Two related and unresolved economic issues are weighing heavily on the market since the beginning of August, creating lots of uncertainty for investors:
- Will the U.S. (and the world economy) go into recession before year end?
- Is the Euro doomed to fail?
Some have called the bottom at 1100 on the S&P 500 Index following the August 9th selling climax. Unfortunately, the answers to the above questions will only be known in hindsight, 6 months or a year from now. In our opinion, investors should remain defensive with a focus on capital preservation.
Three bellwether indicators speak loudly and attest of investor nervousness :
- GLD: Gold still trades near record high levels with GLD closing at $183.24 on Friday following the dismal unemployment report.
- VIX closed at 33.96 and remained about 30 for most of August
- TLT: Yield on long-dated Treasuries are at record lows, with TLT making a new high for the year at $112.51.
We propose two profitable option-based strategies to overcome the current market volatility:
- Sell deep out-of-the-money LEAP puts on cyclicals.
- Sell near-the-money LEAP puts on non-cyclicals and high-yielding stocks.
A put option is the right to sell 100 shares of a stock at a given price (the strike price) by a given date (the expiration date). LEAP puts are puts with an expiration date of more than 1 year away from now.
By selling a put, investors collect a premium right away -- akin to collecting a dividend stream upfront. At expiration date, one of the following two outcomes are possible:
- If the stock closes above the strike price, the put will expire worthless. Profits are equal to the premium collected upfront.
- If the stock closes below the strike price, investors will be forced to buy the stock at the strike price. Their cost basis for the stock will be the strike price minus the put premium. Note that investors should only sell puts on stocks that they are willing to buy as the chance exists that they will have to buy them when the expiration date comes.
Now let's illustrate the proposed strategy using specific stock examples. For cyclical companies (including energy, materials, tech, banking, etc), our stock selection is Apache (NYSE:APA), an independent energy company with operations in natural gas and oil sector. APA has a pristine balance, is generating strong cash flow from its operations all over the world, and trades at a P/E ratio below 10. S&P and Morningstar both give a 5-star rating to APA.
The 52-week low and high for APA are $87 and $134, respectively. On March 9th, 2009, the stock placed a bottom at $52.57. Finally, it closed at $98.65 last Friday.
We propose selling a put contract on APA that expires on January 19, 2013 with a strike price of $65, well below the current 52-week low. Per contract, investors would receive between $5.3 (the bid) and $5.5 (the ask).
If APA closes above $65 on January 19, 2013 (as we expect), the rate of return on investment is equal to 8.3% for one year and a half if using the mid-point between bid and ask spread (or 5.5% on an annualized basis). If APA closes below $65 at expiration date, investors will have to buy 100 shares for each put contract they sold. Note that because they collected more than $5 per contract, their cost basis to buy APA will be below $60, which looks cheap even in the case where earnings drop if we end up going into a recession.
Is there anything magic about the $65 strike price? Not at all. The strike price reflects investors' tolerance (or aversion) to risk. Those with nerves of steal can afford to sell above the $65 premium and collect an even greater premium. Those more cautious should consider selling puts with a strike lower than $60 but will collect less for it too.
One word of caution though: when selling puts on cyclical stocks, stick to the strategy of selling deep out-of-the-money puts (where the strike price is much lower than the current market price) and do not sell puts with strike near the market close (or at the money). Because earnings of cyclical stocks fluctuate greatly with the economic business cycle, stock prices of cyclical companies experience violent swings.
Let us now consider the case of non-cyclical companies (including consumer staples and pharmaceutical stocks) by looking at Pepsi Co. (NYSE:PEP), which engages in the manufacture, marketing, and sale of foods, snacks, and carbonated and non-carbonated beverages worldwide. Above and beyond its blockbuster Pepsi soda, star products include Tropicana juices, Mountain Dew, Gatorade for drinks as well as Rice-A-Roni, Pasta Roni, Frito's Lay, Doritos, and Cheetos for snacks. S&P and Morningstar both give a 4-star rating to PEP. The stock was also featured in a recent edition of Barron's.
Earnings of non-cyclicals are much less affected by the economic business cycle. Case in point: earnings-per-share for PEP kept growing during the Great Recession and increased from $3 in 2006 to a projected $4.5 in 2011. The 12-month forward P/E ratio is equal to 14 and the dividend yield is equal 3.25%, much higher than the 10-year U.S. Treasury bond.
The 52-week low and high for PEP are $60 and $71, respectively. On March 9th, 2009, the stock made an all-time low at $45.63. On Friday, it closed at $63.30.
We propose selling a put contract on PEP that expires on January 19, 2013 with a strike price of $60, close to the current market price and the 52-week low. Per contract, investors would receive between $5.3 (the bid) and $5.5 (the ask).
If PEP closes above $60 on January 19, 2013 (as we expect), the rate of return on investment is equal to 9% for a year and a half using the mid-point between bid and ask spread (or 6% on an annualized basis). If PEP closes below $60 at expiration date, investors will have to buy 100 shares per contract. Note that because they collected more than $5 per contract, their cost basis to buy PEP will be below $55 which look cheap since earnings should not be affected by the state of the economy.
Selling out-of-the-money put is a conservative strategy that should allow investors to enjoy 5 or 6% annual return on their portfolio, while weathering the current market hurricane. We suggest readers do the math and check whether selling puts on another defensive stock Abbott Labs (NYSE:ABT) fits their investment strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short ABT, PEP, APA LEAP puts.