See if this scenario rings a bell:

A) You read an article or hear a news report regarding some company and a new product that supposedly may cause the shares to rise significantly.

B) You think to yourself,”Wow, maybe I should jump on this.”

C) You figure out how much it would cost to buy the shares and say “Well, maybe I’ll jump on the next good idea.”

Has this or something similar to it ever happened to you?  Come on, you know who you are.  Well, take some comfort in the knowledge that this scenario plays out all the time.  And this should not be surprising. 

First off, we are often cautioned not to take other people’s word for things, especially investment ideas.  We are “supposed” to consider any worthwhile idea that we hear and the “do our own research.”  And that all makes sense too, except of course that most people are busy with other things like – living and eating and working for a living (well,OK not as many as in the past) and stuff like that.  Plus, realistically, how are we supposed to know if a particular idea is actually really going to pan out or not?

So in reality it is not so much “if” you jump on a hot idea that matters, but rather “how” you jump on said hot idea.  "Intelligent speculation" is not an oxymoron.  To illustrate consider the three most common “hot tip scenarios:"

-If you bet everything you have on a hot tip and suffer a huge loss, that’s bad.

-If you bet everything you have on a hot tip and hit it big, that was lucky (and stupid) and chances are you will eventually get whacked somewhere down the road – so it's good short-term but probably bad long-term.

-If you completely eschew a particular hot tip simply because someone told you never to pay any attention, and the hot tip pans out and you make zip – that’s bad.

So far, it's all bad.  Now consider an alternative:

-You think a particular idea or tip may have merit so you figure out a way to make some money if it pans out, but at the same time do so without exposing yourself to large risks if it does not. 

Sounds so simple and obvious doesn’t it?  So it is surprising how many people still end up choosing one of the first three alternatives.

Now let’s consider a real world example.

Ticker JNJ

In Barron’s Financial Weekly dated February 22, 2012 there was a front-page article touting two potential drugs for treating Alzheimer’s.  The article cautioned that the odds were not overwhelming that either drug would ultimately pay off for the companies involved, nor that the stocks of these companies would necessarily skyrocket.  It also seems to suggest that it could take at least a year for things to play out (favorable clinical trial, actual production, actual sales, etc.).  Still, it is not irrational to read the article and think, ”wow, maybe I should jump on this.”  The four stocks mentioned were Lilly (LLY), Johnson & Johnson (JNJ), Pfizer (PFE) and Elan (ELN).  For the purposes of this piece we will focus on JNJ.  Let’s look at some possibilities and the relative merits of each.

Strategy #1: Buying Shares of Stock

The most straightforward approach is simply to buy 100 shares of JNJ stock.  As of the time this is written, JNJ is trading at $65.18.  So this position would cost $6,518 to enter.   Figure 1 displays the risk curve for this position.  The bottom line is simple – if the stock price goes up $1 you make $100 and if it goes down $1 you loss $100. 

Figure 1 – Risk curve for long 100 shares of stock

Strategy #2: A Married Put

Another possibility is to buy 100 shares of stock and simultaneously buy say the January 2013 65 put.  The option costs $4.55 so the bad news is that the investor would have to pay not only $6,518 for the stock but an additional $455 for the put option, or $6,973 total.  The other piece of bad news is that the breakeven price for the trade rises from $65.18 to $69.73.  The good news is that by buying the put the downside risk is limited to -$473.

Figure 2 – Risk curve for JNJ married put

Strategy #3: An Out-of-the-Money Butterfly (with an extra call)

As a self admitted options geek (“Hi, my name is Jay”) my favorite position is an out-of-the-money (OTM) butterfly with an extra long call.  OK, there I go complicating things again.  But basically, this position goes as follows:

-Buy 4 Jan13 65 calls

-Sell 6 Jan13 72.5 calls

-Buy 4 Jan 13 80 calls

The particulars and risk curves for this position appear in Figure 3 and 4.

Figure 3 – Details for JNJ Janaury 2013 OTM butterfly

Figure 4 – Risk curves for JNJ january 2013 OTM butterfly

A few things to note:

-Instead of putting up over $6,500 and tying it up for a year, this position costs only $1,000.

-The breakeven price at expiration is $67.50

-Any kind of an upside breakout any time in the next ten and a half months could allow this position to garner a large percentage gain.

-This position has roughly the same upside dollar profit potential as the previous strategies, even though the capital commitment is roughly 85% less (i.e., $1,000 versus $6,518 to $6,973)

-If the stock falls apart, the worst case loss is $1,000, which would only be realized if the position is held to expiration.

Summary

We’ve all been warned to never rely on a “hot tip” when it comes to investments.  But what if that hot tip turns out to actually be a good idea?  What happens then?  Simple, you get left in the dust. 

So am I arguing in favor of jumping on every hot tip that comes down the pike?  Not at all.  What I am making the case for is the idea of using an option position with a lower dollar investment and in many (but in the interest of full disclosure not all) cases a lower overall maximum dollar risk to achieve exposure to potentially good ideas that you might otherwise bypass.

Is the Alzheimer’s drug that JNJ is involved with going to be a wild success – improving the lives of millions of sufferers and their families – and enriching JNJ shareholders in the process?  I hope so, but basically I have to go with my stock answer of “it beats me.”  From an investment standpoint – and based solely on the simple reading of an article – it sounds like kind of a long shot.  But still.  If it does hit, the potential upside is great. 

So here is where every individual investor parts company with every other individual investor and must think for him or herself.  Still the final question for me is, “am I confident enough to commit $6,500 or more for a year in hopes it all works out? Or would I prefer to pony up $1,000 on the same bet?”

I know what my answer is.  What’s yours?  And why?   

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site

NOTES:

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