Defensive Investment Strategy for a Changing Market

After more than three months of sharply higher stock prices, it appears the market is now consolidating those gains. As a best case scenario, we could be in for a short “gut check” move which simply tests the resolve of recent buyers. But the more likely scenario appears to be significantly lower prices as the economic recovery is not as close as many investors had believed.

As markets begin to trade lower, investors are quickly looking for a defensive investment strategy to protect gains from the last few months and to avoid the devastating losses many suffered during the fourth quarter of 2008 and first quarter of 2009. One of the strategies we have used in our hedge funds and individual client accounts is “covered call writing.” This strategy essentially sells the rights to a certain amount of potential stock appreciation while at the same time receiving cash to offset potential losses in the stock. Here’s how the scenario works.

• Joseph holds 1,000 shares of LDK Solar (LDK) which is currently at $9.75 per share for a total value of $9,740.00
• Joseph now sells 10 LDK September $10 calls (each call represents 100 shares) for $1.35 per share and receives $1,350 less commissions
• If between now and September 18, the stock remains at the current level, Joseph will get to keep the $1,350 for a 14% gain over just 2.5 months.
• If between now and September 18, the stock drops to $8.40 (or declines by 14%) Joseph’s cash he received from selling the calls will completely offset the loss in the stock.
  • Any drop below $8.40 will result in further losses, but the first $1.35 is protected against
• If LDK trades up to $11.00 (up 13%) Joseph will likely be forced to sell his stock at $10 per the option agreement. But since Joseph received $1.35 for selling the option, his gain is actually higher than if he had sold the stock at $11.
• If LDK trades higher than $11.35, then Joseph will forfeit his potential large gain, settling for a simple 16% gain over 2.5 months time.

So you can see that this strategy can become very beneficial in a difficult market because it helps insulate investors from significant losses. At the same time, investors are not receiving anything for free, because selling calls actually caps the potential gain (still at a healthy return for the time period.)

The lower markets trade, premium paid for these option contracts typically expands. This is good news for investors who have not sold calls yet, because the price is higher and therefore includes more protection.

There are many dynamics to consider when selling calls against existing stock positions. One can usually choose from a myriad of different contracts with different dates (typically options expire on the third Friday of each month) as well as different strike prices (in the example we could have used a $7.50, $10, $12.50 or other strike prices). Each different contract changes the risk and reward dynamics which allows you to customize an approach to very closely monitor the capital you have at risk and the potential return you are targeting.

During these turbulent times it is important to have a flexible approach to markets and to protect your capital from significant losses. There will be plenty of time for making money as stocks rise, but the first rule is to maintain your capital until a time when the situation is more favorable.