Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Money Trafficking,

Recover Your Losses In FireEye Inc. With This Simple Options Strategy

Shares are collapsing in the after-hours trading, falling by 9% due to mixed quarterly financial results:

The numbers were not particularly bad but analysts had expected more favorable data:

(Source: Seeking Alpha)

If you are long the stock, you are feeling the pain you have felt since late April. I have a cure for your pain, or at least a painkiller. The medicine is called straddles, which are options (calls and puts) sold or bought at the same strike. Obviously, since you are losing on the stock, you want to get cash to offset your losses. Therefore, you want to sell straddles while they are expensive. The cost of options, ceteris paribus, is determined primarily by implied volatility (i.e. the expected risk priced into the options). Tomorrow will be the last day you can sell the options expensively because volatility will be oozing out of the market around this stock. Why is that? Well, the company just reported earnings, so there is little uncertainty on the market right now. In addition, there are no important events for the company in the short-term. Hence, options will be going down in price next week. Therefore, tomorrow is your last chance to sell the straddle.

My suggested trade is essentially this one:

$1

(Source: optionsprofitcalculator.com)

Note: I have used options with the strike of $14.50 because this is the price where the underlying is likely to open at tomorrow.

I like short-term options (in particular, straddles) because they profit the most from time decay:

(Source: optionseducation.org)

The risk-return profile of this trade is given below:

(Source: optionsprofitcalculator.com)

The implied yield on the trade is 15% - 16%, given the new price of approximately $14.50 per share:

(Source: Google Finance)     

Now, with this trade, your downside is exposed. In fact, now your risk has double: you are losing both on the stock and the puts, if the underlying keeps falling. Hence, you want to limit your downside exposure at least to some extent (e.g. cover the sold put's risk). Given the credit balance of $2.32 per share, your break-even point on the downside is $12.18 per share. Hence, you need to buy puts with strikes close to this price level. The closest strike is $12, which costs about $0.10:

(Source: Google Finance)

Note: options prices will change dramatically tomorrow, so my calculations reflect only current market conditions.

What you want to do ideally is to buy two $12 puts for every one $14.50 put you sell. This is because you want to insure both the put's and the stock's downside exposure. This should cost you around $0.20 per share in total. Your net premium at expiration is calculated the following way:

+ $2.32 per share - premium from the sale of the straddle (before transaction fees);

- $0.20 per share - the cost of two $12 puts for every one $14.50 sold;

- $0.36 per share - the difference between the break-even price of the straddle and the strikes of the puts ($12).

______________

= $1.76 - net premium earned at expiration.

Note that I have not included losses on the underlying in the event the stock trades at $12 or lower at the time of expiration (the difference between the current market price of the stock and the defensive puts' strike).   

The net premium yields a return of over 12% over a one-week period, if the stock trades within $12.18 and $16.18 per share (if the stock goes above the upper boundary, you will have to give away upside in it to the call options' buyer). I find this a compelling return over a one-week period. Remember that options are not a magical cure that will compensate your losses on bad investments. Use the wisely and earn more on selling options on good stocks. In this particular case, most of your expected return comes from my own expectations on the options' implied volatility.

What do you think of this trade?