Option Maestro's  Instablog

If the unemployment numbers released Friday are rather ugly (in my opinion they are ugly regardless but in other words, worse than expected), the market could sell off significantly. However I am more concerned about the market selling off sometime after Labor Day, as many traders return and decide the market is just too overvalued on a short term basis. As previously stated in my blog, one major reason I believe we could see a sell off is simple profit taking. I currently see the S&P 500 erasing up to 5% of the recent gains. The recent run up in the Volatility Index [VIX] has certainly hinted a near term sell off may be in the works. Historically September is not a great month for stocks either, below is the performance of the S&P 500 in the month of September from 1999-2008 (data downloaded from Yahoo finance):

Date	Open	Close	% Change
9/2/2008	1287.83	1166.36	-9.43
9/4/2007	1473.96	1526.75	3.58
9/1/2006	1303.8	1335.85	2.46
9/1/2005	1220.33	1228.81	0.69
9/1/2004	1104.24	1114.58	0.94
9/2/2003	1008.01	995.97	-1.19
9/3/2002	916.07	815.28	-11.00
9/4/2001	1133.58	1040.94	-8.17
9/1/2000	1517.68	1436.51	-5.35
9/1/1999	1320.41	1282.71	-2.86
Average			-3.86

Based on this data from the past 10 years, September seems to be a very ugly month for the stock market. The S&P 500 has finished the month of September down 6 of the last 10 years for an average of -3.86%. With this September following a near 50% increase in the S&P 500 since early March, I'm looking to get pretty conservative on the shares I still hold.

I have heard nothing but mixed opinions from the professionals on where they think the market may be heading, some very bullish and others very bearish, therefore I am not selling my shares, as they may still have some upside left (S&P gained an average of 1.92% during the same time frame when it traded higher for the month of September), but I have been selling higher strike covered calls on many of my stocks to get some premium and protect my profits. Selling a higher strike call option will allow me to capture profits on the underlying until the strike price of the option is reached, and offset some losses in the case a sell off occurs. In the event of a sell off, selling covered calls will hedge to the downside (with the premium received). Selling higher strike calls on my shares is ideal for this type of speculation, which is why I have decided to outline 30 ideas for the September options expiration, one for each of the top 25 stocks listed in the S&P 500 and 5 very popular high beta stocks. To learn more about this strategy, and stock options in general click here.

To understand the table, I will give a detailed example of Apple (AAPL) below.Sell the Apple out of the money September 170 strike call option. The premium received from the call option would give a downside protection of 1.72%. 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 3.80% in 15 days.

A more bearish approach would be to write out the in the money Apple 165 Call option. This approach would protect to the downside 3.15%, and if the stock is assigned at expiration it would return 2.23%.

The September options expiration is 15 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.

The stocks listed below are ranked in order from greatest to least market cap. All data as of market close Thursday September 3, 2009.

Company	Ticker	Strike	Return %	Protection %
Exxon Mobil Corporation	XOM	70	3.53	0.98
Microsoft Corporation	MSFT	25	4.52	0.83
Wal-Mart Stores, Inc.	WMT	52.5	2.26	0.79
JPMorgan Chase & Co.	JPM	42.5	3.51	2.59
Johnson & Johnson	JNJ	60	1.39	0.87
The Procter & Gamble Company	PG	52.5	1.15	1.85
International Business Machines Corp.	IBM	120	3.73	0.58
Apple Inc.	AAPL	170	3.80	1.72
AT&T Inc.	T	26	3.98	0.60
Bank of America Corporation	BAC	17	4.33	3.38
Google Inc.	GOOG	470	3.74	1.02
General Electric Company	GE	14	5.58	1.49
Chevron Corporation	CVX	70	3.47	1.02
Wells Fargo & Company	WFC	28	5.80	1.75
Cisco Systems, Inc.	CSCO	22	3.63	1.26
The Coca-Cola Company	KO	50	1.75	0.91
Intel Corporation	INTC	20	4.12	1.13
Pfizer Inc.	PFE	16	1.80	2.30
Oracle Corporation	ORCL	22	4.33	2.00
Hewlett-Packard Company	HPQ	46	4.16	0.67
Philip Morris International Inc.	PM	47	3.19	0.61
PepsiCo, Inc.	PEP	57.5	2.40	0.88
Verizon Communications Inc.	VZ	31	3.24	0.73
Goldman Sachs Group, Inc.	GS	165	3.61	1.54
QUALCOMM, Inc.	QCOM	46	3.82	1.64

Higher Beta Stocks:

 

Citigroup	C	5	8.60	3.77
Palm	PALM	15	9.78	4.22
Las Vegas Sands	LVS	15	8.72	4.05
American International Group	AIG	44	6.18	0.79
Fannie Mae	FNM	2	26.83	4.88

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, Goldman Sachs, and Palm shares, I've written them out for a variety of strikes for September expiration for large premiums on higher levels of implied volatility and purchased them back on weakness and this alone has lowered my cost basis on these shares greatly. Currently my Palm shares are not written out, but I expect to be writing them out on increased levels of implied volatility just before earnings are released this September.

I never write all of my shares out at the same time in case the market continues to rally; shares can be written for higher strike, higher premium, or even a combination of both. If we get a pullback, market volatility should increase, causing even out of the money call options to bring premium (this should make sense: as with higher volatility strike prices have a greater probability of being reached).

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.

Disclosure: Long BAC, C, GOOG, GS, PALM, PFE, Short BAC September 18 and 19 Call options, C September 5 Call options, GOOG September 490 call options, PFE September 17 call options.