How Options Can Mitigate a Bad Trade

At least 95% of my portfolio is composed of stocks and mutual funds that were a product of basic, fundamental research. Companies have to meet certain criteria before I will include them in my portfolio.

The remaining 5% is devoted to more speculative investments. These don’t necessarily meet all of my typical criteria, but they offer some appealing aspect that makes them worth a risk. Today I want to describe such a trade that didn’t turn out well, but was nevertheless mitigated by an appealing aspect that made it worth the risk.

The Appeal of a Risky Trade

Popular meme-stock broker Robinhood (NSDQ: HOOD) went public in late July. Most brokerages didn’t even have a rating on it, so it was a relative unknown. The share price could go either way from the initial public offering (IPO).

What made it appealing is that there was a huge call premium associated with it. This is a reflection of a company that was volatile when it debuted, and one that we expected to continue to be volatile.

Most stocks of average or low volatile have call premiums that are less than 5% of the stock’s prices. For example, a stock trading at $100 might have a call premium of $3 for a call with a strike price of $110 and an expiration in six months.

But Robinhood’s call premium was huge. Within a week of Robinhood’s debut, the share price had doubled. Following a pullback from $70, I bought shares on August 5 for $50.69. At the same time, I sold a call expiring in about five months for a premium of $12.54, which was 24.7% of the purchase price. That meant I had 24.7% downside protection on this trade before I would lose money. That’s huge. There are lots of risky stocks out there I would buy with that kind of downside protection.

On an annualized basis, the call premium gave me a 54% annualized “yield”, and an annualized if-called return of 123%. From my perspective, it’s a risky trade, but it has an appealing risk-reward balance.

The Trade Goes Against Me

Here’s what has happened since. Shares have steadily fallen. I rolled the position by one month, collecting another $1.00 and reducing my cost basis to $37.15. By the time shares had fallen by 26.7%, I was at break even.

But there’s more. For several month’s after its IPO, Robinhood was classified as a “Hard to Borrow” security. When someone sells shares short, they have to borrow them. They also have to pay interest on the shares they borrow, and they have to pay higher interest on shares that are hard to borrow.

I described this program in more detail in How to Get New Income Streams From Your Stocks.

Robinhood must have been extremely hard to borrow, because I was being paid a mind-boggling annualized interest rate for my shares. This is a snapshot from my account, but at one point the interest rate had risen to nearly 90%:

The other holding, B&G Foods (NYSE: BGS), was just returned to my account that day after being borrowed, but it paid a much lower interest rate of about 2%.

On the one hand, someone has to strongly believe Robinhood is going to keep dropping to be willing to pay such a high lending rate. On the other hand, every day my shares were loaned, it further reduced my cost basis. This lending program reduced my cost basis by another $2,400 in under three months, or nearly $5 a share. So my cost basis at this point is around $32 for shares I bought for $50.69 in August.

The Next Steps

My shares were finally returned to my account last week, which means the shorts are starting to take profits. Or, they got tired of paying nearly 90% interest on the shares they had borrowed.

At this point, Robinhood has fallen to 43% below my purchase price. But, because of my reduced cost basis, I am only down 9.4% on my purchase price. That is the power of options (and the lending program) to offset the cost of your stock.

What does the future hold for my Robinhood trade? Right now, my call expires in February. If I look out to the next contracts in May, I could sell another call that’s worth 15% of my net cost, further reducing it. If I keep doing this, I am going to end up with a net cost of zero (and then a negative net cost) for my shares. As long as the premiums are high, I will continue with this trade even if sentiment over the stock is bearish.

Remember, my Robinhood trade makes up only a fraction of a percent of my portfolio. I could let it go all the way to zero without it having a huge impact. These trades can be lucrative, but they can also turn against you quickly. Thus, I recommend you only devote a very small portion of your portfolio to such aggressive trades.

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As chief investment strategist of the premium trading service Velocity Trader, Jim Fink has devised options investing methodologies that make money in up or down markets, in good times or bad.

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