We are quickly approaching our yearly highs in major indices. The SPY, which is the sector ETF of the S&P 500 is trading down today at $140, as of this writing. Its 52-week high, established on April 2nd of this year, is $142.21. We have seen a huge up move in the last 10 trading days, with a only a few down days. We came down, kissed the bottom of our trading range, and rocketed higher than many thought. It's time to seek a little protection for the bulls.
I think the best way for longer term investors to seek protection from an ensuing decline in the stock market would be to buy puts on the SPY ETF. However, many are not comfortable either purchasing or managing puts. There is another alternative, one can sell covered calls. If you were to sell covered calls one of the following situations would occur, either:
- The stock market will continue its rise, your long positions will be exercised and your shares will be called away at even a higher profit.
- The stock market will continue to rally a little higher, then begin to sell off. Your long positions will also likely decline with the broader market, but you will collect cold hard cash on the premium from your short calls you sold.
Six-month chart of the SPY, click to enlarge.
As one can see in the chart above, the SPY is beginning to get near oversold. Though the RSI (relative strength index), which measures the overbought and oversold conditions of a specific asset, is only at 62.50 (below the 70 level for an overbought condition) I still feel that there is limited upside left in the move. At least for now, we need some consolidation time before the next leg up. The yearly highs are just a stone throw away and that's why I think covered calls is a viable strategy here.
Selling upward calls on long positions have several benefits and several drawbacks. One benefit would be that you collect premium, that is you get paid for selling short call contracts. Another benefit is that should you get your shares called away, it will be at a profit (assuming the strike price is higher than your cost basis, which it almost always should be), and you will still keep your premium on top of that. A drawback would be that if you wanted to keep that long position, you would now have to go back into the market and buy back your security, either at a higher price or waiting for it to come down. Another drawback would be that it is not the most protection you could seek. It will help in a decline, but is not as effective as purchasing SPY puts, which is something you could purchase with the premium you collect from writing covered calls, should you choose too.
In the end, as many can agree, this rally is beginning to get long-in-the-tooth. Eventually the markets will pull back, and we'll either start to decline rapidly or we'll consolidate before the next leg up. Either way, risk management is key and it never hurts to protect yourself. Getting called out near the top is never a bad thing, even if you miss it by a few points.
As Larry Livingston would say of Baron Rothschild, in the Book, Reminiscences Of A Stock Operator, "I simply cannot help making money. I will tell you my secret. It is this: I never buy at the bottom, and I always sell too soon."