By: Costas Bocelli — February 20, 2019
Ask any money manager and they’ll tell you: it’s been a very good year.
The S&P 500 has gained +10.9% so far in 2019.
And, all eleven broad sectors that comprise the stock market are in the green.
Mission accomplished, right?
Not so fast… You see, those same money managers also face a dilemma. There’s still ten months left until the end of the year!
Sure, they can just sell all their holdings, cash out, and ride out the remainder of the year sipping champagne and relaxing in the Hamptons.
In 2018, that would have turned out to be a good move, as the major stock market averages suffered two corrections and finished down for the year. But bailing early after a strong start in other years would have been career suicide.
Take 2013. The stock market got off to a great start. By March of that year, the S&P 500 had gained 10% and surpassed the previous all-time high set in 2007 -- before the financial crisis.
But by year end, the S&P 500 was up 30%. I can assure you that any money manager who “mailed-it-in” early that year isn’t in the industry today.
That’s why professional money managers are compelled to maintain exposure at all times -- because their performance is graded against the performance of the stock market benchmarks.
As self-directed Individual Investors, we should also avoid “settling” for a return based on some historical average. This year could turn out to be the next 2013.
Or, it could fizzle out and turn sour like 2018.
Obviously, nobody knows for sure how the next ten months will play out. But we do know we'd be smart to maintain bullish exposure while mitigating risk.
As we've been telling you, the stock market has been in rally mode. And as a result of the strong run, trading conditions have become excessively overbought in the short-term.
Two weeks ago, we discussed the covered call strategy as a means to generate income on stocks that you own, while creating a limited hedge of downside protection.
Last week, we discussed the protective put strategy that allows you to maintain unlimited upside potential while fully protecting against downside risk.
Today we’re going to reach into the option’s toolbox once again and pull out another technique we can use to mitigate risk in an overbought market environment.
It’s called a Stock Replacement Strategy.
The idea is to sell stock, then use a small portion of the proceeds to buy cheap at-the-money Call options in its place. This action will return cash to your brokerage account while maintaining unlimited upside potential throughout the life of the Call options.
The good news is that option premiums are relatively inexpensive right now, which is good for Call option buyers.
With the stock market rallying over the past eight weeks, investors have become complacent. Here is a chart of the CBOE Volatility Index (VIX), also known as the “fear gauge”.
(Click any image to enlarge)
As you can see, the VIX has recently fallen below 15 -- a level not seen since before the winter correction that began in early October 2018.
When the VIX is low, option premiums are relatively cheap as investors feel less in need of protection. In other words, this is a good climate for option buyers.
Also, with fourth quarter earnings season winding down, option premiums are falling, because the market has had time to digest any news.
The key difference between the stock replacement technique and the protective Put technique is the large amount of cash that will now be available in your brokerage account.
In other words, this strategy will allow you to maintain bullish exposure on the stock, while at the same time providing “dry powder” that can be deployed on other investment ideas (or be stockpiled should the stock market fall again).
Here's how it works...
Danaher Corp. (DHR) is a medical equipment and industrial device manufacturer. The stock has gained nearly 20% off of the late-December lows and is now testing the previous highs from last year.
Let’s say in this example that we own 200 shares of DHR and want to reduce risk.
We can replace our long stock position with a cheap Call option position.
With the stock recently trading at $111.32 per share, we can sell our 200 shares and deposit $22,264 (minus commissions) into our brokerage account.
Then, we could buy two June 110 Calls for $6.00 or $600 per contract. (Remember, each option contract controls 100 shares of stock.)
The June 110 Calls allows unlimited upside potential over the next four months while limiting any downside risk to the cost of our two Call options -- in this example, just $1,200.
You have maintained bullish exposure in the DHR and restocked some serious buying power.
You’ve also taken action to mitigate risk in an overbought market environment.
Want to learn more about options and how they can make you a better investor? Then you’ll want to check out Options Soup, our options education program.
Chris Rowe and I designed Options Soup to teach the greenest investor everything she needs to know about options in an easy to understand format.
Give us a call at 855-822-0269 and ask to save a seat.
Until next time!