by Tom Doan
Winter. The word alone brings images of kids playing in snow (unless you’re from Texas), Santa Claus, and a plethora of religious holidays such as Christmas, Hanukah, and Kwanzaa. However, to Snider Method investors, the word “winter” causes people to cringe and have premonitions of the Apocalypse. Winter is a term used in the Snider Method to describe a position that is not able to generate any option premium. Winter positions are never fun and I get many calls from clients asking how to get their positions out of winter, if there is some way to strategize their way out, or simply sell the position and move on. However, the question you should be asking isn’t “How do I escape winter?” but rather “What are the alternatives and is it better than waiting?” There are three main alternatives: selling the position and starting over, buying more stock to reduce the cost basis, and Transmogrification.
The most common suggestion from clients is to dump the stock, take the losses, and start over. The rationale is that taking the loss and starting over with an income generating position is better than having a position sit and do nothing. However, the numbers may tell a different story. For example, say you have 1,000 shares of stock XYZ with an average cost of $34 and the stock is trading at $12. By liquidating, you are realizing a $22 loss per share, or $22,000. By opening a new position, you are asking this new position to make up the $22,000 loss just to get you back to where you were. In addition, there is no way to predict how well the new position will perform; in ten months the new position can also be in winter, causing a reverse compounding effect on your portfolio. When you sell the position, you also reduce the Stake by the amount of the loss. As a result, you may not even be able to open a new position after liquidating a winter position because of the lack of unallocated cash.
Another alternative clients suggest is to go past ten times the purchase limit to further reduce the cost basis or continue trading options. For example, if you have 1,000 shares of XYZ with an average cost of $30 and the stock is currently trading at $15, you could purchase an additional 1,000 shares at $15 to reduce the cost basis to $22.50. This would mean that if the stock price increases to $22.50, you could break even. However, the key word in the previous sentence is “if.” Like most important decisions in life, risk vs. reward is weighed. If the reward is worth the risk, then most of the time it’s a good decision and vice versa. Throughout the life of the position, we are dollar cost averaging into our exposure to the position. However, the limit is set at ten purchases because we are not willing to contribute any more capital beyond ten purchases as a way to limit our risk in any one position. The reward of lowering the cost basis even more may be appealing, but we do not believe it is worth the risk to do so. True, if the position increases you may be able to get out of it sooner, but if the position spirals downward you would lose more capital than you would have if you didn’t continue purchasing.
Any time a position undergoes a merger, acquisition, or if something happens to a company that impacts Snider Method trading, we may send out a position alert to Transmogrify the position into another one. Many clients ask if they can do the same with their winter positions. On the surface it seems like a good idea; swapping a position you’re sick and tired of seeing for a new one, but the end result may be no different. Transmogrification swaps out your current shares for shares of a new position. So, if you have 1,000 shares of XYZ and Transmogrify to BCE, you will purchase 1,000 shares of BCE and BCE will assume the same average cost of XYZ and similar purchases prices on the Individual Stock Purchase Record. The price of the Transmogrified position is similar too, so if XYZ was trading at $10, BCE is also trading in the same range. As a result, Transmogrifying a winter position will most likely require the same time and patience waiting for the price of the new position to appreciate.
Although it is unknown if winter positions will recover, we have seen many of them bounce back. It may be tempting to sell a position that’s buried deep into winter. But keep in mind, you are falling into the same trap of buying high and selling low, the opposite of an effective investment strategy. Waiting may not be an exciting or fun thing to do, but looking at all of the options from dumping the stock and lowering the cost basis to Transmogrification, we recommend waiting as the best option.
