By: Costas Bocelli — February 28, 2019
The major stock market averages continue to streak higher.
Last week, the Dow Jones Industrial Average posted its ninth consecutive weekly advance, its longest weekly winning streak in 24 years.
Since the December 24th low, the Dow has gained 19.5% and recaptured the 26,000 level.
And although the Dow now its the previous October highs in its crosshairs, this recent rally has also pushed many of our internal breadth indicators into the “high risk” region of the field.
Take the percentage of stocks within the S&P 500 that are trading above their respective 10-Week (50-day) moving average.
(Click any image to enlarge)
The reading has moved above 80% and hit 88% earlier in the week. This means that an unusually (even excessively) high number of stocks are now trading above this key moving average.
The common interpretation is that stocks have moved too high, too fast -- and the odds of a short-term pullback have increased significantly. This has been the prevailing theme in True Market Insider over the past several weeks.
On the one hand, the market has been roaring higher. On the other, odds favor a pullback.
To address this "double edged sword", throughout February we’ve shared several options strategies that let you maintain bullish exposure while at the same time mitigating your downside risk.
On February 7th, we discussed selling Covered Calls to generate income from stocks you own, while creating a limited hedge of downside protection.
Then, on the 14th, we discussed purchasing Protective Puts on stocks you own which maintains unlimited upside potential while at the same time providing unlimited downside protection.
And last week, we shared a Stock Replacement Strategy that has you cash in your stocks and use a small portion of the proceeds to substitute cheap Call options in their place. This technique allows you to maintain unlimited upside potential while raising a significant amount of cash.
With trading conditions excessively overbought, it's fitting that we discuss one more options strategy you can deploy in the current market environment.
It's a technique that can be useful for when you want to put some investable cash to work, but are leery of the fact that stocks are overbought.
The strategy entails selling naked Put options.
Now you might think that selling naked Puts is risky, even reckless. And you’d be right -- if you’re using them the wrong way. But use them the right way, and selling naked Put options is no more risky than owning stock.
In fact, in the example you’re about to learn, selling a naked Put option instead of purchasing the stock outright at the current price offers less risk, not more.
Here’s how it works:
When an investor sells a Put option contract, it comes with the obligation to purchase 100 shares of stock at a price known as the strike price. The obligation to purchase the stock remains in effect throughout the life of the option.
The seller of the Put option gets to collect, and keep, the premium for taking on this obligation. Each Put option contract you sell obligates you to purchase 100 shares of stock, should the buyer exercise the option and put the stock to you.
To make sure you’re using the strategy responsibly and the way it’s intended, follow this formula. The total number of Put options you sell should NEVER commit you to owning more shares in the underlying stock than you're comfortable owning.
Let's see how naked Puts can be an effective strategy for putting investable cash to work in a market, or for a stock, that’s considered overbought.
Saleforce.com (CRM) is a leading cloud-computing enterprise software company.
Let’s say you’re interested in taking a 100 share position in CRM. With the stock recently trading around $163.00 per share, you’d have to commit $16,300.
Now let’s say that after the recent run-up, you’re hesitant to buy in at the current level and prefer to wait for lower prices. Remember, the market has been on a huge run and you know the near-term risk of a pullback is elevated.
You could wait it out, hoping the stock will pull back. This choice keeps your cash idle in your broker account where it earns next to nothing.
Or you could consider selling an out-of-the-money Put option where your cash could earn a high rate of return. As a bonus, if those 100 shares of CRM are "put" to you... you wind up purchasing the stock at a substantial discount.
That’s the huge benefit of the naked Put selling strategy.
In the example, you could look to sell one April 145 Put option contract and collect a cash upfront payment of $215.
The premium is yours to keep. The trade will obligate you to purchase the same 100 shares of stock between now and April expiration (about 50 days out), but at a price of $145 which is an 11% discount to the current price of $163 per share.
And here’s the thing…
If the stock never drops below $145 by the expiration date and the option is not exercised, you still get to keep the $215 which equates to an 11% annualized return.
And if you do happen to be assigned, you’ll be put the stock at $145 which is an outlay of $14,500, far less than buying in at the current price of $163 -- which would commit nearly $2,000 more in capital for the same 100 share position.
Now how great is that?
If you’re an investor eager to put cash to work in stocks that you'd like to own, but are reluctant to do so because the market is overbought, consider selling out-of-the-money Put options.
It’s another way options can make your money work harder for you.
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!