Trading Volatile Market Declines
With the stock market declining over 5% in the past month and volatility up 85% as a result of geo-political and global concerns exacerbated by the fears of an Ebola epidemic we find ourselves in a position that may lead to "panic" in our investment decisions. The stock market seemed to stabilize a bit on Friday but we are not out of the woods yet based on just that one day. Whether you are an experienced investor who has "been there, done that" or a newbie who is experiencing this discomfort for the first time, patience and non-emotional responses are the most prudent. In this article, we highlight strategies to manage existing option-selling positions in these extreme circumstances and strategies to initiate new positions for those who want to "stay in the game." Much of the information comes from Blue Collar books and DVD Programs as well as previous published articles.
Managing existing positions
1- Always buy back an option when it approaches the 20%/10% guidelines (declines in value to 20% or 10% of initial sale value depending on when in the contract cycle the decline takes place). This frees up capital to sell another option or to close our long stock position.
2- When market tone is negative (as it currently is) and technicals are also negative, sell the stock. Many investors will also use a percentage price decline to determine when to sell a stock, usually 8% to 10% of the purchase price. Once sold, a decision is needed as to whether to "stay in the game" and enter a new position. See below for some strategies to consider. Many investors are more comfortable staying in cash until a firm bottom is in place.
3- Rolling Down iswhen we buy back a previously sold option (buy-to-close our short position) and simultaneously sell another option at a lower strike price in the same contract month (open a new short position).
We lean towards implementing a rolling down strategy when the market tone and technicals are mixed to negative. We are also more inclined to use this strategy later in the contract period (late in week 2 and week 3, rather than week 1 of a 1-month contract).
Entering new positions-staying in the game
For those who have a higher risk tolerance and want to remain in the market, it is prudent to implement strategies that are appropriate for current market conditions, especially extreme ones like now. Selling out-of-the-money strikes may work out but it makes little sense to take an aggressive stance until the market tone improves and stabilizes. Here are a few strategies that will allow us to generate an initial profit and provide us with some profit protection.
1- Sell only in-the-money strikes
If we buy 100 shares of XYZ for $32 and sell a $30 call for $3.50, we have sold an in-the-money call option because the strike price of the call option ($30) is lower than current price of XYZ ($32). The sale of this call option obligates us to sell 100 shares of XYZ for $30/share (or $3,000 in total) if the option is exercised. Should XYZ increase in price from $32 to $40, we make no additional income due to our obligation to sell our shares @ $30. The option premium we receive from the sale of this option has $2 of intrinsic value ($32 – $30). The remainder of the option premium is solely time value, which represents our true initial profit (ROO). Thus, if we received $3.50 in total option premium from the sale of the $30 call option, the $3.50 premium we receive consists of $2 of intrinsic value and $1.50 ($3.50-$2) of time value. Because our true profit is represented by time value only, for this example we generated an option profit of $1.50/share or $150 per contract, which represents a 5% ROO (the $2 intrinsic value "buys down" our cost basis to $30) per share). The protection of that 5% initial profit is the intrinsic value divided by the current market value or $2/$32 = 6.25%.
2- Buy protective puts-the collar strategy
As safe a strategy as covered call writing is, there is still some risk purchasing the stock, not in selling the option. For this reason, some investors who sell covered calls also buy protective puts to alleviate some of the risk. A protective put is an option purchased for an underlying stock already owned. It defends against a decrease in the share price of the underlying security creating a collar, the simultaneous purchase of a protective put option and the sale of a covered call option. In a true collar strategy, the puts and calls are both out-of-the-money and have the same expiration dates and an equal number of contracts. Thus, we sell an out-of-the-money call and add additional downside protection for the underlying equity by purchasing a protective put option. This strategy protects against catastrophic share value decline but also decreases our initial potential option profit.
3- Sell out-of-the money cash-secured puts
With this strategy, we are selling the right, but not the obligation, for the buyer of the put to sell a stock to us at a specified price, by a specified date. In return for undertaking this obligation, we also receive a premium. For example, a stock is trading at $32 per share and we sell a $30 out-of-the-money put for $1.50, receiving a return of $150 per contract. The returns in these scenarios are generally similar to the returns of generated from selling covered calls, and if the put is exercised, we are required to buy the stock for $30, meaning we purchase the shares at a cost basis of $28.50 ($30 less the $1.50 premium). Some investors consider this "buying at a discount" from the original $32 share price. We can then write a covered call on the assigned shares.
4- Use inverse ETFs
Inverse ETFs use derivatives to bet against the direction of financial markets. Known as short or bear ETFs they will make money if markets decline. They will lose money, however, if markets move back up. Covered call writers who have a bearish market outlook may find these funds useful for hedging.
Many sophisticated covered call writers can benefit from the use of inverse ETFs in the short run when the market is bearish.
Inverse ETFs with options to consider
-- PSQ: short QQQ
-- DOG: short Dow 30
-- SH: short S&P 500
-- RWM: short Russell 2000
Currently equity markets are reflecting concerns about both positive domestic economic news and negative geo-political and global economic influences. This will pass because it always does. The greatest error we can make is to act emotionally without employing the critical investment parameters that will make us all succeed in the long run-fundamental, technical and common sense principles. In challenging times, there may not be great choices to make but there will ALWAYS be the best choices to make under the circumstances. Finding these and implementing the most sensible strategies are some of the prime mission statements of Blue Collar Investors all over the world. The purpose of this article was to summarize and highlight these guidelines.
To learn more about mastering the skill of exit strategy execution and much more information on becoming an elite covered call writer, click on the Blue Collar Investor link.
Wednesday's surprising decline in yield on the benchmark 10-Year Treasury Note to an intraday low of just 1.87% on increased concerns about a global economic slowdown seems to have dispelled anxiety that interest rates will be raising anytime soon. If so, perhaps high yield corporate bonds are worth considering again.
iShares iBoxx $ High Yield Corporate Bond (HYG) 91.77 at the current rate of about .40 per month the return is 5.20% while SPDR S&P 500 ETF (SPY) 188.47 yield is 2.00% paid quarterly while the current correlation is about 75%. From the lows on August 7 to the lows made Wednesday October 15, the decline for HYG was 3.73% compared to 4.53% for SPY.
Comparative options data,