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"Getting Down To 'Business' Part IV - Stability Vs. Profitability"
By Bob Eldridge
Previously
Earlier, we began a to investigate the need for stability in our trading business. We agreed that an
important purpose for stability was having a more or less consistent ability to pay our bills, enabling our
trading business to survive. Additionally, we outlined a strategy which had the ability to maintain our
initial value (our emergency money) and the potential for making profits as well. The strategy; a 'balanced'
straddle; amounted to finding a stock whose price 'oscillated' above and below a particular value. If that
value was also a strike price for that stock, then we could straddle it, buying puts and calls at that strike
with several months before expiration. As the price moved up and down, the value of our calls and puts moved
up and down inversely, keeping the total value of the position roughly the same. In this way, our 'emergency
fund' was more or less kept intact. In this discussion, we see how to draw a profit from such a position.
Stability Implies A Constant Value
If I have a minimum of six months required cash on hand much of the 'production stress' is removed from me.
That is, if a budget of $5,000 per month is required to support my household, then having around $30,000 cash
on hand goes a long way toward making me feel secure financially ... for about six months! Whatever we decide
to do with that money once we've accumulated it, we have to insure that the underlying value is not subject to
erosion. To that extent, then, those strategies and/or trades set aside for our 'stable money' should more or
less insure that what ever amount of money we begin with is available to us at any time in the event of a
financial emergency. Let's continue with our SLAB example.
If we buy a $55 put and a $55 call when the stock price is at or very near $55, we're buying AT the money
options and should expect to pay around $5 or $6 for those options having expirations about 4-6 months hence.
If we buy 10 contracts each, we have about $10,000 - $12,000 invested in the position. We need to be very
sure that money will REMAIN more or less intact and available to us should we need it. To meet MY
requirements for six months 'budget-in-the-bank', I'd need three such positions. I would certainly NEVER put
ALL $30,000 into a single position! Owning a put and a call (at the same strike price & expiration month) is
called a straddle, an inherently 'neutral' position. To understand how a 'neutral' position can provide the
safety and stability you need, refer to the chart of Silicon Laboratories stock above. During the last week
of January, you'll see the stock gapped up, touching $55 that day. We'll assume that we entered a $55
straddle at that point. Follow the chart as the stock moves down. If we paid say, $5 for the puts and calls,
then we can reasonably expect their premium to change in value as the stock moves. For example, around
February 2, the stock has fallen to around $50. Those puts we bought for around $5 are now worth around $9 or
$10. However, the calls we bought for around $5 are now worth around $1. No matter, the POSITION value is
still worth around $10,000, what we PAID for it! So, Though the stock has fallen significantly in value, our
STABILITY money is still there, ready to be used in an emergency. In other words, we could close the position
and take our initial investment back at ANY time we wanted or needed to do so. Continue to follow the stock
price. Notice near the end of February, the stock price has risen to around $60. At that time, our calls
have risen to be worth around $9 or $10 while our puts have fallen in value to around $1. Again, we see that
our emergency money is STILL intact, despite an almost $10 oscillation in the value of the stock. We
can continue to do that for as long as the stock oscillates ... AND our options haven't expired.
Up to this point, we've learned about the importance of having some emergency cash set aside. Additionally,
we've learned about how straddles work and we've seen how the strategy produces a 'safe-haven' for some of
this stability cash. But wouldn't it be nice if we were to figure out a way to make this money produce a
profit in addition to the stability. Well, strictly speaking, a neutral position will not produce a profit
unless the stock moves violently and a long way in either direction. Closing the position at either such
'extreme' (up or down) can produce enough profit in the one option to more than pay for the remaining option.
That requires volatility, a concept not closely tied to the idea of stability. The biggest benefit of these
stable positions is that stability itself, not the lure of profits.
That said, there IS a way to pull profits from these positions, and LOTS of it! However, it requires us to
temporarily LEAVE the safety of neutrality by closing out one side of the straddle, remaining in a now
"directional' trade. If you sense a bit of increased risk and danger here, you're absolutely correct.
Keep in mind that we can ill afford to gamble with this money! We can chase profits in one of two ways;
short term and/or medium term.
We'll begin with the least time-intensive method; medium term next time in part V. See ya then!
If you think that I might be of help to you in sharpening up your trading skills, please give me a call at
my support line, toll free 1-800-206-3935!
Make it a great day!
Bob
Bob Eldridge is a stock market entrepreneur who eliminates risk. He is now offering classes
teaching beginning investors how to understand daily cash flow to make better trades. Visit
Bob's website to find out about online stock market classes.
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options trading classes? Join NothingButOptions.com, a private investment club and find out about classes to make your trading more successful.
