When I first joined the trading desk at Goldman Sachs, I gleaned impressions of how profit-seeking traders looked for opportunities. All of my studies indicated that when expected gains outweighed the risk involved, you took a position. While this was true in practice, there was more I needed to learn. Steady dependable gains were necessary, but there was also a constant search for something more-optionality.
Optionality involves a trade where the expected payoff far exceeds the capital involved. When we find a trade that pays us three or four times our initial position, it morphs a dependable solid position into the opportunity to make great returns.
Those subscribers who implement the option trades recommended in my weekly newsletter EPIC Insights received a very positive dose of optionality last week. In a previous newsletter I outlined the reason why I felt Research in Motion (RIMM) would decline after it reported its earnings. Expecting the drop to be substantial and the shares to trade toward $70, I recommended a put that was far out-of-the-money. By picking such a contract, we kept our costs down and our potential returns high.
Even for someone expecting a great gain, this position exceeded my expectations. As RIMM reversed, the shares gapped lower and sliced through support at $70. With RIMM finishing the week at $68.91, our puts had a one-week return of 270%.
With these gains in hand, we now look toward the future. Given the dismal performance of the stock, I believe RIMM will continue lower and has the potential of trading as low as $60. As shares gapped through support on huge volume (green circle), the bears are clearly circling the stock.
However, the drop in RIMM's stock price has made its valuation more attractive. With a forward P/E of 16, strong growth prospects, and a clean balance sheet, future buyers are receiving a margin of safety this stock rarely provides. Further, the stock has underperformed its peer group and offers the promise of positive performance via mean reversion.
While I am not advising anyone to buy the shares, the arguments of a rally are as compelling as those pointing toward a further decline. Were the technical pattern I predict to become reality, the puts would continue to gain. However, I am not one to leave this to chance and risk surrendering a terrific one-week gain. Instead, I will practice what I preach and take gains. The portfolio we have developed in the newsletter has done extremely well (32% higher over the past year) because we have taken gains where we can and compounded them over time. Following that pattern, I recommend selling-to-close RFY+VT as this week's option trade.
Note: At the time of this article, I am long RIMM 75 puts.