My Favorite Strategies In An Overvalued Market

|
Includes: DDS, RIG, SPY, VXX
by: The Frugal Prof

Summary

Review of put selling strategy and why I like it.

Patience and selectivity win in an overvalued market. Getting paid to wait.

The one strategy I rarely use.

Thesis:

My market view is that the market is overbought in the near term and overvalued based on the fundamentals. I see lots of risks. However, my job is to find undervalued situations and create value-added ideas, no matter what the market conditions are. Is it easier to find values at the bottom of a crisis like in 2008? Yes, it is. But this is the market we have.

Valuation: Rarefied air on this analysis by the Fed of the Stock market vs. GDP. (NYSEARCA:SPY)

Market Action:

It is still very much a bull market. The VXX had that tiny bump in volatility and it was erased very quickly.

Since last week's reversal, I think that market sentiment is shifting.

VXX Chart

VXX data by YCharts

Ready Buyers:

There are buyers ready to buy the dips and they've been rewarded many times in this market. At some point, they will be burned. But for now, it's very much a bull market and an overvalued market.

But, we don't get the market we want. We have to accept the market we have.

Strategies that align with my market view:

Selling Puts:

Why do I keep suggesting to sell puts?

On a $20 stock, if one can sell a $20 put and receive .50, then the cost basis is reduced to $19.50. Every .50 matters actually. If the stock stays flat and one collects a .50 put 4 times over the year, that's an extra $2 or an extra 10.25% return on that security.

(Of course, the return is much better since in this scenario, the stock stays flat and the investor has received $2 with no actual investment in the shares.) But, I am always prepared to own a stock I sell a put in.

I sell puts on companies I feel are undervalued and therefore, would be willing to own the shares if they were put to me. And at a size that's comfortable as well. If I would only be comfortable owning 500 shares of Dillard's (NYSE:DDS), then I would only sell 5 option contracts on Dillard's. And I am aware of this potential position in my analysis of my overall portfolio risk.

This position can make money in a higher market, a sideways market, and a lower market. So, I find that very attractive.

Less Risk:

Again, if the shares are put to the investor at $19.50, instead of buying the shares in the market at $20, then the risk to the investor is .50 less risk. However, many of my strategies are below the market price, so the risk is much less.

A recent example:

RIG Chart

RIG data by YCharts

My strategy on Transocean (NYSE:RIG) getting paid to wait on rig was to sell the $10 put. The stock was at $12.50 and is now at $12.75. The $10 put is very profitable and would require a large 21% drop to break even on the position. So, there was 20% less risk on that recommendation than on simply buying the stock at $12.50.

But in stocks, you must be correct in order to profit.

Another case:

Dillard's: Undervalued Retailer With Multiple Ways To Profit

I was wrong in the short term in Dillard's and the stock went from $52 to $48. But, since the strategy was to sell a put, it is now working out quite well.

And again, the great thing about selling a put is that you are protected and getting paid to wait. So, now that the shares are back above $52, the position looks much, much better.

Why selling puts is attractive:

Again, the nice thing about selling puts is that they can be profitable in three different scenarios: the stock goes up, the stock trades sideways, and if the stock goes down slightly.

How to think about selling puts: Stock replacement

The smart way to think about selling a put is as a stock replacement. If you typically buy 500 shares of stock, then selling 5 contracts (representing 500 shares) below the current price is a prudent strategy. But, selling 10 contracts (representing 1,000 shares) would be risky and less attractive.

Understanding the risk/ reward in the position and overall portfolio is always important.

DDS Chart

Selling Calls:

I wrote an article a few weeks ago when Goldman Sachs (NYSE:GS) was near $250, describing how the run in the shares was over and suggesting strategies to protect capital for longs. Not all investors want to sell. So, selling a call can enhance returns and reduce risk.

In addition, I suggested a strategy for those who wanted to get long the stock at lower price levels. The stock is down over $22 since the article and selling a put would have saved the investor over $16.

Every dollar matters for the investor.

GS Chart

GS data by YCharts

Buying options:

I rarely purchase options. Speculators who buy options to "bet" on expected outcomes are usually wrong and due to the options premiums, can lose money even when they're right. Gambling is best done in Las Vegas, where they give you free drinks and tickets to a show when you lose.

Conclusion:

Even though by many measures the market is overvalued, there are still smart ways to make money. I'm being selective and patient in finding pockets of value and ideas. Using strategies that align with my overall view of the market and individual positions helps me profit in a less than ideal investing environment.

Follow for more ideas and analysis.

Thanks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Options involve risk. Investors should determine if these strategies are suitable. Ideas are for educational purposes.