85.

4. With the stock trading at $10.80 (at the time of the recommendation), that call option is out of the money by 11%, and it just feels wrong to pay that much premium for this option.

5. Of course the recommendation suggests that PALM can rise to $20 per share. If that happens, those calls will be worth at least $8 apiece. A very nice profit of $815, or almost a 100% return on the same $830 (margin requirement) investment.

6. Of course the stock can be any price when May expiration arrives. But here's the dilemma as I see it. If I want to make a bullish play on this stock (and I don't; this is merely a discussion of someone else's recommendation), is it good enough to sell the put and earn a 20% return if the stock remains above $10, and earn some profit if the stock remains above $8.30?

Or is it better to pay that $155 premium, buy the call, and hope that the people making this trade suggestion know what they're doing? The potential gain is much larger, but the downside protection is only to $9.85 per share.

7. I choose selling the put with its much larger downside protection. Others choose the risk reversal because the potential profit from buying the call is too large to resist. But I don't like the odds of buying the call. I prefer a higher probability of success, especially when the (five-month) 20% return is attractive.

NOTE: Anyone relying on recommendations still has to take the time to consider the source, consider the strategy, evaluate the stock -- and then decide if they want to play or pass. I pass on this one.

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No positions in stocks mentioned.

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