As previously stated on my blog, this rally could continue through August; but I'm convinced we may sell off a bit. Nobody knows for sure what will happen in the month to come, but getting conservative and taking profits never hurt anyone. July was an unexpected bull run, and I have to say the economy still isn't that great... I would hate to be completely long before Friday's unemployment numbers come out. So in this post I will explain why it may be a good time to get conservative while still participating in the market, and how a simple option strategy allows you to do this. This strategy actually allows you to both protect and profit.
The strategy is the buy/write option strategy, and requires the stock to be purchased and a covered call option to be sold immediately against it. The premium received will lower your cost basis (providing downside protection), and the strike price the option is written for is out of the money so it allows additional upside gains on the stock. To learn more about options check out my blog or options trading E-Books here.
The chart below from Yahoo finance has the CBOE Buy/Write Monthly index versus the S&P 500.
(click images to enlarge)
The BXM as explained from CBOE website:
The BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index (SPXSM) "covered" call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.
As you can see up until 2008, both correlated very well. However, during market sell offs the buy write strategy protects the portfolio. The negative: the buy/write during bull markets does not return as much (see chart below since market bottom March 6, 2009).
Since the market bottom, the buy/write strategy would have returned less than being completely long. However I have to believe the chances of rallying another 45% are very unlikely. Given the rally we've had in July, and judging by the Volatility Index (VIX), I believe this market is due for a short term correction phase. I am bullish long term, but anticipate a slight sell off in the coming months. This strategy is ideal for this type of speculation. So, I have outlined a list of the top 50 companies (by market cap) in the S&P 500 using this strategy, and will analyze which company is what I call the "best bang for the buck" or which one yields the best combination of both downside protection and potential return.
All data as of stock market close Friday July 31, 2009.
For this analysis I am taking a more conservative approach and writing the option nearest to 3% lower on the share price. The strike price can easily be adjusted for a more bullish approach (less protection and greater return).
To understand the table, I will give a detailed example of Apple (AAPL) below.
Purchase Apple stock, and sell the in the money August 160 strike call option. The premium received from the call option would give a downside protection of 3.86%. If the stock is assigned at options expiration on August 22, 2009 the total return from this position would be 1.78%.
A more bullish approach would be to write out the Apple 165 Call option. This approach would protect to the downside 2.14%, and if the stock is assigned at expiration it would return 3.13% (in 19 calendar days).
The August options expiration is 19 calendar days away, so it may be best to monitor the position and buy back the call option on weakness of the underlying stock, if the stock rallies after it is purchased back, write it back out for a higher premium etc.
|Company||Ticker||Strike||Return %||Protection %|
|Exxon Mobil Corporation||(XOM) ||70||1.51||2.06|
|Wal-Mart Stores, Inc.||(WMT) ||47.5||0.34||5.11|
|Johnson & Johnson||(JNJ)||60||1.08||2.55|
|The Procter & Gamble Company||(PG) ||55||1.96||2.88|
|International Business Machines Corp.||(IBM)||115||0.91||3.39|
|AT&T Inc.||(T) ||25||0.61||5.30|
|Apple Inc.||(AAPL) ||160||1.78||3.86|
|JPMorgan Chase & Co.||(JPM) ||37||1.01||5.28|
|Chevron Corporation||(CVX) ||65||0.26||6.69|
|General Electric Company||(GE)||13||2.24||5.22|
|Cisco Systems, Inc.||(CSCO) ||21||1.59||6.18|
|Bank of America Corporation||(BAC)||14||1.83||7.17|
|Wells Fargo & Company||(WFC) ||24||2.82||4.70|
|The Coca-Cola Company||(KO)||47.5||0.42||5.12|
|Oracle Corporation||(ORCL) ||21||0.90||6.01|
|Pfizer Inc.||(PFE) ||15||0.19||6.03|
|Philip Morris International Inc.||(PM) ||45||1.07||4.51|
|Verizon Communications Inc.||(VZ)||31||0.84||4.18|
|PepsiCo, Inc.||(PEP) ||55||0.88||3.96|
|Goldman Sachs Group, Inc.||(GS)||160||1.75||3.77|
|QUALCOMM, Inc.||(QCOM) ||45||1.56||4.18|
|Merck & Co., Inc.||(MRK) ||29||1.80||5.16|
|Occidental Petroleum Corporation||(OXY) ||70||2.40||4.28|
|United Parcel Service, Inc.||(UPS)||50||0.60||7.54|
|CVS Caremark Corporation||(CVS) ||32.5||1.79||4.72|
|United Technologies Corporation||(UTX)||55||2.90||1.93|
|The Walt Disney Company||(DIS) ||24||1.31||5.77|
|Monsanto Company||(MON) ||80||1.43||6.19|
|Gilead Sciences, Inc.||(GILD)||47.5||1.43||4.35|
|The Home Depot, Inc.||(HD) ||25||1.70||5.32|
|Comcast Corporation||(CMCSA) ||14||2.09||7.87|
|Bristol Myers Squibb Co.||(BMY)||21||1.20||4.60|
|Kraft Foods Inc.||(KFT) ||27||1.27||6.00|
|Eli Lilly & Co.||(LLY)||35||2.12||1.81|
|Medtronic, Inc.||(MDT) ||34||0.99||5.00|
|Colgate-Palmolive Company||(CL) ||70||1.05||4.42|
As you may have noticed, the less volatile the underlying stock and the deeper the call is written in the money, the less the return percentage is. Based on this analysis of 50 stocks, the stocks which offer the greatest combination of both potential return and protection are: Home Depot, Cisco Systems, Amgen, Bank of America, and Comcast. I personally like the Bank of America idea, and will be looking at opening up some buy/writes for the August expiration in the days to come. To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here.
As the Volatility index is creeping back up, call option premiums should increase in value overall, protecting and giving an even higher return. I use this strategy to write my shares out on strength, and purchase them back on weakness (if I am profitable). For example: using this strategy has allowed me to cost average my position on Caterpillar (NYSE:CAT) down to $4.88 a share. Patience is key to succeed with this strategy. If the stock gets called out, and you miss the upside, the position is still profitable and you can always do it again for the next options expiration. If the stock gets hammered and you're down on the position, this strategy will keep you in the game and allow you to cost average the shares down month after month. Note you should be willing to be long a stock before using this strategy.
All of these options expire on August 22; therefore the last trading day is Friday, August 21, 2009.
These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.
This strategy will give protection if the market sells off, as well as provide a return if the market continues to rally. If the stock is not assigned, this strategy is a great way to create additional income for your portfolio. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.
So in case the summer rally fades and turns into a summer sell off, these are just some strategies which can be used to help pad the portfolio, without spending additional money by purchasing put protection.
Disclosure: Long BAC, CAT, GOOG, GS, PFE