Time to Get Conservative? 50 Ideas for a Summer Sell-Off

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:
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 Reason:
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
Microsoft Corporation	(MSFT)	23	1.70	3.91
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
Google Inc.	(GOOG)	430	1.32	4.27
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
Intel Corporation	(INTC)	19	1.87	3.17
Pfizer Inc.	(PFE)	15	0.19	6.03
Hewlett-Packard Company	(HPQ)	42.5	2.42	4.27
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
Abbott Laboratories	(ABT)	44	1.24	3.45
ConocoPhillips	(COP)	42	1.21	5.12
Schlumberger Limited	(SLB)	50	1.31	7.85
Merck & Co., Inc.	(MRK)	29	1.80	5.16
Amgen, Inc.	(AMGN)	60	2.47	6.18
Wyeth	(WYE)	45	0.86	4.19
McDonald's Corporation	(MCD)	52.5	0.40	5.05
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
3M Company	(MMM)	70	1.82	2.55
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
Schering-Plough Corporation	(SGP)	26	1.47	3.39
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
U.S. Bancorp	(USB)	20	2.16	4.16
Colgate-Palmolive Company	(CL)	70	1.05	4.42
Morgan Stanley	(MS)	28	2.81	4.56

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

Comments

[Paul Zimbardo:]

Another excellent article from Mr. Hickey.

I narrowed in on AMGN as the best trade out of your list based on its risk/return profile and solid fundamentals even if I am forced to buy keep the stock short-term. Another plus for Amgen is its low beta of ~.5.

In future articles of this type, I would complement the listing by including the equity betas.

Aug 03 02:03 PM

[notsosmart:]

i guess this is what the word "investing" has morphed into. the wall st ponzi/casino scheme has very little to do with a co's business.of course lying ceo's & their self serving bod's have very little to do with the business they ruin.buffett said it best-"invest in a business that any idiot can run cause sooner or later an idiot will run it".now lately- not only idiots but crooks.made-off is a piker compared to all the swindlers raking it in.

Aug 03 04:44 PM

[Dr. O:]

Nice article on hedging/collecting premium with selling calls. As you mentioned, this seems to work best in a sideways or declining market. A declining market serves up increased call premiums, hence the enhanced return relative to the index/stock. A sideways market allows you to collect premium and make money even while the underlying index/stock does nothing.

As a frequent trader, the first thing I wondered about were costs of commissions and how selling calls with each stock purchase might affect returns.

Aug 04 06:52 AM

[Dirk McCoy:]

It was only 2 years ago that the Dow was at an all time high and many of these stocks were flying. Yet, the future earnings potential for many of these companies is in doubt given the potential for higher taxes, higher energy and labor costs, regulation, and worst of all- protectionism.

Trying to value these stocks in light of today's economy- that was built on American opportunism and leadership that led to hundreds of millions of new middle class worldwide - is colored by a view of tomorrow's that could be built on a different ethic- global downsizing.

It may be awhile before we really know the effect of the current policy proposals, considering Soviet malaise didn't appear right away and it took Mao over a decade to starve millions of his citizens. I can see why someone would turn to short term technical trading instead of relying on the vision of an American-led resurgence in global consumption.

How much would you have paid for railroad company stock if the government had promised to increase taxes to fix up tenements instead of allowing immigrants to travel westward?

Aug 04 09:19 AM

[Ralph Hunkey:]

Excellent article.....AND comments...it is always good to read and learn ideas about America

Aug 04 09:26 AM

[User 274233:]

This is a great article, informative and potentially profitable. For those who feel uncomfortable writing options or calculating price points, as well as moving capital into and out of the market, there is an ETF called BEO that uses the same strategy on the BMX index. This has been recommended in the past by Richard Lehmann, and is currently distributing around 23% in dividends. The payouts are semiannual, so you'll have to wait longer for your money, but then again, they handle all the details. Thanks again for the insight into the options market.

Aug 04 10:23 AM

[tomdotstar:]

In order to use this strategy, you really need to be a disciplined investor. I've been using it and have missed some of the upside on the rally because I have not been disciplined to buy back the call and "reinvest" in the underlying stock...

This article gives you great insight on how to use this technique.

Aug 04 10:30 AM

[Paul Zimbardo:]

@Dr. O - In regards to commissions, that is a very good question. My broker charges the same fee for buy-write trades as it does for option commissions so I effectively get a 50% discount on commissions. A very important note - if your position is called away (as it often will be in this type of trade), you often have to pay a commission that is twice as high as a normal commission. As a result, you may consider buying back the option and writing out a covered call for the following month, especially if you are bullish on the underlying security.

@User 274233 - I am very interested in ETFs that employ this strategy so I will look into BEO; however, I usually stay away from actively managed ETFs due to the fees.


On Aug 04 06:52 AM Dr. O wrote:

> Nice article on hedging/collecting premium with selling calls. As
> you mentioned, this seems to work best in a sideways or declining
> market. A declining market serves up increased call premiums, hence
> the enhanced return relative to the index/stock. A sideways market
> allows you to collect premium and make money even while the underlying
> index/stock does nothing.
>
> As a frequent trader, the first thing I wondered about were costs
> of commissions and how selling calls with each stock purchase might
> affect returns.

Aug 04 10:37 AM

[260736:]

A lot of good homework done here.

Doing buy/writes is a good place to start but if you want to graduate into the big leagues then you need to attend the "RadioActive Trading" webinar today at Noon by Kurt Frankenburger. I don't get anything out of making this recommendation . . . I simply use the options strategies taught by Kurt.

"Many folks are familiar with the concept of covered call trading… the “siren call” of which is taking INCOME on a stock you already own, without necessarily having to sell it. We will not only expose the actual riskiness of the incomplete covered call strategy… it will also show you how to FIX the two biggest problems with it… and also THREE of the SEVEN Income Methods contained in The Blueprint, our premier RadioActive Trading product."

You can register for the free seminar at www1.gotomeeting.com/r...

Aug 04 10:56 AM

[260736:]

Here is the rest of that url from the last post

www1.gotomeeting.com/r...

Aug 04 10:58 AM

[Avooch:]

Nice intro to the subject - well done


Some fundamental analysis on my weblog: gudovac1941.blogspot.c...

Aug 04 11:06 AM

[jimmy46:]

purchased and a covered call option to be sold immediately against it"

THIS IS A STRATEGY FOR LOSERS,
YOU KEEP YOUR LOSERS
& LET OTHERS HAVE YOUR WINNERS.

Aug 04 06:30 PM

[secmaven:]

Writing calls on stocks that pay dividends is a loser. Sweep programs in the broker's shop will call your stock away every time to get he dividend if the stock is a winner. The double commissions kill and you lose the expected dividend. You keep the losers and break even on the winners.

Aug 04 08:33 PM

[demosthenes:]

Who is your broker?


On Aug 04 10:37 AM Paul Zimbardo wrote:

> @Dr. O - In regards to commissions, that is a very good question.
> My broker charges the same fee for buy-write trades as it does for
> option commissions so I effectively get a 50% discount on commissions.
> A very important note - if your position is called away (as it often
> will be in this type of trade), you often have to pay a commission
> that is twice as high as a normal commission. As a result, you may
> consider buying back the option and writing out a covered call for
> the following month, especially if you are bullish on the underlying
> security.
>
> @User 274233 - I am very interested in ETFs that employ this strategy
> so I will look into BEO; however, I usually stay away from actively
> managed ETFs due to the fees.

Aug 05 10:34 AM

[Anthony Alfidi:]

Good analysis. Buy/writing is a safer bet after a rally that has no justification in fundamentals. The biggest difficulty IMHO is picking a strike price far enough away from the stock's likely closing price at options expiration that the position won't be called away.

Aug 05 12:20 PM

[Paul H. M.:]

For frequent traders, Think or Swim charge $0.75 to $1.50 per contract, depending on how good you are at negotiating, and how much capital you have.

Aug 09 03:34 PM