PayPal - Importance Of Risk-Defined Options Trading

Introduction:


Options trading can provide a meaningful addition to one’s portfolio when used in a discipled manner. When used as a component of an overall portfolio approach, generating consistent monthly income while defining risk, leveraging a minimal amount of capital and maximizing return on capital can be achieved. Options can enable smooth and consistent portfolio appreciation without guessing which way the market will move. An options-based portfolio can provide durability and resiliency to drive portfolio results with substantially less risk via a holistic beta-controlled manner. When engaging in options trading, specific rules of option trading must be followed and one of the most important rules is to structure every option trade in a risk-defined (put spreads, call spreads, iron condors, etc.) manner.


PayPal (PYPL) was a recent example where the stock witnessed a massive meltdown from an ill-advised acquisition target (Pinterest) coupled with quarterly earnings that were deemed dismal. These two events culminated into a 35% slide from a 52-week high of $310 down to ~$200 post earnings. Hence the importance of risk-defining all options trades to limit any downward stock movement beyond your protection strike. Risk-defined options trading prevents any losses beyond a specific strike price, avoids the assignment of shares, does not require a significant amount of capital and does not potentially result in unrealized losses while soaking up capital with any share assignments.


Risk-Defined Options Trading:


Risk-defined option trades are straight forward. Below is a theoretical example deploying a put spread on a stock that currently trades at $100 per share.


1) Sell a put at a $95 strike and collect $1 per share in premium – You take on the obligation to buy shares for $95 by the expiration date and receive $100 in option premium income.


2) Buy a put at a strike of $90 by using some of the premium received (e.g. $0.40 per share) – You have the right to sell shares at $90 a share by the expiration date.

In the above put spread scenario, premium income was $60 per contract ($1.00 - $0.40) and the maximum risk was $440 ($95 - $90 = $500 - $60 of net premium income). If the shares remain above $95 by the expiration date, then the option expires worthless and the seller of the put spread locks in a realized gain of $60 or a return on investment of 13.6% ($60/$440). This is the essence of risk-defined options trading where a minimal amount of capital is leveraged and return on investment is maximized.


No matter where the stock moves, losses are capped at $440 per contract even if the underlying stock falls to zero. This is the case due to the protection put leg that was purchased at the $90 strike. In the worst case scenario, if the stock was to fall to zero, you would be assigned shares at $95 and then sell the shares for $90 for a max loss of $5 per share less the $0.60 in premium thus max loss of $440 per contract.


PayPal Case Study:


PayPal (PYPL) experienced a dramatic fall from $296 on September 8th to ~$200 on November 10th after a two-step debacle of a mishandled acquisition target and a big earnings miss. This 32% downslide happened over the course of 8 weeks. A put spread of $245/$240 was sold on PayPal and a near max loss was suffered however the $40 additional dollars per share in unrealized losses were avoided with the $240 protection strike. In a cash covered put situation, shares would’ve been assigned at $245 and a subsequent ~20% loss would’ve incurred. Cash covered puts can not only be dangerous in situations like this but can also tie up substantial amounts of capital with unrealized losses. A risk-defined put spread was essential in order to protect downside risk and avoid any capital intensive assignment of shares.