As we can see from the chart, there was a large gap on the 30th of July due to bad earnings results, in other words, lower-than-expected. Despite this strong decline an interesting bullish opportunity is covered under this gap and I am going to explain it below. Gap has always been an interesting and profitable opportunity for the swing traders who usually enter bullish positions after bearish gap and vice versa. According to the many historical examples gaps are usually filled by 100% but however, everything depends on the time it will take the price to fill the gap. So, the period is the main question. It has already passed more than 2 weeks from the actual gap date (16 days to be more exact) and it may take even more time for the bullish forces to help the price rise. Another sing that makes the image of the situation more precise (check) is that during last 16 day a chart pattern was formed - a famous wedge or just triangle pattern. According to many technical analysis guides, articles and countless books - wedge indicates a coming reversal to the current trend and in the case of Garmin, Ltd this trend is bearish. What is more interesting in the current situation - the wedge is neither rising nor falling. As we know the wedge is formed of the declining and rising support and resistance levels. Although wedge pattern usually indicates a reversal, its support and resistance levels should also be taken into account. Mr. Market sometimes acts very irrationally and the support level may be crossed and gap will remain unfilled for the next…. month or even two. Thus all our bullish hopes will explode. But price may behave in another way and cross resistance and hit 41$ and then 45$ (the lowest price before gap). Again, timing is very important here. It may take 2-3 day approximately for the price to hit the support or resistance and then decide to cross or not to cross. After all this analysis I came to the conclusion that buying an underlying asset in this case would be irrational. To solve all the above mentioned problems the following option strategies will suit:
- Long at-the-money call
- Long deep in-the-money call
- Synthetic Stock (Buy atm call and sell put at the same strike and with the same period)
- And at last - my favourite ratio spread (I think 1 to 3 ratio will be OK)
So, Now I should explain in detail all the strategies, how they may be appiied to the current situation, etc, etc..
- Long at-the-money call
Stock price at the 08/21/2008 close - 36.04$. So, the nearest option strike is 35.00$. I suppose that the most efficient time frame in this situation will be 2 months. So, October 08 call option 35.00$ will be most suitable. It costs 3.30$ and expired on the Friday, 17 of October, 2008. As you know, you cannot lose more than premium when you buy option. So, if you, for instance, buy 1 option contract (100 shares) your maximum potential loss is 330$. It’s OK. However, gap will be filled, you will earn approximately 615$ if you exercise your option contract. That shows us 1.86 profit/risk ratio. Not bad.
- Long in-the-money call
Will speak very shortly about this position. It is useless to exercise itm option first of all. So here the most efficient way is to buy for example October 30$ strike call option for 7.8$per share and after the gap is filled sell it maybe for 12-14$ (I won’t calculate, the number is approximate). Profit/risk ration is again about 2.
- Synthetic Stock
This variant if for those traders who wish to buy stock but take less expenses. for example buying a synthetic stock with 35$ strike and expiration in October, 2008 will cost you 60$ if you buy and sell 1 contract. But however, the risk profile is the same as if you buy the underlying.
- Ratio Spread (1 to 3), 35$-45$
There are many reasons traders like buying ratio spreads when bullish on the stock. The main and most important reason is price. You pay very small price for such spread but however, the less you pay the more are the risks. In this case you take more risks then if you buy simple Bull call spread. But ratio spread has more advantages than disadvantages. So, let calculate everything. Firstly, you should take into account that you can receive the max profit when stock price is equal to the strike of short calls. If you buy 1:3 ratio spread with 35$-45$ strikes you pay 159$ (330$ - 3 * 57$), instead of 330$ as when you buy just a call option. Thus your lower breakeven equals to 36.59$ and upper one to 48.33$ (45$+(45-35)/3)). Note: upside risk is unlimited.
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August 28th, 2008 at 6:11 am
hi GSA
love your detail analysis. wished there was a blog like your when i was trading options a year or 2 back…keep the good stuff coming!
August 28th, 2008 at 11:07 am
Thank you for kind words about my blog