Expecting a Sell-Off: 35 Ways to Protect for Less

I believe a pull back [7%-15%] on the major indices is not only inevitable but necessary for a healthy market recovery.

Let's face it: we've come too far too fast, and as we were oversold on the downside until early March, I believe we are currently overbought.

As I was listening to Bloomberg on Sirius (SIRI) over the weekend, many professionals also shared my opinion and the overall sentiment seemed to be bearish. The economy still isn't that great; in order for a real recovery to take place, I think we need to see the unemployment rate decline.

With that being said, it is worth noting that I think real jobs (nothing paid for by the government) are key for a recovery.

Although the market is a leading indicator for the economy, in recent times the two seem to be very disconnected. The market has got ahead of itself on better than expected economic data and company earnings; keyword is expected. Measure earnings for the previous quarter over the same period one or two years ago... When earnings return to those levels, perhaps a real recovery will be in the works.

Of course there will be companies that grew, but I am referring to the majority.

Three major reasons I believe a sell off is in the works:

1. Simple profit taking - What goes up must come down; can you imagine the market if profits were never taken?
2. Analyst revisions - Just as analysts upgrade stocks when they are undervalued, it is also their job to downgrade stocks when they are overvalued... I imagine you have formed some opinions of some overvalued stocks.
3. Earnings season is coming to an end - Right now there seems to be an overwhelming amount of good news flooding the market. But I believe it is only a matter of time before the bad news outweighs the good news (or better than expected) once again, and a correction will occur. What reason would the market rally with overwhelming bad news?

I don't think the market will sink by more than 20%, but a correction of up to 15% over the next couple months isn't out of the question in my opinion.

With my reasons outlined above as to why I believe a correction will occur, I have been getting very conservative. I have my portfolio geared for roughly a 10% correction on the S&P 500. Many people choose to purchase put options as protection including myself, but most of the time I will use the most basic form of option out there for protection; a covered call.

Although I am not anticipating the market to continue rallying, I will also note that the rally easily could, as money continues to pour into the market from the sidelines.

As I stated earlier, I've been selling covered calls on many of my stocks to protect my positions. Even though I'm young and can risk a lot, I believe it is better to be safe than sorry and if I get called out and have to sit in cash, I'll take it. Selling covered calls is a great way to create income off the shares in your portfolio, as well as allow for an additional gain. 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. For those who can risk more, I have also included a list of 10 higher beta stocks.

Monday kicks off the week for August options expiration, most of the stocks outlined in this article will yield very small premiums for the August expiration, so I have used the options expiration for the month of September on all the stocks. For those which currently have the October contract available I have also noted it, the October contract will be available on all stocks as of Monday August 24, 2009. All stocks are rounded and written for the closest possible strike price.

To understand the table, I will give a detailed example of Apple (AAPL) below.

Sell the Apple in the money September 165 strike call option. The premium received from the call option would give a downside protection of 4.18%. If the stock is assigned at options expiration on September 19, 2009 the total return from this position (assumes the buy/write option strategy was used) would be 3.11% in 35 days.

A more bullish approach would be to write out the Apple 170 Call option. This approach would protect to the downside 2.71%, and if the stock is assigned at expiration it would return 4.65%.

The September options expiration is 35 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... Writing stocks out before the weekend will take some premium away from these option contracts as well, which is another positive to being the seller of these options.

All data as of market close Friday August 14, 2009.

Company	Ticker	Strike	Return %	Protection %
Exxon Mobil Corporation	XOM	70	4.38	1.76
Microsoft Corporation	MSFT	24	3.76	2.49
Wal-Mart Stores, Inc.	WMT	52.5	2.99	1.62
Johnson & Johnson	JNJ	60	1.70	1.83
The Procter & Gamble Company	PG	52.5	2.67	2.43
International Business Machines Corp.	IBM	120	3.46	2.25
AT&T Inc.	T	25	2.08	3.85
Apple Inc.	AAPL	165	3.11	4.18
JPMorgan Chase & Co.	JPM	42.5	5.02	4.90
Google Inc.	GOOG	460	2.79	2.79
Chevron Corporation	CVX	70	3.96	1.97
General Electric Company	GE	14	5.10	4.53
Cisco Systems, Inc.	CSCO	21	2.82	4.27
Bank of America Corporation	BAC	17	5.35	7.59
Wells Fargo & Company	WFC	28	6.09	5.12
The Coca-Cola Company	KO	47.5	1.40	3.40
Oracle Corporation	ORCL	22	3.96	3.78
Intel Corporation	INTC	19	4.37	3.14
Pfizer Inc.	PFE	16	4.19	2.73
Hewlett-Packard Company	HPQ	44	3.88	4.08
Philip Morris International Inc.	PM	47	3.39	2.57
Verizon Communications Inc.	VZ	31	2.77	3.02
PepsiCo, Inc.	PEP	57.5	3.25	1.59
Goldman Sachs Group, Inc.	GS	165	4.84	3.44
QUALCOMM, Inc.	QCOM	46	3.21	3.53

The 10 higher beta stocks are listed below, as you can see the return and protection % are higher on average. This is because they are much more volatile and volatility plays a major role in pricing the options.

Company	Ticker	Strike	Return %	Protection %
Las Vegas Sands Corp.	LVS	14	13.59	8.48
MGM MIRAGE	MGM	9	10.96	10.29
Teck Resources Limited USA	TCK	26	7.59	8.92
Genworth Financial, Inc.	GNW	9	15.34	6.64
American International Group, Inc.	AIG	24	12.35	13.87
Wynn Resorts, Limited	WYNN	55	6.56	10.32
Barclays PLC ADR	BCS	25	7.98	4.03
Citigroup Inc.	C	4	8.66	9.65
Ivanhoe Mines Ltd. USA	IVN	7.5	6.67	20.37
Palm, Inc.	PALM	14	9.38	9.94

For those which currently have the October options contracts available you can see the calculations below. I prefer staying as short as possible, so I wouldn't consider the October options expiration with more than 10 days until expiration for the September contracts.

Company	Ticker	Strike	Return %	Protection %
Exxon Mobil Corporation	XOM	70	5.63	2.93
Microsoft Corporation	MSFT	24	5.19	3.88
Johnson & Johnson	JNJ	60	2.70	2.83
The Procter & Gamble Company	PG	52.5	3.78	3.52
International Business Machines Corp.	IBM	120	4.92	3.67
AT&T Inc.	T	25	3.14	5.00
Apple Inc.	AAPL	165	4.79	5.92
Cisco Systems, Inc.	CSCO	21	4.27	5.81
Wells Fargo & Company	WFC	28	8.84	7.79
Intel Corporation	INTC	19	6.45	5.16
Verizon Communications Inc.	VZ	31	3.70	3.97
PepsiCo, Inc.	PEP	57.5	4.40	2.70
Goldman Sachs Group, Inc.	GS	165	6.93	5.45
QUALCOMM, Inc.	QCOM	46	4.83	5.17

To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here. As an owner of Bank of America, Citigroup, and Goldman Sachs shares, I've written them out for a variety of strikes for August expiration and will be writing them again for the September options expiration, as the volatility of the underlying stock gives a very nice premium, even on out of the money options and a month until expiration.

I never write all of my shares out at the same time. If we get a pullback, market volatility should increase, causing call options to trade for higher premiums, 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).

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, C, GS, LVS, IVN, PALM, Short BAC August 17 and 19 Calls, C August 3 and 4 Calls, LVS August 13 Calls, IVN August 7.50 Calls, PALM September 14 and 16 Calls

Comments

[Old Developer:]

"I believe a pull pack [7%-15%] on the major indices is not only inevitable but necessary for a healthy market recovery."

What the heck is a "pull pack"?

Next time let someone else check it for errors before you publish. Spelling and grammar checkers don't catch everything.

Aug 17 10:19 AM

[Novice Trader:]

Does he "shave" yet...?
A typo...?

I can't believe that out of all that this gentleman wrote, the two of you felt compelled to write what you did.

This "kid" probably pays more in taxes than you two make in a year.

Aug 17 10:56 AM

[Angela M:]

Marco, ignore these clowns. I enjoy reading what you write and you give me lots of ideas and have made me a lot of extra money. Next time you throw an immature comment out there about being young, it would help if you acted like an adult... And I'm sure you've never made a typo before right Old developer? 99% of the people would know from the context what he meant.

Aug 17 11:17 AM

[R A F:]

SIRI has been holding exceedingly well in the face of pronounced declines in the general markets (DJIA, S&P, Nasdaq) over the last few days. This is a testimony to the technical strength that is now dominant for SIRI and support should remain solid on any near term pullbacks. Once the general market stabilizes, SIRI should resume the upside testing that was evident over the last few weeks. All previous projections of upside potential remain in force: .75 around November - 1.00+ over the next six months to one year - considerably higher longer term. Shorts who have been hoping for deeper pullbacks due to the general market weakness are disappointed by the current firmness in SIRI and should remain nervous until their positions are covered.

Aug 17 05:13 PM

[bolt turner:]

the whole options market should be shutdown.. just more obfuscation and manufactured headwinds

Aug 17 07:25 PM

[Mad Hedge F...:]

aertt. Wow! One triple digit move down in the Dow, and all of a sudden, everyone is bearish. Once invisible falling home prices, soaring deficits, bogus corporate earnings, catatonic consumers, a crashing Shanghai market, and a suicidal Baltic Dry Shipping Index are now staring nervous stock owners in the face, eyeball to eyeball, and the picture is not pretty. Expect a run at Walmart on the Imodium and Kaopectate supplies. Even Robert Prector, of Elliot Wave fame, was on the tube proclaiming an end to a bear market rally. Did all the BSD bears just come back from family vacations to find the short selling opportunity of the year? Technical analysts think so.

Aug 18 01:03 AM

[Andrei Babn...:]

NYSE:SDS!

Aug 18 02:51 AM

[Plan B Econ...:]

There are definitely valuation and technical problems with the market right now.

But it's hard to judge where the market will go since everyone all of a sudden 'knows' that there will be an imminent correction. Is that a contrarian indicator or a self-fulfilling prophecy?

Aug 18 07:28 AM

[Kris Tuttle:]

If you are concerned about the general market but still wanting to stay long the individual stocks that are most attractive one could short the closest index: SPY, QQQ, SMH to provide a cushion. If they underlying stock selection is good then even if the pullback doesn't come you should stay in positive territory. Then you can adjust your short position in the index as you see fit. Covered calls are also okay but they cut both ways and you can still lose quite a bit of capital with them. Unless you set up a stop loss with a buyback of the (much lower) call options at a certain threshold.

Aug 18 08:35 AM

[bigdog1:]

What do you mean when a stock falls the option calls sell at a higher premium, do you mean the value of the call FALLS?

Aug 18 08:37 AM

[TCK:]

Without over thinking and piling up commissions, I am buying puts on the QLD. Consequently, I can hedge several positions with one trade. Also these double long ETF's tend to trend down even in a sideways market. Other 2X long funds could be used as well depending on your outlook.

Just my opinion, but the one issue with covered calls is that it caps the upside while only providing a limited hedge to the dowside. Consequently does not help if expecting a correction of more than 5%.

Comments appreciated.

Aug 18 08:43 AM

[xmplary:]

Guess you chose a bad day to publish this... yesterday would have been ideal ;-)

Aug 18 11:45 AM

[ain't no fo...:]

Until Obama, Summers, Geithner and Bernanke relinquish control of the markets to the market participants, and take it away from Lloyd, Jamie, and Immelt (thru CNBC), shorting is just a death sentence. Fundamentals weaken daily in the broad economy, and those entities print vast amounts of money and cycle it into the equity markets daily.

Fundamentals don't matter, technicals don't matter, nothing matters in the least until they return the markets to the real participants, and they show no interest in doing so whatsoever.

Aug 18 12:14 PM

[ain't no fo...:]

There has been very little reason to put up with the immature cetin annoyances, but in and of itself it wasn't the end of the world, and so I have complained to management and then kept on posting.

Recently, however, I've been getting virus and spyware warning messages and actual screens popping up trying to hijack my PC and force it into doing virus scans. They appear randomly when I access different articles on this site. They've been happening off and on for a week or two, no rhyme or reason to when they occur. They do not occur on any other programs of the hundreds I access weekly.

I have no idea whether others are receiving similar stuff but I have no interest in subjecting my system and my records to crap like that.

Hence, I will not be contributing comments to this site anymore - its just not worth it.

I've enjoyed reading and participating in what have usually been serious subjects and discussions that have taken place here, and I've developed respect for a number of authors and commenters, like swashbuckler, john gordon and trader mark, etal.

I wish you all good fortune on your investing and personal lives... and as the sarge used to say in Hill Street Blues, "Be careful out there!" because we are far from home and there are many miles to go before we sleep.

Aug 18 12:14 PM

[Atypical:]

I have had one similar occurance. Never happened before last week. Would like to know what caused it.


On Aug 18 12:14 PM ain't no fortunate son wrote:

> There has been very little reason to put up with the immature cetin
> annoyances, but in and of itself it wasn't the end of the world,
> and so I have complained to management and then kept on posting.
>
>
> Recently, however, I've been getting virus and spyware warning messages
> and actual screens popping up trying to hijack my PC and force it
> into doing virus scans. They appear randomly when I access different
> articles on this site. They've been happening off and on for a week
> or two, no rhyme or reason to when they occur. They do not occur
> on any other programs of the hundreds I access weekly.
>
> I have no idea whether others are receiving similar stuff but I have
> no interest in subjecting my system and my records to crap like that.
>
>
> Hence, I will not be contributing comments to this site anymore -
> its just not worth it.
>
> I've enjoyed reading and participating in what have usually been
> serious subjects and discussions that have taken place here, and
> I've developed respect for a number of authors and commenters, like
> swashbuckler, john gordon and trader mark, etal.
>
> I wish you all good fortune on your investing and personal lives...
> and as the sarge used to say in Hill Street Blues, "Be careful out
> there!" because we are far from home and there are many miles to
> go before we sleep.

Aug 18 12:25 PM

[ain't no fo...:]

Since I posted this on a couple of blogs here, a number of people have mentioned it happened to them as well... at least one (TheresaE) complained to the webmaster about it.

The cause is a spammer.. taking an educated guess, I would say in all probability the same "iamned" guy who has been spamming the site relentlessly for months now, and who management has been totally unable to get rid of.


On Aug 18 12:25 PM Atypical wrote:

> I have had one similar occurance. Never happened before last week.
> Would like to know what caused it.

Aug 18 12:32 PM

[specks:]

I've had similar problems also and thought my system was being attacked by the worm as I use a local library internet service.
FYI.

Aug 18 04:52 PM

[whidbey:]

The analysis is thin on why, and therefor the possible depth and time for a correction.

The suggestions are close to financial advice requiring registration (RFA). I think the specific stocks are useless recommendations since you have not a clue who or what the buyer is all about.

Walk the plank please.

Aug 18 05:04 PM

[realold:]

I have experienced the virus problems when clicking on a link that accompanies the articles.

Though I agree with all the fundamental reasons for a correction, with all this pessimism, it seems that a leg up is pending.

Aug 18 11:34 PM

[Old Rick:]

Wouldn't the simplest strategy be to purchase slightly in the money puts on SPY or QQQ or (if you feel real lucky) QLD puts for say October09? It eliminates a lot of commissions and note that individual stocks can still go up even if "The Market" declines.

Aug 19 12:16 AM