How To Profit From Continued Market Downturn

With the recent collapse in share prices globally, investors are probably thinking, "It can't get any worse from here." A 40%-50% decline in shares for the U.S. market is virtually unprecedented. Well, there may be more downside to go. While the fallout from the bad bets Wall Street made on the house of cards that was subprime lending turned exotic investment vehicles, we have yet to realize atonement for several other sins.

The credit card defaults have yet to come full circle. While housing has been in a downturn for some time now, the full impact of America's credit habit has not nearly been realized yet from car loans to home equity lines of credit. Things can certainly get worse from here, as evidenced by the inability of the indices to recover following the recent bailout bill.

As you continue to see global markets unwind (remember when investment professionals said that by buying international stocks, you were "diversifying" due to the "decoupling" effect? Wrong.), commodity prices collapse and no rebound in sight for equities, surely we're about to see the collapse of major hedge funds. When this occurs, expect further panic to ensue. While value investors like Warren Buffet are starting to strike, so much capital (and leverage!) has been taken off the table, that there is little left to prop up prices in the event of a massive selloff.

What To Do?

Well, for a long term horizon, do nothing. It is ill-advised to be moving money in and out of stocks in your 401K. For all you know, I'm completely wrong and you may have missed a nice 20% bump in the next quarter. However, for money you need soon or if you actively trade, you should also be cautious about being fully invested in stocks without adequate hedging.

Selling Covered Call Options

Options are expensive these days. With the VIX at record highs, you're going to pay a heavy premium for buying puts or calls at this point. Therefore, selling options is quite lucrative in this environment - covered calls that is! If you want to test the waters with stocks, but fear a continued decline and want to lock in some extra premium in the event markets remain flat or drop while you hold, here's an example:

You buy 100 shares of Apple (AAPL) at today's close of 98.23 for $9823.

You sell a call with Jan. 09 expiry and a strike of 110 for 7.35 [$735].

This allows for a virtual 7% loss in your underlying share price without even losing a dime since you've captured that $735 premium that expires worthless. If Apple rallies, you will be able to capture the 12% move up to $110, then after that, your sold call starts to lose value commensurate with the share price movement (sort of; starts at about .5 on the dollar, but by expiry, the moves are dollar for dollar pure intrinsic value). In an extreme case, if shares run to $200, you will have captured your 12% up to $110, made the extra $9000 on the shares up to $200 and will owe $9000 on the sold call, so it's a wash past $110. Note that you still keep the $723 premium since the shares and the option move in lockstep to neutralize each other, so your max upside is decent, at 19%.

Depending on the volatility environment, I'm either a buyer or seller of options. With volatility like this, I tend to sell.

Comments

[Smarty_Pants:]

Another idea for those who don't mind the risk involved:

Sell naked Jan 2010 puts on Qwest with strike of 2.50.

Currently bid/ask at 0.95/1.15. Q is trading at about 2.25.
Say you receive $100/option for the sale. Margin required will be $150/option.

Possible outcomes:

1) If Q rebounds above 2.5 you will earn 66% on your posted margin in 15 months or less.
2) If you are exercised, for each option you will buy 100 Q at $150 net and earn $32 dividends/yr (20+% yield) with possibility for capital gains in the future (assuming dividend holds at current levels)
3) Worst case scenario is Q goes bankrupt after you are exercised, net loss $150/option (small probability)

There's the kind of 'risk' to be taking if you want to try "buying the bottom". If the presumption is that Q will not go under and continue paying a reasonable dividend, then this will let you buy shares really cheap or get paid big returns for your trouble.

First you need to have an brokerage account that will let you sell naked put options with full cash margin (TDAmeritrade recently allowed this sort of trade for those with approved 'full' option trading accounts).

2008 Oct 24 11:00 AM

[moonbat1775:]

Ouch, my brain hurts.

2008 Oct 24 11:10 AM

[investor88:]

Covered call is a popular strategy but obviously there will be situations where it doesn't work eg if the share drops like a bomb. Good to have another tool in the trading tool kit.

2008 Oct 24 08:37 PM

[Pauly B:]

I use FRO's (binary) or Fixed Return Options in this environment. They finish high or finish low. As long as you finish on the right side and place your bet far enough out your fine. 100 bucks profit for each contract right. Down side if your wrong you loose your 100 bucks and not as profitable as other plays but in this environment it works for me.

Plus side No Theta decay, no Vega issues, European style expiration, and you just break even if you throw a condor type play because one side is going to be right. I agree with others covered calls are great but the volatility is just too high in the SPX and RUT for my risk tolerance.

2008 Oct 25 09:18 AM

[Augustus:]

The CC plan can work pretty well. Maybe daytrader has a fifteen minute time horizon. However, if Apple does decline, continue to sell the calls. Use the Call premium to buy Apple shares. In a declining market, I would look to sell only slightly above the current proce. It is a guess anyway as to where the price will be in a month.

I'm not a big fan of Apple, the company. There are others which I would rather hold for a long term play. Try buying 100 shares, selling 2 calls and 2 puts. The premiums are now pretty extradordinary. The put premium plus the call premium should cover a large down move. If you get the shares, sell calls for the next cycle. Holding the original 100 shares should give some protection against having the price run away from you to the upside with the calls and getting wiped out.

2008 Oct 26 02:24 PM

[User 286954:]

I just sold covered calls on the stocks in my portfolio that I am going to hold through this economic downturn, because it's too late to sell the stocks. I think that makes sense. If the calls move toward the strike price and I don't want to have the stock called away, I can buy it back, so I don't have to pay capital gains on the sale of my stock. In the meantime, selling covered calls seems about the only thing to do these days.

2008 Oct 27 06:40 PM