Conservative investors can profit handsomely off of other investors' panic selling.
Even day traders could appreciate such big, quick profits; after all, that's what they shoot for, every day.
Both long-term and short-term investors who keep their wits about them can agree on this strategy of selling covered calls in a panic atmosphere.
As the long anticipated market correction finally commenced last week, the "panic of 2014" got underway in earnest on Thursday, as the Dow fell a robust 317 points, and the S&P 500 fell 2%. Friday, the selling continued. All of a sudden Nasdaq 5000 doesn't look so close any longer. Monday? Stay tuned.
How do I loathe this market? Let me count the ways
Pundits advanced all sorts of theories to lay blame for the selloff:
- Unemployment claims increased by 20,000.
- The unemployment rate increased to 6.2%.
- Fighting in the Mideast intensified, with over 1400 Palestinian and 59 Israeli dead. Israel increased pressure by bombing Hamas infrastructure, destroying their only power plant and knocking out electricity to the whole of Gaza's 1.8 million inhabitants.
- Russia was proven to have fired artillery and other heavy weaponry from their territory into Ukraine, directly involving themselves in the war while Putin showed no signs of backing away from this fight.
- Western powers initiated greater sanctions against Russia.
- Argentina defaulted on its sovereign bonds for the second time in 13 years.
- Reported second-quarter profits were coming in light, disappointing investors.
- The Fed expressed the view that the economy was continuing to strengthen as it cut back bond buying yet again, and advanced the possibility of rate increases perhaps sooner than the market had gauged.
Any one of the above would be enough to rattle the markets out of complacency. In combination, they provided the spark and gave all manner of individual and institutional investors the ammunition they needed to finally pull the trigger. They began dumping their holdings and decided to shoot first and ask questions later.
This created the kind of panic-induced volatility that gave investors who were able to divorce their emotions from their investment behavior an opportunity to profit handsomely from covered call selling.
Panic up, call premiums up
Because call premiums often increase markedly due to panic, it created the perfect environment to profit with very little risk involved. Because so few option sellers can be found during moments of panic, the prices on options can skyrocket. In addition, huge amounts of short covering by investors looking to lock in profits from the downdraft that can accompany market sell-offs can conversely push prices back up in the panic, and push call option premiums higher.
Instead of standing by passively watching as Mr. Market savages your positions, you have the opportunity to make lemonade from lemons by collecting premiums from buyers willing to pay a small price to take a chance on future stock price appreciation.
Selling calls against stock you already own gives the buyer, for a premium he pays you, the opportunity to buy the stock from you at a set price (strike price) by a pre-determined time, sometime in the future (the expiration date of the contract). The premium he pays is normally higher, the further out in the future the expiration date.
The call he buys from you is a decaying asset; that is, as the time to expiration grows closer, the value of the premium above intrinsic value decreases. If the call is way out of the money (stock price far below the strike price) as the expiration date nears, the price of the call rapidly approaches zero.
The ideal scenario for the covered call seller is to sell a chance for stock appreciation to a buyer, collect his money, then never have to deliver the securities or make any type of payoff to the buyer.
Just as insurance companies collect premiums and sell an opportunity to protect the value of your car or home, in the same way, they calculate the odds and hope to never have to pay out a dime to you.
What are the risks associated with covered call selling?
Of course, there is always the risk that your stock will rebound, go through the strike price and be called away from you. But if the time to expiration is short, the panic and its aftermath usually gives you enough time for the stock price to remain depressed or flat, letting the option expire worthless to the buyer and allowing you to collect the entire premium as well as hold onto your stock and continue collecting your dividend income stream.
Panic hits the biggest gainers, first
When panic strikes, profit taking and consequent dumping of shares usually hits those momentum names that have had the biggest run-ups in the recent past.
Thursday, 7/31/14, as the Dow was plummeting, you could have sold covered calls on Magellan Midstream Partners (NYSE:MMP) for $1.87.
Selling 20 calls, representing 2000 shares in your portfolio, would have resulted in $3740.00 being credited immediately to your account. If the shares ended at less than $80.00 by expiration 16 days later, you'd get to keep your shares and book the entire $3740.00 as profit, giving you additional capital to invest for additional dividend or distribution income.
On that same day, you could have sold covered calls on Legacy Reserves, LP (NASDAQ: LGCY) for $.65.
Again, selling 20 calls representing 2000 shares in your portfolio would have resulted in $1300.00 being credited to your account. If the shares ended closing at less than $30.00 by 8/16/14 expiration, you'd hold onto your shares and have earned an additional $1300.00 profit.
Rinse and repeat
Adding just these two trades together would have given you over $5000 in just 16 days. Of course, if you are inclined, you can do this with as many different companies in your portfolio as you wish as long as the profit potential is there.
Closing positions early; hey, a profit is a profit
Since these options are time-wasting assets, as the price of your shares erode during a panic, the closer to expiration, only 16 days away, the faster the calls will fall towards $0 value. If you choose, you could close out each of these positions profitably before expiration by buying back the same calls at drastically reduced prices, ensuring a somewhat lesser profit, but a profit nevertheless.
Both short-term day traders, in the market for quick gains, and long-term dividend investors primarily interested in growing their income stream for retirement, can avail themselves of extra income and growth of portfolio capital by utilizing this conservative method. In times of high volatility, and especially panic times such as these, the profit potential expands exponentially as premiums explode then erode as expiration approaches.
Adding this strategy to your bag of tricks can help your portfolio grow at a much faster pace compared to just standing pat and collecting passive dividends.
Dividend investing doesn't have to be boring and static for those investors interested and willing to be a bit more active and creative.
To the nimble go the spoils.
Feel free to read any of my previous articles in which I detail the many strategies I've employed to consistently increase yield and income, including buying at discounted prices when secondary issues in my stocks are announced.
As always, I look forward to your comments and discussion.
Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.
Disclosure: The author is long MMP, LGCY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.