By: Costas Bocelli — November 20, 2019
A melt-up rally is underway on Wall Street.
All three of the major stock market averages (S&P 500, Nasdaq Composite, Dow Jones Industrial Average) have been marching to new all-time highs.
As for the S&P 500, the primary U.S. stock market benchmark, it recently broke above 3,100 for the first time ever.
(Click any image to enlarge)
In fact, the S&P 500 has posted its sixth straight weekly advance dating back to early October.
So, yeah... Demand is in control of the stock market.
What's more, many of our internal breadth indicators (aka, “the true market”) confirm the bullish strength over the medium-to-longer-term.
That’s great news for investors.
But what’s there to say about the shorter-term breadth indicators?
In a word... OVERBOUGHT.
Refer back to the top of the S&P 500 chart above. You'll see that the RSI technical study, a popular momentum indicator, shows a reading above 70. That level is consistent with a market that’s overbought in the shorter-term.
Now there’s a couple of ways to alleviate a short-term overbought trading condition. The most obvious is a pullback with prices moving lower.
And the other way is to consolidate the recent gains where prices move sideways for a period a time. Whichever way it gets resolved, the stock market is overbought in the short-term and the risk of a corrective action is now elevated.
Markets can remain overbought much longer than you’d think, so there’s no telling for sure exactly when it will ultimately unwind.
If you're concerned the overbought condition will result in a meaningful selloff (greater than 5%, like we saw in three corrective instances earlier this year) you can reach for some downside protection.
In last week’s column, we discussed a hedging strategy -- a simple trade that can protect an entire portfolio against downside risk. But the thing about insurance is that you have to pay for it.
If you take a more optimistic view, that any short-term weakness will be brief and shallow, there's another hedging strategy that works almost as well, and actually gets you paid.
So if you think stocks will melt-up a bit longer or take a brief breather, now’s a great time to generate some holiday cash from stocks you own.
I’m referring to the Covered Call strategy.
This is where you sell Call options against a long stock position. Properly constructed, this strategy can generate instant double-digit returns.
Right now (much like the with the major market averages) you can find many individual securities that are overbought in the short-term, or even trading near all-time highs.
Take CBOE Global Markets (CBOE).
Here we find the stock in a long-term positive trend and trading around its prior highs during the summer.
It’s also technically overbought in the short-term (RSI at or above 70).
This would be considered a good candidate for the Covered Call strategy.
Here’s how it works…
Let’s say we own 200 shares of stock (CBOE).
In this example, the stock is trading $122.05 per share.
Owners of the stock could look to sell the December 125 strike Call option for a $1.50 credit, which means you’ll instantly collect $150 for each Call option contact sold.
Since each Call option obligates you to deliver 100 shares of CBOE (in the case of an assignment), you’ll want to sell one contract for every 100 shares you hold, ensuring the position is completely covered.
Since we own 200 shares, we can sell two contracts and grab $300 in holiday cash -- enough to purchase a Sony PlayStation 4. (My twelve-year old son has this on his holiday wish list so, believe me... I'm well aware of the cost.)
There are two things to get right when you deploy this strategy...
The first is to make sure you properly size the position. The other is to choose the proper Call option to sell.
In this example, we targeted short-dated out-of-the-money Call options a strike prices above the current price of the stock. This will allow three additional points of upside appreciation (+2.5%) should the stock indeed be called away.
Since the Call option obligates us until December expiration, or 29 days from now, the return on investment is more than 15% annualized, not including any of the capital appreciation should the stock get called away at $125 per share. (Remember, the current price of the stock is $122, or about $3 lower).
And if the stock remains below $125 at December 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 in this type of market landscape when many stocks are overbought can be a good strategy to boost returns, create a limited hedge and generate some holiday cash.
And here's an early holiday present from me to you.
I've compiled a list of 30 widely held stocks I think are good candidates for the covered call strategy.
AAPL, ADBE, ADSK, AMAT, AMD, BAC, COST, CRM, DHI, EW, FB, GPN, GRMN, HUM, IR, ITW, JPM, KLAC, LMT, LRCX, MA, MSFT, PAYX, QRVO, RJF, ROST, STX, TJX, V, WMT.
See you soon!