The Broken Stock Strategy
One of my favorite strategies that I incorporate into my
trading is what I call the "broken stock" strategy.
The theory is that when a stock gaps down AND suffers a complete chart
breakdown, odds are that it is not coming back so fast. The first tendency is
to "bottom fish", and/or take "cheap" shots in the calls. But those shots
aren’t so cheap; the calls tend to carry a relatively high volatility,
particularly as trading begins.
My play is to sell calls at different prices with about 1-3 month’s to go, ideally at strikes
within or a shade above the gap. And my play is to do it quickly, before the
stock settles into a new and/or lower range and the buying interest dries up.
If the trade *works*, I may bid lower and buy the calls back. Or I may just
let nature take it’s course and chance letting time decay kick in. It depends
on the specifics of the stock action, time until expiration, etc.
But of course not every trade plays out as you intend. So what is the "stop"?
What I do is take the opening range, maybe the first 15 minutes of trading or
so, give or take, and use the top of that range as my *stop* trigger. And if
it triggers, I either just close out the very calls I sold, or buy some stock
and turn the position into a buy/write. The best aspect is that the since it
was presumably *fat* option premiums that inspired me to put the trade on to
begin with, the lift has likely caused a contraction in that volatility, as a
clear bottom has formed. So the loss may be less than it seems.
Now I do not do this sort of play all that often, because I have certain
requirements. I never ever ever never ever try it in a biotech, or anything
health related for that matter. Too prone to sudden news events in both
direction. Today’s bad guidance could become tomorrow’s FDA approval, and the
stock gaps right back up. I also avoid stocks with biotech-like behavior such
as RIMM
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PowerRating), which also can gap right back up on some court
decision or whatever. GM
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And I also require that volatility actually pop. That is the *vig* so to
speak, that the probability of a quick bounce back is overpriced. Otherwise,
there is no advantage to using calls as opposed to simply shorting the stock
itself. Nothing wrong that strategy, just a different animal altogether.
A great example took place recently on July 26, 2006.
Here is a chart of Panera Bread Co.
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PNRA
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PowerRating) was a near perfect candidate. Volatility was high, though not
explosive; that was the only moderate negative. But on the *plus* side, the
stock was in total breakdown and the industry is ideal for this sort of play
as it is not likely there’s a sudden new development in sliced bread. I
hope this strategy has taught you a new way to look at "broken stocks".
Adam Warner