If you had read my post on May 31st about investing in Facebook without fear, you would know that it is probably time to make a purchase. In my theoretical investment, I would have purchased the number of put options to protect those shares that I ultimately wanted to purchase. At the time, we could have gotten the July $28 strike puts for $2.50 and shares of Facebook for $28.50 or better.
Had we ultimately wanted 1000 shares of Facebook (FB), I would have gotten 10 put contracts and 500 shares. Our net cost for the position is then $33.50. Now that it looks like Facebook has seen at least a temporary bottom, let’s see what would happen if we decided to finish out our share purchases.
As I write this, FB stock can be bought for $30.70. Let’s get the other 500 shares. We already own puts for protection, but let’s sell 5 contracts of the July $30 strike calls for $2.05 per share to help offset the cost of some of the puts that were purchased earlier. What will be the net effect of all these transactions?
Figuring The Basis
We bought half of our shares of FB for $28.50 and half for $30.70. We also spent $2.50 per share on the put options. The cost for these trades is $32.10. We will also sell the July $30 strike for $2.05 per share for the 5 contracts. Our basis is reduced by $1.02 across all 1000 shares making the total outlay for our shares $31.08.
What Have We Done?
We have effectively hedged ourselves against another decline in Facebook stock while giving 500 shares the opportunity to rise some more. Facebook had a strong showing last week and there might be more opportunity to see the stock rise past $32. Nevertheless, we are still protected against a downturn with only about 10% of the basis at risk. The most we could lose is $3.08 per share since below $28, the puts will be exercised.
Now we can wait some more for the stock to continue a possible upward trend. If that happens, we will look to sell the July $32 strike calls for $2 or more to drop the basis closer to $30. If it doesn’t happen, then we will make some adjustments by the end of the month depending upon where the stock is and where it seems to be headed.
As you can see, I prefer to react to the market rather than predict it.