By: Costas Bocelli — January 9, 2020
Stocks are on the “stairway to the heaven”.
Ever since the S&P 500 broke out to new highs in October of last year, U.S. equities have been racking up record high after record high.
(Click any image to enlarge)
In the fourth quarter, the S&P 500 gained +9%, capping off an annual gain of +29% in 2019. That was the best yearly gain for the US stock market benchmark in six years!
And this year stocks basically picked up right where they left off.
All three of the major averages hit new all-time highs on the very first trading of 2020.
But the risk of a corrective action is now elevated because there are many signs of an overbought condition permeating the domestic equities asset class.
That’s a theme we’ve been sharing with our readers of late.
Earlier this week, Chris Rowe opted to let a picture do most of the talking in his recent True Market Insiders column where he shares an image of negative divergences over the past year between the S&P 500 and a key technical indicator.
And here’s the thing…
Just hours later after Chris sent out the article, an Iranian missile strike targeting U.S. military bases in Iraq sent the futures plummeting late in the evening.
The S&P 500 and the Dow Jones Industrial Averages were lower by more than -2% before the “fog of war” became a bit clearer.
Ultimately, the Iranian response to the killing of one of its top generals was not as destructive as feared. Stocks rallied on the news of an apparent de-escalation of tensions between the two countries.
Yesterday, the S&P 500 and the Nasdaq Composite hit new intraday record highs.
But the point is that stocks are highly vulnerable to a potential selloff much like was the case two years ago.
At the end of 2017, another strong year for stocks, the rally persisted for another month. The S&P 500 gained an additional +7% in January of 2018 until the bottom fell out.
So we continue to be in a situation where the market internals are strong, yet the near-term indicators are flashing “overbought”.
There are several ways investors can manage this type of market environment.
The last thing you’d want to do is sell all your stocks and go to ALL cash. That could be a real killer if stocks are destined for another strong year of returns.
So in today’s column, we’re going to reach into the option’s toolbox and pull out another technique that can be used to mitigate risk.
It’s called the 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 stocks on the stairway to “record highs”, investors have become complacent. Here is a chart of the CBOE Volatility Index (VIX), also known as the “fear gauge”.
As you can see, the VIX has recently fallen to 13, a historically low reading that indicates minimal fear.
It’s not even been 48-hours since the Iranian missile attack and investors returned to a complacent disposition.
Now here’s the thing...
When the VIX is low, option premiums are relatively cheap as investors feel less need for protection. In other words, this is a good time to be option buyers.
So let’s run through a timely example of how to stay bullish on stocks while returning a major portion of cash back to the account.
Here's how it works...
Let’s say that we own 200 shares of Visa (V).
We can replace our long stock position with a cheap Call option position.
With the stock recently trading at $191.95 per share, we can sell our 200 shares and return more than $38,000 back to the brokerage account.
Then, we could buy two March 195 Calls for $4.75 or $475 per contract. (Remember, each option contract controls 100 shares of stock.)
The March 195 Calls allows unlimited upside potential over the next two months while limiting any downside risk to the cost of our two Call options -- in this example, just $950.
So what we’ve been able to do is maintain bullish exposure in V and restocked some serious buying power. That could come in handy should the stock market correct over the couple of months.
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 or email us at firstname.lastname@example.org and ask to save a seat.
Better still, grab a seat in today's FREE presentation, the Prime Time Trader Summit. At 1PM EST today I'll show you a trading strategy that's prefect for today's market.
Until next time!