By Chris Ebert
There are some basic rules that govern stock prices, and those rules are set by the options market. Enforcement of these rules is not done by any legal authority, but by traders themselves.
Dell Inc. (NASDAQ:DELL) is now in in violation of the rules. Traders are under no obligation to force Dell to comply. However, those who hold positions in the stock or its options, and who ignore the breach of the rules do so at their own risk. Just because the rules are not being enforced today does not mean they will not be enforced tomorrow.
Options Rule #1
Whenever the bulls are in control of a stock, they shall maintain the stock price such that covered call trading* remains profitable at all times. Whenever the bulls relinquish control of a stock to the bears, they shall ensure that covered call trading becomes unprofitable.
Dell has actually followed this rule quite well. The bulls gave up control on May 7, 2012 and covered call trading instantly became unprofitable. That was followed by a gap down just a few weeks later as the bears took hold. The bulls took over again on December 17, 2012, and returned covered call trading to profitability. A sharp rise in the stock price soon followed.
Options Rule #2
Whenever the bulls are in control of a stock, they may, at their discretion, maintain the stock price such that long call trading* is profitable.
Dell has also followed this rule. The bulls reigned for much of 2011 and early 2012, and during that time allowed long calls to be profitable on multiple occasions. Most recently, the bulls caused long call trading to resume profitability on January 7, 2013.
Options Rule #3
Whether the bulls or bears are in control of a stock, they may, at their discretion, maintain the stock price such that long straddle trading* is profitable. However, at no time shall the profitability of these trades be allowed to exceed 8% of the share price. In addition, at no time shall the losses on long straddle trading be allowed to exceed 12% of the share price.
Dell has a habit of breaking this rule, and each time it breaks the rule traders eventually step in to enforce it. Each time long straddle trading losses were allowed to exceed 12%, traders have stepped in and caused the stock to break out into a new price range, sometimes a higher range, sometimes lower. The break out in turn caused long straddle trading losses to return to acceptable levels. Enforcement works!
Dell also has a habit of allowing long straddle profits to exceed 8%. Each time, traders have stepped in and caused a correction, either by a reversal of the trend or by a prolonged move sideways. The correction in turn caused long straddle trading profits to return to acceptable levels. Enforcement works!
Currently long straddle trading on Dell is experiencing profits that far exceed the 8% rule. Although traders are under no obligation to enforce to rule, they do have a history of enforcement. If they repeat the process now, it would mean Dell stock is either in for a pullback off of the recent high price, or an extended period of several weeks of sideways range-bound prices.
*Covered calls, long calls, and long straddles are all opened at-the-money, 112 days prior to expiration and closed on expiration day. Data has been extrapolated where strike prices and expiration dates were not available in actual trading. Commissions and bid/ask slippage are excluded.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”
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