The 'Broken Stock' strategy

One of my favorite strategies is what I call the "Broken Stock" strategy. A recent example that I traded took place on July 26th in Panera Bread (PNRA) when it gapped down about 12%.

The theory is that when a stock gaps down AND suffers a complete chart breakdown, odds are that it is not coming back so fast. The first tendency is to "bottom fish", and/or take "cheap" shots in the calls. But those shots aren't so cheap; the calls tend to carry a relatively high volatility, particularly as trading begins.

My play is to start selling calls with about 1-3 month's to go, ideally at strikes within or a shade above the gap. And my play is to do it quickly, before the stock settles into a new and/or lower range and the buying interest dries up.



If the trade *works*, I may bid lower and buy the calls back. Or I may just let nature take it's course and chance letting time decay kick in. It depends on the specifics of the stock action, time until expiration, etc.

But of course not every trade plays out as you intend. So what is the "stop"?

What I do is take the opening range, maybe the first 15 minutes of trading or so, give or take, and use the top of that range as my *stop* trigger. And if it triggers, I either just close out the very calls I sold, or buy some stock and turn the position into a buy/write. The best aspect is that the since it was presumably *fat* option premiums that inspired me to put the trade on to begin with, the lift has likely caused a contraction in that volatility, as a clear bottom has formed. So the loss may be less than it seems.

Now I do not do this sort of play all that often, because I have certain requirements. I never ever ever never ever try it in a biotech, or anything health related for that matter. Too prone to sudden news events in both direction. Today's bad guidance could become tomorrow's FDA approval, and the stock gaps right back up. I also avoid stocks with biotech-like behavior such as RIMM and RMBS and MO which also can gap right back up on some court decision or whatever. GM too, way too many moving parts (no pun intended).

And I also require that volatility actually pop. That is the *vig* so to speak, that the probability of a quick bounce back is overpriced. Otherwise, there is no advantage to using calls as opposed to simply shorting the stock itself. Nothing wrong with that strategy, just a different animal altogether.

PNRA was a near perfect candidate yesterday. Volatility was high, though not explosive; that was the only moderate negative. But on the *plus* side, the stock was in total breakdown and the industry is ideal for this sort of play as it is not likely there will be a sudden new development in sliced bread.

Adam Warner is a professional options trader. He started trading in 1988, first as a member of the American Stock Exchange, and since 2001, from off the floor. Adam began writing in 2003 for StreetInsight.com, penning the Options Column until March of 2005 and maintains a blog at http://adamsoptions.blogspot.com.