Buying Red Hat Using Options as Stock Replacement

08/08/2014 8:00 am EST

Focus: OPTIONS

Gregory Harmon, CMT

Founder and President, Dragonfly Capital Management

Technician Greg Harmon of Dragonfly Capital outlines a way to use options, not just as a way to generate extra income or as protection against your position, but as stock replacement.

Options are most often thought of in one of two ways: Covered Calls to generate extra income on positions, and protection against your position moving against you in the short run. But they can be used for many other uses as well. One of those is stock replacement.

In a stock replacement strategy the trader or investor will invest in a stock using only options instead of buying the stock. For a trade to the upside they will buy Calls. This can drastically reduce the capital at risk and limits the downside. Look at Red Hat (RHT) as an example that looked like a possibility on Thursday.

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Red Hat established a Cup and Handle pattern (orange) that triggered July 22. If you bought the stock then at 55 you have a $3 gain today with a target on that pattern to 64 higher still. What makes it even better is that there is now a bigger Cup and Handle (green) that targets 70, should it trigger by moving higher out of the bull flag that makes up the Handle. But that handle can continue lower for a while without negating the pattern. That means there would be no technical reason to sell the stock until the pattern failed at 53.50. But, at that point, you would be down on the initial trade.

So, what to do? You can continue to participate in the upside and take some gains on your trade by replacing the stock with a Call Option. Selling the stock at around 58.25 and buying the September 57.5 Call for $2.50 is one way to do it. That would put 75 cents in your pocket and allow you to continue to participate in the upside. But the difference in your participation is that now your downside would be limited to the cost of that Call at $2.50. This means you are guaranteed at least that 75 cent profit no matter what. That is because even if the stock goes to zero tomorrow, the Calls have no risk outside of the initial price paid, or premium. If you keep the stock with a stop loss at 55.75 to try for that same 75 cent minimum profit, you still have risk that the stock gaps down on you overnight and you can take a loss.

Take the trade one step further and even if you have no position now, you can start to participate in the upside at a cost of no more that $2.50 by buying that September 57.5 Call.

By Greg Harmon of Dragonfly Capital

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