How To Use Puts To Buy A Stock That Has Gapped Up

Mastering both conservative option selling strategies, covered call writing and put-selling will allow us to maneuver our way through most market situations. This past Wednesday, May 27, 2015, several of the stocks on our BCI Premium Watch List gapped up. On last week’s blog commentary, I addressed the situation with BRCM (NASDAQ:BRCM) and AVGO (NASDAQ:AVGO) and the merger rumors causing their meteoric price increases. Another gap-up occurred with Synaptics, Inc. (NASDAQ:SYNA) as shown in the chart below:

SYNA gap-up on May 27, 2015

SYNA gapped up nearly $4.00 per share to $99.11. Was this an opportunity lost? Let’s assume for a moment that we planned to buy SYNA at the “pre-gap-up price” of $95.00. Now we have a dilemma because share price is so much higher. One way to deal with this situation is to use our put-selling skills. Below is a screenshot of a put options chain for SYNA pre-market on May 28, 2015:

Put option chain for SYNA on 5-28-15

We can sell the $95.00 put for the published price of $1.45, and, if exercised, buy the shares at a cost basis of $93.55, or we can sell the $97.00 put for the published price of $2.10 and, if exercised, buy the shares at a cost basis of $94.90. The beauty of this approach is that if the options are not exercised, we have leveraged this security to generate a significant cash flow. Next, let’s feed the option chain information into the BCI Put Calculator:

Put calculations for SYNA

Note the following:

• If unexercised, the $95.00 put generates an annualized return of 25.72%
• If unexercised, the $97.00 put generates an annualized return of 36.71%
• If exercised, the $95.00 put results in a cost basis of $93.55, a 5.61% discount from current market value
• If exercised, the $97.00 put results in a cost basis of $94.90, a 4.25% discount from current market value
• For both puts, the cash required to secure those puts is slightly less than the cash required to buy 100 shares at $95.00

Discussion

Mastering the skills of covered call writing and selling cash-secured puts will allow us to deal with most market events, like the gap-up of the price of a security we are interested in. By selling out-of-the-money cash-secured puts (strike price below current market value), we can craft our trade to buy the shares at the pre-gap-up price. If the trade is not executed, we still will have generated a significant cash flow. Another way to view this is that we either purchase the shares at our price or get paid not to buy that security.

Market tone

Concerns over Greece’s potential exit from the eurozone weighed on markets. Adding to investor concerns was economic contraction in the US, Canada and Switzerland. This week’s reports:

• The US economy contracted in the first quarter by 0.7% annualized, revised down from the initial estimate of 0.2%. Key factors were the larger trade deficit, smaller inventory accumulation and weaker consumer spending than first estimated in addition to a harsh winter
• Pending home sales rose by 3.4% to a seasonally adjusted 112.4 in April 14% above the previous year and the highest level since May 2006
• Sales of new homes rose by 6.8% in April to a seasonally adjusted annual rate of 517,000
• US home prices continued to rise in March, according to the S&P/Case-Shiller Home Price Index. Over the 12 months ended in March, the national index increased by 4.1%
• Durable goods orders dropped by 0.5% in April after a revised 5.1% gain in March
• The US Conference Board’s index of consumer confidence rose to 95.4 in May from a downwardly revised 94.3 in April
• The University of Michigan’s consumer sentiment gauge rose to a final reading of 90.7 for May from 88.6 at midmonth
• Initial unemployment insurance claims rose 7,000 to 282,000 for the week ended May 23rd, the 12th consecutive week below 300,000

For the week, the S&P 500 declined by 1.1% for a year to date return of 2.3%.

Summary

IBD: Confirmed uptrend

GMI: 6/6- Buy signal since market close of May 11, 2015

BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2

Wishing you the best in investing,

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