By: Chris Rowe — August 6, 2019
Thank you Xi Jinping and Donald Trump for knocking the market back down.
Over the last few days the stock market dropped 6% from head to toes due to trade wars escalating between the U.S. and China. But these types of conflicts are made to be resolved.
Xi Jinping's and Trump's buddies will get the call prior to the resolution so they can position themselves in the stock market to bank big upside gains, just as they were alerted prior to the series of political moves that clobbered prices to where they are now.
And if you follow technical indicators, you won't have to be in the "in crowd" to get paid handsomely.
First, know that this brings the S&P down to its 200-day moving average (green) - a key price point that tends to trigger trading activity from automated trading systems. Typically, in the context of a strong bull market like we've been in, the action will be to BUY.
But it won't happen immediately. It will be choppy for a little while.
And for those of you that like to follow "The True Market", let's take a look at the granddaddy of all market indicators, "the New York Stock Exchange Bullish Percent Index".
For those who don't know (and I won't make a lesson out of this), the far right column determines whether we are to buy aggressively or to be more defensive.
Right now, in an O-column (down column), the indicator suggests being defensive (while remaining long-term bullish).
Let's think about what it means to be defensive.
For two days straight, the stock has been gunning higher. Imagine how the stock would have performed in an up market.
These are the types of stocks to either buy, or keep an eye on and buy when you're ready to step in with more cash.
Before you say this is a risky strategy - It's NOT. It's the lowest-risk strategy options have to offer, after the "collar" which is hardly even a profit strategy but a neutral hedging strategy.
Selling naked puts is the exact same thing as selling covered calls.
If you don't believe me, just google "synthetic naked puts" so I can get on with my article.
You'll do this with a stock you'd like to own.
You can do this even if you don't have additional cash in your account as long as you have a margin account. Otherwise (at most brokerage firms) you'll need to have cash that represents 20% of the notional value (the amount you'd need to buy the stock you wanted to buy anyway).
Sounds confusing, but it's simple. But let me back up for a second.
A put option gives the owner of the put the right (not obligation) to sell a stock at the option's "strike price". For this right, the put buyer pays a premium (just like insurance companies). The seller/writer of the put receives the payment/premium in exchange for the commitment that the put seller/writer will buy the stock at the strike price if it comes down to it... Literally.
If you are the put seller/writer (you are selling insurance on a stock) sees a stock trading at $100.75, and would like to own that stock, then the put seller would sell the September 100 put. You don't have to have already owned the put in order to sell it. You can create it ("write it") the same way an insurance provider "writes" an insurance contract.
In reality, you're just clicking a few buttons on your computer.
The put seller wants to sell puts that expire in about 30 - 45 days.
Just trust me for now that that's the best time-frame for expiration. It will always give you the largest and quickest return.
The put seller also wants to sell the "at-the-money" puts, which means the put option with the strike price that's closest to the price of the stock at the time. (If he truly would rather not own the stock, but simply wants to collect a premium, then he might sell the put with the next lower strike price - in this example it would probably be the 97.5 put).
Nearly all options represent the ability to trade 100 shares of stock. Check with your broker if you're not sure.
In my hypothetical, the put seller is selling one put with a strike price of $100.00, which is a commitment to buy the stock at $100.00. So he may collect $200.00 (or 2%) of the notional value ($100 X 100 shares = $10,000 notional value).
If you think about it, 2% collected in 45 days is pretty darn good. That's a 16.1% annualized return (not counting fees), which is twice as much as what the stock market returns on average over any significantly long-term period.
What's even more amazing is the fact that options become more expensive when the market is fearful.
So if you use this strategy when the market is bullish and complacent, then you may collect 2% with this strategy. But when the market is fearful like it is right now, that same set of circumstances (stock at $100.75 with an option with the same $100 strike price and same expiration day) might pay you 3%.
But it doesn't stop there...
While you're making 2% - 3% on your overall risk ("risk" assuming you are technically risking your stock can go to zero), you are actually making more like 10% - 15% on the capital outlay, which I'll explain. But that's an 80.5% - 120.75% annualized return on capital outlay.
This is a pretty fair way of looking at it because most stocks simply aren't going to go to zero. If the stock typically has price swings of about 20% then you're essentially risking 20%. Let me get back to the capital outlay...
The strategy is a premium collection strategy that you'd basically use with the intent of collecting a quick 1.5% - 3% (sometimes much more) return on "your investment".
And since your capital requirement is only 20% (1/5) of "your investment", you can essentially multiply that return by 5 to get your return on your capital requirement.
To sell naked puts, I need 20% of the exercised position in my account.
If I sell naked puts to buy 100 shares of a $100 stock, it's a $10,000 trade if I get "assigned" to buy that 100 shares at $100 per share.
Remember, in my example I'm collecting 2%.
By selling one put on a stock with a strike price of 100, then I would have to have $2,000 cash in my account.
But what if you're fully invested and WISH you had the cash to do this?
If you're doing this for a quick bounce, or a short-term trade, the interest rate won't impact you very much if you do this on margin.
So if you don't have that $2,000 cash then you can do the trade with $2,000 in marginable securities in the account - basically giving you another $2,000 buying power.
If you aren't able to withstand volatility or if you have a small dollar amount and you need the money for something anytime soon -- then don't do it on margin. In fact, talk to your advisor about what's appropriate, please. Because if the stock continues lower, below $100 and then down to $70.00, you'll end up with a margin account that is in decline.
If you would have been fine with owning this stock on margin then go ahead and do it.
One other reminder:
You don't even have to commit that 20% of the notional value because you've collected that premium.
So in our example, the requirement would be to have $1,800 either in cash or on margin, because we've collected $200.00 in premium for that put we sold.
You can factor that into the return on capital requirement if you'd like but you get the point.
Can We Do This With All Stocks and ETFs?
Not all stocks and ETFs trade options, so no, and the ones that do trade options don't always have great options to do it with because the spread may be too big. This would apply to stocks that don't trade a lot of volume.
Some will have spreads that are pretty big but you can still do it anyway.
So I'll take one of those "middle of the road" examples. Let's do this with Big Bills small-cap Saturday trade!
Remember, the man said the stock would likely pop 20%. He basically gave this to you with a big red bow on top. But the stock since popped in the face of a bloody market!
You look at the stock and say "hey, I wish I had gotten in a bit lower and I still want to own a stock that stands like a stone pillar in Rome when the market is down."
The stock is at $17.50.
Here are two ways to play it.
Notice that the at-the-moneys that expire in 10 days are the August 17.5 puts.
I know I said it's ideal to do this with options that expire in 30 - 45 days but these options actually have fat premiums even with only 10 days until expiration!
The spread is big. The bid is 5 cents and the asking price is $1.10. So the mid-price is 60 cents. I would try to sell these for higher than 60 cents first, but with this low-volume stock and big spread puts, we may or may not get that 60 cents.
Assuming we can, I want to commit to buying 1,000 shares ($17,500 notional value).
I must commit $3,500 to the trade. Subtract that $600.00 I'll receive and that's only $2,900 I need to commit.
This is a 3.4% premium in 10 days!
That's a 124.1% annualized return on the entire notional value of $17,500 (1,000 shares of stock at $17.5).
But considering you've only committed $2,900 to do the trade and received $600.00, that's a 20.6% return on the capital requirement (of $2,900) in 10 days, or 751% annualized return on capital requirement!
And your risk is that this great stock is below $17.5 in ten days and so you have to buy it at $17.50.
If you have a hard time doing this with the August puts then you can move out to the Septembers. They expire in 45 days.
Basically you'd do the same thing as I described, above. You'd just try to sell it first for a price above the current mid-price (currently it's 80 cents). So maybe start by trying to grab $1.20. At that level, you're getting twice the absolute return I described.
And I'm sorry to say that most firms require that you have at least $20,000 account value so if you don't have that yet, keep reading True Market Insider and we'll try to help you get your account value up!