Sell Off Ahead? 25 Ways to Profit and Protect from a Stock Market Correction

People keep calling me a bear, but I'm just being conservative. Given the rally we've had, I think it's a great time to take profits. I was selling a lot of covered calls for the August expiration Thursday, as we approached market close. I'm getting conservative because I think we're due for a pull back on the major indices.

Reason 1: The recent activity in the Volatility Index [VIX] is telling me a short-term sell off may be near (click chart to enlarge).

Historically the VIX and the S&P 500 have a negative relationship (as one increases the other decreases and vice versa). However the 10 day chart above shows both have increased together in recent trading. This signals a sell off may be near in my opinion, or at least a lot of traders are betting on a sell off short term.

Reason 2: Simple profit taking. With the unemployment data coming out Friday, whether it's better or worse than expected, I believe profits will be taken. If it's better than expected data, I believe it will sell off because it is already factored into this recent market rally, and if it's worse than expected data... It should send a signal that the market may be overvalued considering the worst may not be behind us.

Reason 3: Earnings season is coming to an end. With the majority of companies beating estimates (simply because revisions have been set extremely low), it has certainly contributed to this ongoing rally. I believe the "better than expected" earnings quarter has inflated these stocks too fast on a short term basis.

As I stated earlier, I've been selling covered calls on many of my stocks to protect my position. I've also stated in my blog recently, that this market can continue to rally, as there's still a lot of cash on the sidelines. Selling covered calls is a great way to create income off the shares in your portfolio, as well as allow for an additional gain as well. Selling covered calls is ideal for this type of speculation, which is why I have decided to outline 25 ideas in this article. To learn more about this strategy, and stock options in general click here. I will use the 25 largest stocks (by market cap) in the S&P 500 for my analysis.

To understand the table, I will give a detailed example of Goldman Sachs (GS) below.

Sell the Goldman Sachs in the money August 165 strike call option. The premium received from the call option would give a downside protection of 3.00%. If the stock is assigned at options expiration on August 22, 2009 the total return from this position would be 1.95%.

A more bullish approach would be to write out the Goldman Sachs 170 Call option. This approach would protect to the downside 1.54%, and if the stock is assigned at expiration it would return 3.49% (in 15 calendar days).

The August options expiration is 15 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... The weekend will take some premium away from these option contracts as well which is another positive to being the seller of these options. According to the current Theta, the 165 call option will lose roughly $25 per contract, and the 170 call option will lose roughly $23 per contract sitting inactive over the weekend.

All data as of market close Thursday August 6, 2009.

Company	Ticker	Strike	Return %	Downside %
Exxon Mobil Corporation	XOM	70	1.72	1.33
Microsoft Corporation	MSFT	23	1.24	3.20
Wal-Mart Stores, Inc.	WMT	50	2.92	0.84
Johnson & Johnson	JNJ	60	1.45	1.33
The Procter & Gamble Company	PG	52.5	3.19	1.17
International Business Machines Corp.	IBM	115	1.12	3.15
AT&T Inc.	T	26	2.90	1.14
Apple Inc.	AAPL	165	2.62	1.95
JPMorgan Chase & Co.	JPM	41	3.53	2.92
Google Inc.	GOOG	450	1.99	2.07
Chevron Corporation	CVX	70	2.35	1.27
General Electric Company	GE	14	2.31	4.47
Cisco Systems, Inc.	CSCO	22	1.84	3.14
Bank of America Corporation	BAC	17	5.21	3.41
Wells Fargo & Company	WFC	28	3.97	3.86
The Coca-Cola Company	KO	50	2.19	0.95
Oracle Corporation	ORCL	21	1.84	2.83
Intel Corporation	INTC	19	3.37	1.76
Pfizer Inc.	PFE	16	3.10	1.77
Hewlett-Packard Company	HPQ	42.5	3.46	2.77
Philip Morris International Inc.	PM	47	1.72	1.70
Verizon Communications Inc.	VZ	31	1.94	1.81
PepsiCo, Inc.	PEP	57.5	1.50	2.08
Goldman Sachs Group, Inc.	GS	170	3.49	1.54
QUALCOMM, Inc.	QCOM	46	2.81	1.82

To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here. As an owner of both Goldman Sachs and Bank of America shares, I've written some / will be writing more in the days to come, as the volatility of the underlying stock gives a very nice premium, even on out of the money options and 2 weeks until expiration.

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 down to $4.88 a share. Patience is the key to succeed with this strategy. If the stock gets called out, and you miss some of the upside, you can always use the buy/write option strategy to get the stock back for the following month. With the VIX at historic highs and call premiums exploding, selling deep in the money covered calls on my shares from September to December allowed me to trump the market, and actually make a profit.

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.

Instead of spending additional money on put protection, this strategy allows income to flow to your portfolio providing protection on the position.

Disclosure: Long BAC, CAT, GOOG, GS, PFE

Comments

[WhoisJohnGalt:]

I cannot agree more on reasons 2 and 3. Profit taking should have occurred at this point in the game, but investors are giving into their glut (and gut) that the future is bright. It is dangerous to put money in a rally propped up by hope instead of numbers: the "less bad" trend is not going to appease the bulls soon. But then again, the markets can stay irrational longer than you remain solvent.

Aug 07 11:25 AM

[truthteller:]

I have learned that jumping in and out of stocks can be very foolish. There's a certain degree of wisdom to removing cash from the market, when you know there's a deep recession on it's way. However, buying on the way down or selling on the way up is a very good way to lose a big chunk of cash. It feels like we're due for a pullback eventually, maybe in September, maybe not. Sometimes, it's best to just ride out small pullbacks and hedge using some short positions or pull out of stocks for major corrections.

Aug 07 11:33 AM

[Crashnburn:]

I'm no expert, and lately my timing has been atrocious. Still, I'm almost 100% invested in the market, since late March, early April, and was out from Sept 8 until the above time frame.

I won't be at all surprised if the market pulls back significantly in Sept/October, mostly because about half the world's economy (Europe) shuts down completely in August. I don't know if I'll have the courage of my convictions.

Probably, the most I'll do will be to sell my excess weight in my diversified portfolio in late August, early Sept. I don't do options.

Aug 07 01:29 PM

[Mad Taxpayer:]

I agree. Historically, the market rises when DC is on break and not messing things up, However, I think that the market is oversold and due for a correction. It may be wise to take profits and wait for the down turn.

Aug 08 08:25 AM

[Oh come on now:]

You make a lot of good points in your post. Yet, I hope the rest of your predictions go better than your reason #2 which played out the opposite.

Simple supply and demand is not factored into your analysis sufficiently for this time, in my opinion. Traders and individuals, who kept bearish too long, are trying to get in on the rally. That might help explain the upside bias that seems clear from recent performance being so bullish.

Aug 08 09:23 AM

[CLH:]

Marco--We have had a great rally but you have continued to lose because you are a bear. Should you be giving out advice?

Aug 08 10:24 AM

[calisdad:]

wow- the consensus is BUY BUY BUY !! How often is the consensus right for an extended period?

Aug 08 10:56 AM

[Northstar10000:]

Just buy SDS and sleep at night.

Aug 08 11:13 AM

[haymakerforyou:]

Excellent choice...if he is correct.


On Aug 08 11:13 AM Northstar10000 wrote:

> Just buy SDS and sleep at night.

Aug 08 01:36 PM

[bowman711:]

Is it possible that this over extended market rally is being kept alive by the 'bailout' money . . . that isn't being lent to businesses and consumers?

Aug 08 02:47 PM

[Cpowell:]

Where will C be next Friday? Anybody? I'm curious to know about exit strategies for the Citigroup (C) trade in the next week or weeks, and I know I ain't the only one. I am in a "fine mess" here!

First, though, regarding some comments above. On Aug 08 11:13 AM Northstar10000 wrote: "Just buy SDS and sleep at night" and Haymaker seems to agree, sort of:

"Excellent choice...if he is correct."

Um, yes. When anybody is right, it's an "excellent choice." But using SDS, even if you're right, and it takes the Market another month to hit the long-anticipated correction, can you really sleep at night? Even as a hedge against longs, SDS wouldn't give much comfort. BTDT:

I was totally positioned for the drop back when SPX was at 875 in early June. Obviously, the Market went the other way, and left me along with the hedge fund guys scratching our heads. But I added insult to injury, as my bearish stubbornness persisted all that month. It cost me. I jumped in and out with SSO and SDS and learned again:

(1) why I hate Ultras (Marco & others have spreadsheets showing holding an Ultra longer than a day or week is mathematically an automatic loser)

(2) Why I don't scalp. Scalping with big positions is deadly, doomed, and DUMB. Yeah, I'll cop to it. I've made all the mistakes common to traders, like chasing, dollar-cost (dollar-loss) averaging, taking profits on winning trades PRIOR to exit target and market signals, etc. And I made most of them again in June due to skittishness about having a trade roll over (left a lot of money on the table with a winning trade on a very big position in AA established on 30 April), and over-trading. And yes I knew the virtues of rigorous discipline, patience, etc etc.

(3) On Aug 07 11:33 AM truthteller told it: "I have learned that jumping in and out of stocks can be very foolish. There's a certain degree of wisdom to removing cash from the market, when you know there's a deep recession on it's way. However, buying on the way down or selling on the way up is a very good way to lose a big chunk of cash. It feels like we're due for a pullback eventually, maybe in September, maybe not. Sometimes, it's best to just ride out small pullbacks and hedge using some short positions or pull out of stocks for major corrections."

Back to the C trade in with these thought: "A crowd always seems to gather around anyone living life without a net." - Tom Petty.

"That's another fine mess you've gotten me into," said my bearish half to my bullish half. (FWIW, an FYI from Wikipedia: The catchphrase most associated with

Laurel and Hardy is almost always misquoted as "Well, that's another fine mess you've gotten me into." Ollie actually said, "Well, here's another nice mess you've gotten me into." The phrase has passed into common usage and means to blame a partner for causing an avoidable problem.)

I have a BIG position right now in C under $4 and I'm not happy about my entry. I sold for a modest profit at 3.73 and was waiting for a pullback to 3.30 to get back in. Then that guy Cramer had to go tout the damn stock on his show (guess he finally flipped the switch with the surprising BUY from S&P and had his positions set, and the previous day's Lightening Round question about C caused him to declare) I watched in disbelief as the after-hours trade jumped at that moment from 3.73 to $4. My own personal VIX is sky-high about this position. See, I had pulled the trigger too fast again, but this was a killer! To help our trader (me) sleep, I don't see any downside protection with a covered call in this instance. Choices, best first:

(a) Chunk out the dough for a $4 protective put ("the fine mess") and hold out

(b) Take some off with any pop over $4.20 (remember the Alcoa trade I mentioned)

(c) I could dump the whole postion on any 5% pullback.

(d) Or, finally and most dramatically, just let it ride, babe! (Tom Petty's comment)

So what would you do if you found yourself in this situation? Got a bad case of the Exit Eeks again this weekend welcome any wisdom!

cp

=======================
S&P Analyst Research Notes and other Company News

August 3, 2009 02:19 pm ET ... S&P MAINTAINS HOLD OPINION ON SHARES OF BANK OF AMERICA (BAC 15.36***): According to an unconfirmed Wall Street Journal report, Sallie Krawcheck, who previously headed CitiGroup's (C 3.21****) wealth management business, will take a position with BAC. If confirmed, we think this would be a positive for BAC's wealth management business, which has been losing personnel after its Merrill acquisition. Separately, BAC agrees to a $33 million settlement with the SEC in connection with bonuses paid to Merrill Lynch executives before completing the deal.We are raising our target price $2 to $16, a below historical 1.37X current tangible book value. /S.Plesser

August 3, 2009
On July 24, 2009, Citigroup, Inc. Board of Directors announced that three new outside directors had been appointed to the Board, effective July 24, 2009. The three new outside directors are: Diana L. Taylor, the former Superintendent of Banks for the New York State Banking Department, and current Managing Director of Wolfensohn Capital Partners. Ms. Taylor will be a member of the Board's new Citi Holdings Oversight Committee; Timothy C. Collins, Chief Executive Officer of Ripplewood Holdings L.L.C. Mr. Collins will join the Board's Audit and Risk Management Committee and Robert L. Joss, Dean and Philip H. Knight Professor of the Graduate School of Business at Stanford University, and former Chief Executive Officer and Managing Director of Westpac Banking Corporation Ltd. Mr. Joss will be a member of the Citi Holdings Oversight Committee.

August 3, 2009
Citigroup, Inc. announced that Jerry Grundhofer will be the non-executive chairman of the board and that two additional outside directors, Michael O'Neill and Anthony Santomero, will be directors. Mr. Grundhofer will replace Bill Rhodes, who will step down as chairman and CEO of Citibank. Mr. Rhodes will be senior vice chairman of and will remain on its board. He will also continue to serve as senior vice chairman of Citigroup, where he will focus more of his time on Citi's international franchise.

July 30, 2009
C in deal to sell its entire ownership interest in Nikko Asset Management to The Sumitomo Trust and Banking Co., Ltd. as part of a transaction that values Nikko at $1.26B. Deal expected to close in CY Q4 '09, subject to regulatory approvals and customary closing conditions, and is not expected to have a material impact on C's net income.

July 29, 2009
Citi's Board of Directors announced three new outside directors. The three new outside directors are: Diana L. Taylor, the former Superintendent of Banks for the New York State Banking Department, and current Managing Director of Wolfensohn Capital Partners, a fund manager. Timothy C. Collins, Chief Executive Officer of Ripplewood Holdings L.L.C, Robert L. Joss, Ph.D., Dean and Philip H. Knight Professor of the Graduate School of Business at Stanford University, and former Chief Executive Officer and Managing Director of Westpac Banking Corporation Ltd.

July 29, 2009
On July 21, 2009, the Board of Directors of Citigroup Inc. appointed Jeffrey R. Walsh as Controller and Chief Accounting Officer of the company. Mr.Walsh, 51, has been with Citigroup for more than 19 years in a variety of product, regional and functional finance roles, including Controller for the Global Consumer Businesses, Interim Global Consumer CFO, Senior Finance Officer for International Operations, EMEA Consumer CFO and UK Country Controller. Previously, Mr. Walsh spent 11 years with KPMG.

July 27, 2009 02:48 pm ET ... S&P UPGRADES OPINION ON SHARES OF CITIGROUP TO BUY FROM HOLD (C 2.65****): Our upgrade of these volatile shares is based on valuation as upside potential from current levels seems attractive to us. C has successfully exchanged preferred into common equity and we now think capital levels are adequate. Given heavy dilution, we acknowledge that C's shares have long-term limitations vs. peers. Still, we estimate that a burn down of our tangible book value (TBV) estimate of $4.20, even assuming more pessimistic loss assumptions, still provides upside to the current share price. We think C's brand remains intact and are maintaining our $4 target price.

Aug 08 07:06 PM

[FloridaBoy2:]

Where will C be next Friday? Anybody? I'm curious to know about exit strategies for the Citigroup (C) trade in the next week or weeks, and I know I ain't the only one. I am in a "fine mess" here!

stockcharts.com/h-sc/u...

I can't tell you where C will be Friday but if I were long below $4 I would sell on a pop and get back in after a drop. I just don't see C as a rocket stock that will go into orbit anytime soon. It has had a sharp rise in a short period of time My 2 cents.

Aug 09 08:51 AM

[Crude Oil T...:]

I agree with your bearish stance but I think having now crossed the 38% line we'll continue to work higher. And that's OK, the higher we retrace the more we'll over shoot to the down side.

Aug 09 04:05 PM

[BHG:]

Macro, would you mind expanding on your numbers regarding the GS strategy? I visited your site and didn't see much other than the option to buy some e-book.

Aug 09 04:05 PM

[Dialectical...:]

I dabbled modestly in C too. Then I suddenly woke up and asked myself what I was doing playing with this fire. C is one of the ones that will TANK if and when the other shoe drops on this "recovery." It is just not solid. So I got out. Could have made more if I got out later, but would have had no one to blame but myself if it suddenly started trading where it should be. So if you care for my opinion it is to get out now and not look back unless or until the price drops back to 2.30. Even then it is no great buy, just that it has an upside that warrants some gamble. C could go up high in this market, but it will not be based on health or value and that just makes it too much like shooting craps for my taste. Good luck.

On Aug 08 07:06 PM Cpowell wrote:

> Where will C be next Friday? Anybody? I'm curious to know about exit
> strategies for the Citigroup (seekingalpha.com/symbol/c) trade
> in the next week or weeks, and I know I ain't the only one. I am
> in a "fine mess" here!
>

Aug 09 06:03 PM

[Cpowell:]

I will look at the Pre and Open today for C. The resistance is 4.20. New support seems to be at 3.73 - 3.80, then 3.63, then 3.47. Line of least resistance still seems up, but early entry is always a wild ride. If C closes above 4.20 and sets a new support there, then that's a big buy signal. Above 5.00 the institutional traders can go long. There are not many doubles left, but C could double.

One real cloud is the reverse stock split buzz, which is just "being considered" and is supposed to be presented and voted at a 9/2/2009 shareholders meeting. The big insider buys recently are more than just PR.

Note the Volume-by-Price here:

online.barrons.com/pub...~0&comp=&ma=1&...


On Aug 09 06:03 PM Dialectical Materialist wrote:

> I dabbled modestly in C too. Then I suddenly woke up and asked myself
> what I was doing playing with this fire. C is one of the ones that
> will TANK if and when the other shoe drops on this "recovery." It
> is just not solid. So I got out. Could have made more if I got
> out later, but would have had no one to blame but myself if it suddenly
> started trading where it should be. So if you care for my opinion
> it is to get out now and not look back unless or until the price
> drops back to 2.30. Even then it is no great buy, just that it has
> an upside that warrants some gamble. C could go up high in this
> market, but it will not be based on health or value and that just
> makes it too much like shooting craps for my taste. Good luck.<br/>
>
> On Aug 08 07:06 PM Cpowell wrote:

Aug 10 03:21 AM

[xhtt:]

I like the article, a very clear analysis of the current market status, especially the three bulltet points, which can be applied to even great universe.

Aug 10 05:03 AM

[Steve20423:]

Ok so there is going to be a correction. A stopped clock is right twice a day. I would guess there will be a correction timining is the elusive unknown and equity holders would be wise to use trailing stops to preserve capital. I have ridden the market into the trough too many times and will never do so again.
Any holding I have a gain in will be sold 5 -10% below its recent high.
Can SDS and other short indexes actually go to or approach Zero net asset value?

Aug 10 10:02 AM

[DonFurio:]

I love when stupid SA author shorts are wrong and it has been so great busting the shorts all year.

You can call this whatever you want to call it, but I've been buying all year much to the dismay of the whiners, losers and shorts. Will there be a correction at some point? Who knows, who cares, because if you buy every month and have a couple of years time horizon, you should be fine.

The reality is that things are getting better. Will there be more bankruptcies ahead, sure, but a lot of those loans/bonds are priced to reflect that. Are things great right now, no, of course not, but if you are college educated and willing to relocate, there are jobs. Now if you if live in a town that relied on GM or some other plant and got to reap the benefits of the union demanding too much all these years, then yea you have some tough times ahead and should relocated / switch careers.

Aug 10 01:25 PM

[thevoice@vo...:]

Agree with the sell off:

Dow Jones Stoxx 600 Index traded at the most expensive relative to earnings in almost six years.Traders are betting the VIX, a gauge of expected stock swings, will increase 13 percent in the next five weeks.
The better than expected results for retailers and economic reports are due to the stimulus package not real wage increases. As the unemployment number showed, the US is still losing jobs. Its funny how the positive spin on the story was that the US "ONLY" lost 200,000+ jobs instead of 500,000.

Aug 11 12:05 PM

[Anthony Alfidi:]

A sell off is likely with corporate earnings down 96% yoy. The main unknowables are when and how much. I'm seeking profit by selling out-of-the-money puts under things I want to buy more of anyway: FXI and GDX.

Aug 11 12:20 PM

[JPRU-dog:]

If you get out now, what's your time frame for getting back in?

Aug 11 05:45 PM

[JPRU-dog:]

DonFurio, I agree with you and your points.

Aug 11 05:47 PM