On Friday we bought a $25 May 2006 put option on Motorola (MOT) for $2.50/option. Their Q1 earnings report earlier in the week gave a very strong sell signal according to 4 technical indicators: price broke downward through 30-day average, macd turned negative, stochastics broke downward through the 75% mark, under very heavy volume (53M shares vs. a 52-week average of 20M). Though their company fundamentals aren’t too bad, their stock group Technology/Communications Equipment is on the down-turn, so this looked like a good opportunity for a 1-month put option play.
We’ll discuss exactly what a put option is on a non-trading day, but for now these are the steps that were taken for choosing the best option. We went to http://finance.yahoo.com/q/op?s=MOT&m=2006-05 and copied and pasted the put option table that expires in May of 2006 into a spreadsheet. We then created an ROI (Return On Investment) table for the range of target prices from 20-25. This range was chosen because the stock has been fluctuating in the 20-25 price range for the past 9 months. Balancing safety with profitability, it seemed the $25 strike price was most attractive. If MOT closes at $22.50 on May 19, we break even (minus brokerage fees.) If it closes at $22, we make 20%. If it closes at $21.50, we make 40%, etc.
Our exit strategy is to sell all the options prior to the option expiration date of May 19 if the stock price hits or drops below $20.55. This price was chosen from observing price resistance at around $20.50 for the past 6 months. Our online broker conveniently allows an options trade to be triggered by behavior of the underlying stock. A trade trigger was set to sell all options if MOT hits or drops below $20.55.
Options trading can be very risky. For example if MOT closes at $24 on May 19 and we have not yet sold our options, we lose 60% of our investment. If it closes at $25 or higher we lose 100%. Today we are up 16%. Not bad for 1 trade in 1 day. But these tempting returns attract many investors into trades that will take the shirt off their back.