As a rule I don’t often talk about by trades. The main reason for that is I’ve found talking about a trade influences it. I’m not talking a butterfly flapping its wings over Japan here, I’m talking about real and very tangibles effects. As soon as I mention a trade to anyone then my ego comes in to play. I’d like to say it doesn’t, but I know it does. If you talk about your trades the easiest test to see if doing so effects the outcome is to honestly consider whether you ever think about having mentioned it. If you say no, you’re a legend, with no ego. The ego can do nasty thinks like stop you admitting when you’re wrong, stop you from getting out of the trade or freeze you.

I know I should keep my mouth shut, but saying that I thought I should follow up on a recent trade I have mentioned. I sold March $15 Puts on LUK in late February before earnings. The earnings were bad, LUK tanked. Although the earnings were bad they did not materially change my view on LUK.  You can see some of my analysis and thoughts on LUK here. I decided I’d still be happy to take ownership of LUK shares in March, but I’d prefer to lower my cost basis from $13.20 ($15 strike – $1.80 premium). I decided to sell April $15 calls for $0.55, a very dangerous move as it left me naked on the upside. However, I figured it was unlikely that LUK would close above $15 by March 20 and even if it did I would still make a profit up to $17.35 ($15+1.80+.55). As LUK’s book value was $11.22 year end I decided there was a very small probability of losing on the upside, while reducing my cost to $12.75.  I’m not recommending a series of trades like this to anyone and clearly I would have ensured an even lower cost basis if I had of waited until after earnings. However, at the time of my initial trade I had no way of knowing that.

Naturally there is no free lunch. I have sacrificed potential upside and capped my profit to the premium received $2.35  per share (if put in March and called in April). But you know what, I don’t view missing upside as a risk, to me investing is primarily about covering the downside and letting the upside take care of itself. While I am now naked those calls,  I view lowering my cost basis as reducing my risk and giving me a higher probability of a better return. Particularly when I saw the downside risk as greater than the upside potential. There are now three possible outcomes for which I need a plan. Always having a plan is one of the keys to success when using options.

1. Shares close above $15 on March 20. I am not put. While I view the probability of the shares closing above my break-even point of $17.35 by April 17, I see no reason to stand in the way of what could be the start of a strong uptrend. I’ll close my calls and walk away with a profit
2. Shares close below $15. I’m put to and no action is required. That was my orginal aim of the trade.
3. Shares close below $15, but quickly move up afterwards. That’s fine too, I either get called or I don’t.
4. I know I said three outcomes, but of course I can’t just have three outcomes which are all good. The fourth outcome is LUK tanks to sub $10 range. If that happens this week or after does not mater as I have downside risk whether I’m short Puts or long stock. At this stage I don’t have a plan for that outcome as it would depend on circumstances. If it was due to a fearful market sell-off I would not be concerned and may look to add. However, if it was due to say Fortescue going bankrupt or some other calamitous LUK specific event, then I’d take my lumps.

Let me know if you would have handled it any differently.

Related posts:

1. Closed Options Trades
2. Day Three, Investing Brain Dump: Idea Generation
3. 2011 LEAP Schedule and Info