How to Use Options to Limit Your Risk

Don’t try to catch a falling knife

… But if you have to, use options

Buying the Shares vs. Buying Calls

There’s an old trading saying that’s always important to remember, and has certainly become very timely in the past several weeks. That trading saying is “Don’t try to catch a falling knife.”

What does that saying mean and how can it be applied to trading and investing today? A stock that has fallen in price is often a trap for investors who are tempted to buy the stock because it has sold off from a previously higher level. These investors see a stock that was trading at 100 a month ago and assume that it’s a good buy now that it’s trading at 80. But time and time again, traders and investors get hurt trying to buy a stock that is falling, thus the saying about trying to catch a falling knife.

You may have tried, and failed, at catching a falling knife. I certainly have. I put on a bullish position in Lehman Brothers after the stock had been cut in half … only to see the company go bankrupt a couple of weeks later. Later, having still not learned the proper lesson, I put on a bullish position in Research in Motion at 70-it now trades at around 8.

(If you’ve been hurt trying to catch a falling knife in the past and want to share your story, reply to this email and I’ll share your painful experience-anonymously, of course-in my next Cabot Wealth Advisory.)

Over the past several weeks, we’ve seen a tremendous selloff in “growth” and “momentum” stocks, and when the selloff will end is anyone’s guess.

Let’s take a look at just a sampling of some of the stocks that have been hit hard recently:

Amazon (AMZN) was trading at 380 on March 13 and is now trading at 304.

Chipotle Mexican Grill (CMG) was trading at 620 on March 21 and is now trading at 500.

Netflix (NFLX) was trading at 425 on March 21 and is now trading at 320.

FireEye (FEYE) was trading at 96 on March 6 and is now trading at 40.

Clearly, if you had tried to buy any of these stocks after they had dropped 10% or 20%, you would have been burned extremely badly as they’re now down significantly more.

Take FEYE for example. Having traded at 96 just a couple of months ago, had you bought the stock when it was down a whopping 20% from its highs at 77, you would now be out another $37 a share.

With all of that said, let’s say I couldn’t help myself-and ignoring everything I just wrote above, I was willing to take a speculative shot on a bullish position in one of these stocks. How would I go about doing so?

I believe the best way to initiate a bullish position in one of these hard-hit momentum stocks is by using call options.

The purchase of a call is the right to buy a stock at a specified price within a specified time period. For example, if I bought one July 50 Call for $1 on stock XYZ, I would have the right to buy stock XYZ at $50 a share anytime before my call expired in July. One call represents 100 shares of stock, so it would cost me $100 for each call that I purchased. The most I could possibly lose on the trade is the $100 per call that I paid.

I can promise you that neither you nor I can time the bottom in these momentum stocks. In fact, maybe there isn’t a bottom. So if I were to take a speculative position on one of these stocks, I would use calls to reduce my capital at risk. That’s the true power of options … the leverage.

Let’s take a look at a theoretical trade in FEYE.

(First off, I want to be clear that I’m not recommending this trade. I know nothing about the company’s product or earnings or future. This is strictly an example.)

A purchase of 1,000 shares of FEYE would be a capital outlay of $40,000.

On the other hand, the purchase of 10 FEYE September 40 Calls would only be a capital outlay of $7,000. This call purchase would give me the right to buy 1,000 shares of FEYE at $40 any time before the call’s expiration. The maximum I could lose on this call purchase is the premium I paid, or $7,000.

Let’s compare my call buying strategy to a purchase of 1,000 shares of the stock.

Here’s a chart illustrating the profit and loss potential of buying 1,000 shares of FEYE at 40:

 

Here’s a chart illustrating the profit and loss potential of buying 10 FEYE September 40 Calls:

 

 

As these charts show, the upside potential in these positions is similar. The downside, however, is extremely different as the maximum risk on the call purchase is limited to the premium paid, or $7,000.

I hope you will think twice before trying to catch that falling knife. However, if you can’t stop yourself, I recommend using options to lower your dollars at risk.

To learn more about options and how using options can lower you risk, consider taking a trial subscription to Cabot Options Trader.  

Click here for more details.

Your guide to successful options trading,

Jacob Mintz
Chief Analyst, Cabot Options Trader

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