In my opinion, the recent market gyrations typify the indecision and fear that investors feel, which short-term traders and high-frequency gamers take advantage of to amplify volatility. The markets whip up and down with each new economic report as analysts try to get a reading on the market pulse as to whether the Fed can boost confidence and stimulate growth or if we are heading back into another recession.
The decision to invest or not has never been more difficult. If you buy and we head into another recession, you could easily lose 30-50% of your investment, which could take years just to break even again. But if this is simply an irrational dip, then you stand to lose out on massive gains. If you are risk-averse, how can you navigate these murky waters?
One tactic is to make a wish list of your favorite stocks that you always wanted to buy but were previously too expensive. Analyze the fundamentals and settle on a price that you would be happy with. Next, you sell Put options with a strike price at the purchase price you are happy with. It can go one of two ways.
- The market falls to your purchase price or rises and you keep the premiums you collected from selling the Put options as net profit.
- The market crashes below your purchase price and you are required to buy shares in the company at your discounted price. You can still make net profits depending on how far prices fall.
The worst case scenario is where the market tumbles extremely far or some fundamental bad news rocks your stock and share prices fall down way past your strike price. In this case, you are forced to buy shares at a higher price than what the stock is actually trading for at that time. But if the market crashes that heavily, at least you can feel confident that you lost a whole lot less than if you bought months earlier, and you still have some options income that may still put you in a profit position.
Let's go through a few stocks to see how this might work.
Apple (AAPL): What a rocket stock this has proved to be. With an average 61% earnings growth over the past five years and an expected 22.52% over the next five years, this stock still has good valuations with a price-to-earnings dividend by growth ratio of 0.61. It seems every time you turn around, the earnings are being upgraded and large earnings surprises are reported. Yet with a price tag of $371 and staring a possible bear market in the face, this still might seem a bit too high for our margin of safety.
At what price would you be very happy to buy shares of Apple for in 17 months? While share prices could be as high as $500 or more, they could also bounce downward during a market meltdown. Would you be okay with buying shares at $250 each? Then sell Puts at this strike price and collect about $22 per share. What is your cost, possible reward, and risk?
Make sure you have the cash you will need for purchasing shares. This is not selling naked Puts. You are selling cash-secured Puts. So 100 shares of Apple at $250 each minus your $22 options income works out to $228 per share. This is the most you can possibly lose if Apple goes bankrupt in 17 months. This is also your break-even point. This means that if prices fall down to $228 in 17 months, you will need to buy the shares at $250, but you also have $22 per share in Put premiums for a trade that neither made nor lost you money. This represents a 17-month price drop of 38.5% in the shares of Apple, and you still break even on this strategy.
What is your upside gain? As long as share prices are trading at $250 or higher, you keep your $2,200 of premiums. This means that the price can drop 32.6% or go as high as it wants, and you collect and keep your net profit of $2,200. Based on your $22,800 of risk capital, this is a 9.6% total gain over 17 months, or 6.8% annually. Granted, 6.8% doesn't seem like a lot, but remember the situation we face of mass uncertainty. If you are highly risk-averse, 6.8% gain despite a 32.6% drop may seem like a good decision right now.
Green Mountain Coffee Roasters (GMCR) is another company that has risen relentlessly over the past year. Share prices have tripled since the beginning of this year. This is another story of upgraded earnings and large quarterly EPS surprises. The past five years of growth have averaged 92.39% and the next five years are expected to be 37.48%. That being said, the price-to-earnings ratio is very high at 98.62, and even the forward P/E ratio sits at 39.07. Since the higher valuations give this stock higher risk, you decide to go with a shorter-term time frame than with Apple. You go with a shorter horizon of only seven months. Even if earnings keep growing during a market crash, you still need coffee in a recession; you expect that prices could pull back to $70 or more. But if prices did go that low, you'd be fine with buying.
The Put options with a $70 strike price currently sell for $6.90 per share while share prices hover around $102.31. If you buy 100 shares, your initial cost is $7,000. However, since you collect $690 in options income, the max you can lose is $6,310. Your break-even point is if GMCR shares fall down to $63.10, or your strike price minus the kept premiums. This means that share prices can fall $39.21 from what they are currently trading at and you still break even. If share prices are anywhere above $70 per share or a 31.6% drop, you stand to profit 10.9% in seven months (your profit of $690 divided by your total risk capital of $6,310), and this figures out to a whopping 18.7% annual profit.
Chinese online media and mobile value-added services company SINA has bounced nicely off $80 support many times over since the beginning of 2011. Again, this does have some fairly high valuations. The past five years the earnings have went up 13% on average and looking forward, the next five years are expected to go up 14% annually. This gives a very high PEG ratio of 6. Next year the earnings are expected to jump 71%. While share prices are at $101.69, you might be inclined to buy well below support at $65. Again, because the valuations are high you decide to use a seven-month expiration date. These options sell for $8.50 per share.
Your max risk is $5,650 per 100 shares (or $6,500 cost minus $850 income). Your capped profits are about $850 per 100 shares. This means that share prices can drop 36% over seven months and you still earn a total 15% profit, which works out to being an annual profit of 25.8%.
The final example will be Travelzoo (TZOO), the online travel portal which reversed the positive earnings surprise trend with a negative surprise of over 23%. Still, there are high earnings expectations for this year (81%), next year (40%), and for the next five years (27.33% per annum). Share prices have been as high as $100, but they are trading far below that at $44.32 today. So you sell Put options with a $40 strike since you feel that current prices are near support. With a seven-month expiry date, you gain $11.80 per share. Your break-even point is 36.4% below the current share price. If prices are at $40 or higher in seven months, how much will you make?
- Premiums for 10 Put contracts expiring March 16, 2002 @ $40 strike = $11,900
- Total loss if TZOO shares trade at 0 dollars in seven months $40,000 - 11,900 = $28,100
When markets are whip-sawed and choppy and you still want the ability to make decent gains, selling Puts can be a risk-averse strategy. True, your gains are capped but you can also collect high premiums and profit even while the markets are going down. If you have a hard time going long or short due to lack of confidence in market direction, selling cash-secured Puts on stocks you might like to own at lower prices is a good way to play.