January expiration - a time for reflection

What do Yahoo! (NASDAQ - YHOO), Motorola Corp. (NYSE - MOT), and Cisco Systems (NASDAQ - CSCO) have in common? Aside from the fact that their share prices are down from this time a year ago there is another thing that they have in common. These stocks all have long-term options, better known as LEAPS. Even more importantly, many investors who purchased long-term call options a year or more in the past have watched their investments erode into the great abyss. With a week left until expiration, there are 4,805 call option contracts that have no bid. This number includes options that were introduced a year or more ago.

Purchasers of LEAPS contracts are not considered speculators but rather investors. In fact, while many of these options are expiring worthless, holders are experiencing a lower capital loss than if they had purchased the equivalent number of underlying shares. However, the secret is not to let the situation get so bad that all of the capital investment should be in jeopardy. Stock and option investors should take appropriate action and set up a certain discipline to avoid going down with the ship. Let us look at a couple of examples to see how this type of mistake can be avoided in the future.

On January 14, 2000, shares of Priceline.com (NASDAQ - PCLN) were trading at a value of $56.88 per share. This company was expected to change the way consumers purchased airline tickets, groceries, and even gas by bidding for these items over the Internet. The concept was considered revolutionary, and, to illustrate that, the company hired Star Trek's Captain Kirk to lead consumers where they had never gone before. Unfortunately, the company encountered problems worse than Klingons. Since then, the grocery operations have ceased, competition has increased, and the shares of the stock have plummeted to $2 3/4 per share. The now expiring January 60 Calls, which had traded as high as $46.00, are virtually worthless. What makes this scenario worse is that the open interest for this contract is 1,034. While the maximum loss for the person that paid the high is $4,600.00 per contract, the buyer of 100 shares of the stock on that same day is losing $5,413.00. So, the call buyer fared better than the stock buyer, but we still remain distressed about how many of these options will die an unceremonious death.

Let us look at the weekly chart of PCLN to see how the options purchaser could have avoided such a tragedy. Assume that you purchased one contract last January at $27.50 per share (based on the theoretical value) when the stock was at $56.88 (Point-A). As the chart illustrates, there was significant support at $48.75 (Line-1). It would have been appropriate to place a working mental stop just below this support level. Additionally, the call buyer should have also placed a mental stop on the option at a value between 10% and 15% lower than the purchase price. As the shares moved higher, the working stops should have trailed the appreciation. Note how the stock broke above the $78.25 resistance (Line-2). This would have been a perfect opportunity to move the working stop point on the shares to the new support level. Remember that old resistance becomes new support when crossed. This would have also been a good opportunity to move the mental stop on the options contract as well. When the stock began to turn around and break below Line-2 (Point-B), the contract should have been sold at $40.25 (based on the theoretical value). Our buyer would have realized a gain of $1,275.00. A purchaser of more than one contract could have sold half of the position at this stop price and left a working stop for the remaining portion of the position at the original working stop point. A buyer who purchased the contract at the high could have minimized the loss by placing a working stop at a break below Line-2. The point is that these positions should not be expiring worthless.

Priceline is one example of many stocks that have dropped severely during the past year, and whose longer-term call options have suffered the beatings of their respective lives. Add up the paid value for these contracts and the fact that many will expire worthless and you probably could have solved the housing and homeless problem of a major city. And if you are holding one or more of the calls that are in the losing column, you might learn a lesson, albeit an expensive one. Discipline pays; or more important, not having discipline losses. Forget the possibilities and stick with the realities of the here and now when making those investment choices. Take action.

It is important, regardless of the story, the name of the stock, or the price to set certain parameters. We suggest the use of target and stop points. More importantly, the buyer should adhere to these points and not rationalize changing them. It is better to sustain a small loss and lose an opportunity than it is to sustain a mega loss and have a possibility of a turnaround.

At this writing, with just a week until expiration, more than 1/3 of the call options expiring this month were virtually worthless. At least another 25% of the expiring calls are bid less than $1 per share.

The important lesson here is that while volatility levels remain high, the relationship between the stock and exercise price do play a factor…and…no matter how much we don't like it, time remains the enemy…especially for option buyers.

For investors holding shares in companies that are substantially lower, all may not be lost. Repair strategies using options contracts may help lower your break-even price level without risking any additional capital. While these types of strategies are not available for every situation, they are available for many. For more information on repair, get my book Options: A Personal Seminar, and check out Chapter 19.

Looking Forward

The implied volatility levels for many stocks have risen to new 52-week highs as the shares have neared intermediate-term bottoms. Note "ivolatility.com's" implied volatility chart for the NASDAQ-100 Index (NDX), shown below. Compare the current implied volatility level against the same period one-year ago. The recent action by the Federal Open Market Committee (FOMC) to ease monetary policy is adding attraction to many companies. Since many traders and speculators were burned (some beyond recognition) by the downturn in stocks, money flows are likely to support companies with earnings and future potential.

Higher volatility levels translate into higher option premiums. This makes the use of writing strategies more attractive (and in many cases more prudent) than option purchases. Would-be stock and option buyers should consider the use of the conservative covered call writing strategy, while more defensive investors should consider the covered combination strategy.