Precisely Defining Entry Points

The great American humorist Will Rogers was once asked to explain his views on the stock market. His answer: “You buy a stock because it is going up. If it doesn’t go up, don’t buy it.”

As was so typical of Mr. Rogers his answer was simple yet contained a hint of truth. We do buy stocks because we think we will be able to sell them at a higher price. But that objective is so often compromised because it is so difficult to precisely time entry and exit points.

A better way, I think, is one in which we spend less time trying to time entry and exit points, and more time building reasonable portfolios that hold good quality stocks purchased at precisely defined entry points. And if we do not make initial purchases we ensure, at the bare minimum, a profitable shorter term trade within the portfolio.

The principal strategy is to write “cash secured” puts on stocks you want to own. Say for example, you want to acquire shares of Bank of Montreal (TSX: BMO Friday’s close $59.57) but are concerned that the price may be inflated. You could write the BMO January 60 put for $1.90, which obligates you to buy BMO at $60 per share until the January expiration.

Having received $1.90 per share in premium income, your net cost should you actually buy the stock is $58.10 ($60 less $1.90 = $58.10). With the cash secured put you should set aside $5,810 per spread to meet the attendant obligation.

The risk with the cash secured put is the same as the risk of holding the underlying shares. While you may end up with the stock at a slightly reduced price you are still buying shares that could theoretically fall to zero.

Of course zero is not a likely scenario if you are buying blue chip stocks. However, even good stocks can experience bouts of extreme volatility that can cause one to re-think their position. Research in Motion (TSX: RIM, Fridays close $7.69) being a recent case study of a so-called blue chip stock experiencing extreme volatility where zero is a distinct possibility.

Given the RIM example you might consider another approach that follows the cash secured put theme but provides for more precise entry and exit points. The goal is to take on an obligation to buy stocks that you think will go up but with a bull put spread strategy you limit downside risk.

Take Agrium as a case in point. The stock has rallied nearly 50% since the beginning of the year. Much of that rally was driven by activist shareholders who have been lobbying the company to enhance shareholder value by spinning off its retail operations.

The debate around the AGU retail operations has hit a stalemate which raises concern about where the shares may go from here. We see that in the cost of AGU options that are trading at implied volatilities that are 60% higher than the actual historical volatility recently experienced by the underlying shares.

Assuming you want AGU in your portfolio you could look at writing the January 105 puts at $5.50 while simultaneously purchasing the January 96 puts at $2.10. The net credit from this trade is $3.30. If the short puts are assigned you would end up purchasing the AGU shares at a net cost of $101.70 which is still below the current market value.

If AGU goes up (the reason for buying the stock in the first place) and closes above $105 at the January expiration, both puts expire worthless and you retain the $3.30 net premium received.

If the shares fell sharply to say $85 you would have to buy the stock at $105 but have the ability to put the shares to someone else at $96. Your maximum loss would be $5.70 per share which is the difference between the initial strikes of the spread less the net credit received.

The real advantage with a bull put spread is that it precisely defines an entry point regardless of the current price of the underlying stock. In a worst case scenario where the stock price collapses – as we saw with RIM during 2012 – you end up buying shares at a net price that in the AGU case, is never more than $5.70 (the spreads maximum risk) above the current market price.

In my mind that is probably the best way to accumulate a portfolio of good stocks because a limited risk spread removes sentiment from the equation. When you have precisely defined an entry and exit point you are able to re-evaluate your view on a particular stock without having to worry about further losses. If the reasons for initially buying the stock are no longer relevant you absorb a small loss and can then look for opportunities elsewhere.