Fri Nov 9, 2007: GOOG Finally Breaks Down

After flying high to a new record altitude of 747 on Wednesday, Google stock suddenly took a big nosedive, falling more than 80 points by Friday to close at 663!

With one week left before November option expiration, how should we play this now?

Let's sell strangles. But not for November. Let's take a patient long-term income-oriented approach, not a short-term speculative approach, so we can increase our probability of success, by selling June 2008 options.

As shown in the table above, the percentage option income available, assuming a 50% margin deposit, is 44.6% for 7 months, or about 6.3% per month.

This is the maximum return, assuming GOOG stock finishes between 660 and 670 at June expiration. If it finishes outside that range the option income gain will be partially offset by a loss on the stock, which you'd be assigned on either long from the put, buying 100 shares at 660, or short from the call, selling 100 shares at 670.

But realistically, at that time you needn't take that loss, as we've discussed previously you could sell covered calls or puts to hedge your stock position at that time, or even adopt a more aggressive ratio writing strategy to further reduce your risk and increase your income from a probabilistic point of view.

Also, as a practical matter, the estimated margin deposit of 50% is actually higher than most brokers require for writing option strangles. Typically they require only 30%, so the monthly income figure quoted above is conservative.

What is the chance that GOOG stock finishes in our tight range of 660-670 in June? Not very good. But we're not betting on that. We're betting that the total premium we receive will more than offset the amount that the stock finishes outside that range.

The total premium received per strangle write is 149.50 points. ($14,950 of juicy income!)

Calculate the range in which we'll end up with at least some profit:

660 - 149.50 = 510.50

670 + 149.50 = 819.50

So if GOOG finishes anywhere between 510.50 and 819.50 then we'll have some sort of profit.

I think that's a good risk.

Along the way, as we've discussed before, there will be plenty of opportunities to adjust your position by adding additional option writes. Option writing is not static; it's a dynamic strategy with lots of flexibility.

Still, naked option writing like this is inherently high-risk and not suitable for most investors. Consult your financial advisor before getting involved in any of these strategies. Discuss with him or her the risks of losing money.

Until next time, best of luck with your GOOG option investments!