By: Costas Bocelli — October 9, 2019
If there’s one word to describe current market conditions, it’s volatile.
Since the calendar flipped to October, the month has certainly lived up its infamous reputation.
We’ve seen all the major stock market averages move in excess of 1% in each of the month’s trading sessions thus far.
And the big moves haven't all been to the downside either.
You see, Mr. Market is getting a great deal of pleasure tormenting not only those long the market, but also those that are betting against it.
So it’s not surprising at all to see the CBOE Market Volatility Index (VIX) trading back above 20.
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The VIX is also known as the “fear gauge”. And when the VIX rises above 20, it signals that investors are feeling unsettled.
Typically, when the VIX is rising, options prices become increasingly expensive. That’s because options are inherently an insurance product. So when investors get nervous, they rush into the options market seeking protection so option premiums get bid up in the marketplace.
In last week’s column, we discussed a hedging strategy to protect a bullish portfolio of stocks using Put options and Put spreads.
The hedging technique uses Exchange Traded Funds tied to the performance of a major stock market index such as the Dow Jones Industrial Average or the S&P 500.
For those still wanting to protect a basket of stocks against downside risk, we still recommend applying this hedging technique.
But here’s thing about insurance -- you have to pay for it. And when markets are volatile (like they are right now), insurance can get expensive. Of course spreading helps reduce the costs, but still, not every investor is keen to pay up for protection.
The good news is that there is another hedging strategy you can deploy that actually benefits bullish investors when volatility is high and options premiums pricey.
Properly constructed, this strategy can generate instant cash with double-digit returns.
I’m referring to a Covered Call strategy where you sell Call options against a long stock position you own. So instead of buying options, we’ll be taking the other side and selling them instead.
See the beauty here...? With options premiums richly priced, you’ll get paid handsomely to do it.
Selling Covered Calls instantly generates cash and provides a limited form of downside protection from the premium collected by selling the option.
Here’s how it works…
Let’s say we own 100 shares of Edwards Lifesciences (EW), the large-sized medical equipment and supplies company.
In this example, EW is trading just above $220 per share.
Investors could look to sell the November 230 strike Call option for a $6.00 credit, which means you’ll instantly collect $600 for each contract sold.
Since each Call option could obligate you to deliver 100 shares of EW (n the case of an assignment), you’ll only want to sell one option contract -- thus ensuring the position is completely covered.
If you happened to own 300 shares of stock, then you'd sell three option contracts.
Now we choose the proper option. In this example, we targeted an out-of-the-money Call option with a strike price above the current price of the stock.
This will allow upside appreciation should the stock indeed be called away. At $230 per share, it would reflect a sale price just above the prior all-time high. That would not be a bad result during a time a time when markets are very volatile.
The $6.00 collected from the option that’s sold is immediately deposited into your broker account. Which means you’ve just generated $600 in cold hard cash. It’s yours to keep and can do anything you like with it.
Since the Call option obligates us until its November expiration, or 36 days from now, the return on investment is more than 26% annualized, not including any of the capital appreciation should the stock get called away at $230 per share (Remember, the current price of the stock is $220, or about $10 lower).
And if the stock remains below $230 at November expiration, the Call option will most likely expire worthless, freeing you of your obligation.
Better yet, you can sell another round of covered calls and collect even more cash.
Selling Covered Calls when market volatility is high can be a good strategy to create a limited hedge while at the same time allowing you to generate a high return on your asset.
Want to learn more about the Covered Call strategy? In Options Soup, our options educational program, we show investors exactly how to generate income on stocks that you own (and even on stocks that you don’t own).
To learn more about Options Soup, call 855-822-0269 or email us at email@example.com
Until next time!