Inside Our Portfolio and the Mailbag

This was a quiet week for us, but it was a wild one for the market.

The S&P 500 experienced its largest decline in five months on Tuesday, sparking fears that a more sizable correction may be in the cards.

For us, this doesn’t really concern me — a coming correction, that is. We know at some point the market will have a correction — a drop between 5% and 20% (past 20%, and it’s a bear market) — but our system is designed to adjust on its own.

That’s because our trades have to meet certain parameters to be triggered — and that happens no matter what way the market turns.

For one, if a bear market arrives, most of our trades will be bearish plays because that negative sentiment will be reflected in earnings.

Likewise, as long as things are looking up, our bullish plays will continue to compose the bulk of our trades.

Essentially, our portfolio will automatically adjust to market conditions during each earnings season — we just have to sit back and follow our system.

With that, I want to briefly touch on our open positions and then address two questions from the mailbag.

Portfolio Update

Last Tuesday, we added a new position to the portfolio: the June $45 call options on Monster Beverage (Nasdaq: MNST). Those options were filled at our official entry price of $3.38. We found $3.38 by taking the average of the option’s price right after the alert was broadcast and the price one hour later.

During this week, there were three more companies on our list that reported earnings — but none of them hit our parameters for trading. And we never trade just to trade, so we’re sitting tight for now.

In total, we still have five open trades in our portfolio: call options on Monster Beverage, Lowe’s (NYSE: LOW), Interpublic Group of Companies (NYSE: IPG) and Garmin (NYSE: GRMN), plus a put option on Akamai Technologies (NYSE: AKAM).

All but our newest trade, Monster Beverage, are underwater at the moment, with IPG down the most at 55%.

But let’s be patient for the moment.

I’m sticking with our trade guidelines, including our 75% stop-loss rule (and selling the first half at a 50% gain). To buffer any extreme losses, we will continue following our exit dates, which are based on the historical drift patterns.

For example, we will look to exit IPG by April 10 — so that should leave some premium in the option, even if the price doesn’t go our way, since it expires on April 21.

Of course, occasionally a trend can upend during its historical drift dates, which is why we are sticking with the 75% stop-loss. And don’t worry, I’ll update you if our positions near that level, so we can get our exit positions in place.

We have until April before we start exiting most of these, so there’s still a week or two of time left to see them turn around.

Looking ahead, the next three weeks will be slow. As of right now, only one company on our list is set to report earnings (estimated for April 6). After that, things will start to heat up on April 13 — so take this time to prepare for the next wave of trades. Read our trading manual if you haven’t got the chance. If you have any questions or comments about our system, feel free to send them in, and I’ll take time to answer them over these slow weeks. You can reach me at earningsdrift@banyanhill.com.

With that in mind, let’s turn to the mailbag.

Answering Your Questions

John Doe writes:

I am using a broker that doesn’t have a stop-loss order but has stop limit orders with a warning when it triggers at the limit for the option price. How do I handle this?

My response:

Thanks for the question. I’m sure others are running into this as well. When it comes to using stops, the type we are discussing is a standard stop-loss order.

That means if you set your stop at $1, and the option trades below that, your stop is hit and your orders will be executed at the market price.

What John refers to is a stop limit order. These are a bit more complicated, but there is a way to handle them the same way.

With a stop limit, you’re setting a stop level, which would trigger at your designated price ($1 for example). Once your stop level gets reached, that stop turns into a limit order, which ensures you can sell the option at your stop price — or above it.

The idea is that if the price goes past your stop trigger and your limit price, then your order would not be closed until it rebounds. This fixes the flaw with stop-loss orders, which trigger at the first price below your stop-loss.

Back to our $1 example…

If you placed a stop-loss there, and the option first traded at $0.50 — that would be your exit price. But if you used a stop limit order, and had $1 as the trigger price and $0.80 as the limit price, then your order would not have closed.

The downside with the stop limit is that the price may not recover, and you could exit with a 100% loss.

So, for those using a stop limit, I suggest setting your trigger price where we set our stop price, then place your limit price near zero. That way, you should see similar results to the model portfolio.

Alvin E. writes:

My [Activision] purchase price was $1.44. Then I set a 50% gain at $2.20 [for the first half]. The last half was stopped out at $4 for the 175% gain. Overall, [an average] gain of 112.5%.

The order to sell the first half at 50% gain appears to be a winning system! Given that the buy orders are to receive the best price available, how did you get 70% [in Tyson] or 89% [on the first half of Activision Blizzard] if the 50% rule was followed?

My response:

This is an excellent question about why our closing prices on the first half are higher than the limit prices.

It stems from the way our portfolio system works. We need proof that a price traded at a certain level to add it to our portfolio. The easiest way to do that, and the way it automatically works, is by taking the closing price of the day an alert is either issued or filled.

I realize this is not an accurate system, though. So I’ve updated the portfolio.

For the two option gains Alvin mentioned — Tyson Foods (which shows a 73% gain on the first half) and  Activision Blizzard (which shows an 89% gain on the first half) — I’ve adjusted the gains to reflect the first price traded at or above our set limit price.

For Activision, it’s the $2.20 Alvin listed, since that is proof it traded there for a gain of 51.72%.

For Tyson, its $6.27 — exactly a 50% gain.

So, thank you, Alvin, for bringing this up so that I can clarify our system — and, going forward, we’ll use the first price the options trade at.

Also, it’s important to note that we may not always be so close to our limit prices.

That’s because limit orders close your positions at the first price the option trades at — or above it. In other words, if you set your limit at $2.20, but the first option price at or above that is $2.40, your orders will then be triggered and sell at the market price — likely around $2.40 or higher. If the price first hits $2.20, then you could be filled right at $2.20.

So it just depends on where the prices trade, but it is something I’ll follow closely.

That’s all for this week. I’ll continue to monitor our portfolio and possible trades, and I’ll be sure to alert you when there’s any action to take.

Regards,

Chad Shoop, CMT
Editor, Earnings Drift Alert