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Understanding why a Trade was initiated?

Richard Croft
March 18, 2013
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Investors implement various options strategies for very different reasons. For example, buying a put to protect a stock position is very different from buying calls that profit when the underlying security is rising. Despite the fact that both strategies share the same risk reward characteristics!

In this example, the puts are insurance being used to protect an existing stock position whereas the long calls represent a leveraged investment strategy.

It is important to understand the initial objective for a position because that has an impact on any follow-up action. With the put trade, any enhanced return will be the result of a rising stock price while the puts simply provide a downside cushion. The long call is a straightforward investment strategy that generates a return if the underlying security rises prior to the calls’ expiry date.

Any follow-up strategy with the stock plus the protective put would involve the sale of the underlying security. For example, the stock rises to the point at which you no longer see additional upside potential and you sell the shares and pocket the profit. At that point you would also sell the put to pocket any remaining premium assuming the put has any value.

The call would deliver the same result because you would simply sell the call if the stock increased in value. Presumably pocketing a profit and then seeking out other opportunities.

The difference occurs if the underlying shares fall in value. Since the long put was initially purchased as insurance, you may want to hold the position until expiry. Providing you an opportunity to re-evaluate your position, which would dictate how you would deal with your long stock position. Assuming you wish to retain your stock position you would sell the put at a profit and roll down to the strike price based on the current stock price. Or if you felt that the stock was now at a technical support level you may not replace the put on the belief that insurance was no longer required.

In a downwardly biased market the long call will lose value which also requires you to take action. But the action you would take would be based on an investment objective. You could roll down and out or simply take a loss on the call and look for another opportunity. The point being with the long call you are making a decision based on a return objective rather than from the perspective of an insurance policy.

Bottom line it is important to understand why a position is established in the first place because that determine what strategies you employ ex-post.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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