How to Catch a Falling Knife

I ran across this post on “Catching Falling Knives” at The Market Capitalist and felt that it was a great topic for my first post on options here at Cash Flow Mantra.  Most people would be scared to catch a real falling knife, but if you do so with a little bit of practice and training, it can be done relatively safely.  It can even be entertaining as seen here:

Tommy Drake Knife Juggling

Now if I were to catch a falling knife, I might do so with a block of wood or a chain mail glove to keep from getting hurt.  But if I want to catch a stock in free fall, I would do so with put options.  Allow me to explain how to catch a falling stock by looking at a real life example.

Recently, Linked In (LNKD) issued stock in a much hyped IPO.  The stock opened at over twice the offering price and shot past $120 per share, but then immediately began falling.  There have been questions about valuation and earnings, but I am not interested in debating that.  Rather, I am interested in how could you get involved in the stock not knowing where the bottom might be and still not get hurt!

It didn’t take long for options to start trading on the stock so here is what I would have done had I been interested.  You could consider this type of strategy for Facebook when it comes out since it is likely to be a stock that will have some hype involved.

Let’s say that you would have wanted to get 500 shares of Linked In.  That first day of trading it would have cost $50,000.  But the stock started declining right away.  Within a few weeks, the stock is at $70 per share.  Is this a bottom?  How low will it go?  I have no idea, but I do have a plan.

When the stock is at $70, I could purchase 5 contracts of the $60 put that expires in November for about 25% of the value of the stock or about $17.50 per share.  Each put contract covers 100 shares.  The puts are very expensive for this stock since volatility is still high with real potential downside risk.  Then I purchase 500 shares.  So, what have I done?

I own LNKD and can brag to everyone at work.  But my cost for the stock and the put options is  $87.50.  If LNKD is trading at $30 in November, then I can sell it for $60 but I will still lose $27.50 per share which is better than $40.

Alternatively should LNKD increase to $100 again like it did today on July 11,  I will make a profit of $13.50 per share on the stock plus whatever value the puts may hold.  Could LNKD go to $150?  Sure.  That would be great if I owned the stock.  Could it go to 30?  Sure.  That would be terrible if I owned the stock.

The point is that puts can be used to limit the downside and allow you to pull the trigger on a falling knife.  Puts are that chain mail glove protecting you while you practice juggling those knives.  No sense losing a finger or a lot of trading capital.

There are even techniques that can be used that might even allow you to profit from a falling knife, like buying 8 or 10 put contracts on those 500 shares and selling off the puts one at a time as they increase in value and you wait for a bottom.

I use puts in my retirement accounts to double down and buy into a declining stock.  I sold EMC from my account last November after holding for 3 years.  My original purchase price was $25.37 in October of 2007.  I watched it drop into the low teens but because I made money on the puts and was able to purchase additional shares with confidence knowing that it would eventually recover somewhat.  I sold at $21.82 but made 8.7% annualized return over those 3 years because I averaged down.  My basis ended up being $15.78.

I was able to invest without fear knowing that I couldn’t lose all of my capital.  Plus, I made a better return than buying and holding in which case I would have lost money.

So reader, have you traded options?  Do you think options are risky?  Have you any idea what I was saying?  Please offer your comments below.  I will be working on another site that will start at the beginning and explain options in a simple manner so that anyone could understand and appreciate them.

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