This post came out of a discussion with a friend last night.

He wanted to know what he could have done to take a protected long position on FXI (iShares FTSE/Xinhua China 25 Index) on the “breakout” trade setup.

Plan A: The Situation

One way to go about it is to buy the stock and protect it with puts. Let’s walk through the numbers.

Date = 2007.06.14
The Underlying = FXI
The Setup: “It’s a breakout!”, long directional trade
Close = $119.85
PT.TradingSystem Stop = $109.94

The July 110 strike price was chosen because it was the closest one to the PowerTools TradingSystem stop.

July 110 PUT = $1.45
$110.00 - $119.85 = $0.00 intrinsic value, $1.45 time premium

Plan A: Buy 100 shares FXI @ $119.85 AND 1 July 110 PUT
Cost = (100 x $119.85) + (100 x $1.45) = $11,985 + $145 = $12,130 = $121.30/share + commission

The Dilemma

If you make a bad trade and you have money management, you are really not in much trouble. However, if you miss a good trade, there is nowhere to turn. If you miss good trades with any regularity, you’re finished. — William Eckhardt

The problem with breakout trading is that it might turn out to be a fakeout. This is particularly worrisome when everyone knows there is a bubble out there. Still, we know that long positions can be protected while there is no way to remedy a missed opportunity.

If we buy the underlying and the puts, there is still a problem. The difference between the purchase price of the shares and the strike price of the put remains unprotected:

Adjusted cost per share of underlying = $121.30
Strike price of puts = $110
Adjusted Cost - Strike Price = $11.30
Potential loss = (100 shares x $11.30) = $1,130 + commission

But wait, there an alternative and I wrote about it in Chapter Four.

Plan B: The Solution

We can accomplish the objective with in-the-money calls. Note that this transaction requires two commissions, one each way for the options, while Plan A requires four commissions, one each way for the options, and one each way for the stock.

July 110 CALL = $10.40
$119.85 - $110.00 = $9.85 intrinsic value, $0.55 time premium

Plan B: Buy 1 July 110 CALL
Cost = 100 x $10.40 = $1,040 + commission.

Breakeven Analysis

The breakeven point for Plan A is $121.30 per share plus 4 commissions, while the breakeven point for Plan B is ($110.00 + $10.40) $120.40 plus 2 commissions.

The What Ifs

If FXI closes at exactly $110 per share at expiration, Plan A loses $1,130 plus 4 commissions while Plan B loses $1,040 plus 2 commissions.

If FXI closes at $130 per share at expiration, Plan A makes ($130.00 - $121.30 = $8.70/share) $870.00 less 4 commissions, while Plan B makes ($130.00 - $110.00 - $10.40 = $9.60/share) $960.00 less 2 commissions.

If FXI closes at $100 per share at expiration, Plan A makes ($110.00 - $100.00 - $1.45 = $8.55/share) $855.00 on the puts, while the FXI shares lose ($119.85 - $100.00 = $19.85/share) $1,985.00 for a net loss of $1,130.00 plus four commissions.

What happens to Plan B depends on the trajectory of the price of FXI after the calls are purchased. As we write, FXI is trading at $129ish, and both the at-the-money puts and calls are selling at around $4.50. This gives us an indication as to how much the time premium is worth, because if the trade does not work out, the calls will be sold when they are at-the-money.

If the price of FXI went down from the moment the calls were purchased, the calls would be sold as FXI closed under the initial Trading System stop of $109.94 at approximately $4.50 for a loss of ($10.40 - $4.50 = $5.90/share) $590.00 plus 2 commmissions.

If the price of FXI went up from the moment the calls were purchased, the Trading System would hike the stops along the way. At yesterday’s closing price of $129.94, Plan A would be up ($129.94 - $121.30 = $8.64/share) $864.00 less 4 commissions, while Plan B would be up (bid was approximately $20.00 - $10.40 = $9.60) $960.00 less 2 commissions.

Conclusion

If the intent is to profit from a move to the upside while protecting against the downside, Plan B — in-the-money calls — is the way to go.