WATCH: The 4 Stage Stock Market Cycle

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Understanding this strategy, can protect your stocks without selling one share!

By Chris Rowe November 9, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

A funny thing happened to me this week.  I had a conversation with my cousin Adam about the economy since we are both in the financial world (he owns a mortgage firm and I’m, well, me,) and I mentioned that I noticed that the NYSE short interest was up to a new 5-year high on Friday. 

Short interest is the amount of stock that is "short" or that has been sold as a bet that a stock will trade lower, at which point, the idea is to buy the stock back cheaper, profiting from the difference in price. 

Now keep in mind, I don’t try to predict the direction of the market, and I would never bet the ranch on one single indicator.  But you should know by now what typically happens at this time of year, which is another heavy factor.  But it’s worth noting that short interest being at a 5-year high is considered to be a contrarian indicator, since the stock has already been shorted, or sold, and now has to be "covered" or bought back.  

Buying all of that stock back can cause a rally in the stock market called a “short squeeze.” 

The short squeeze could come after the market trades lower, and the “shorts” decide to cover (buy back stock) in order to take their profit causing a spike in the stock.  Or, if the short sellers were wrong about their prediction, the short squeeze could happen if some super positive event took place pushing the market higher, forcing the “shorts” to cover (buy back stock at a loss) in order to limit their losses, causing an even larger spike in the market. 

Either scenario can unfold; however, it’s usually the first scenario that takes place. 

It's important that you remember that if we are seeing short interest at 5-year highs, it isn’t your next door neighbor on e-trade taking such enormous bets against the market (no offense, anyone,) but these are heavy duty funds taking these bets on a lower market, at least for the short-term.  The good news is that if the market tanks, it is likely that the dip would be followed by a big spike higher.

So why was this conversation a funny thing? 

If you were to look at the Tycoon Report Archives, you would see that I mentioned in an article that I wrote last year around the same time (August 24, 2005) that the month ending Aug 15, 2005 NYSE Short Interest report also showed short interest at record levels.  Check out the 2-year charts below of the NYSE and the S&P500, which highlight the period during and after short interest hit record highs. 

2-Year Chart of New York Stock Exchange

  

 

2-Year Chart of S&P 500

 

Anyway, I was telling my cousin Adam that it's just something to keep in mind, but not to use it to try to time the market.  As I was talking to him, and looking through The Tycoon Report Archives, I noticed that I wrote an article about another similar conversation that I’d had with him where I was actually giving him a solution to this same type of market at this same time in 2005! 

We had both completely forgotten about that conversation, and he didn’t even know that I had written about it! 

So I will give all of The Tycoon Report readers the chance to read what I wrote about when my cousin suspected that we might possibly be in for our traditional dip in the stock market, but he still didn’t want to sell his stocks. 

I offered him two strategies which offer two solutions.

"Basic" Solution/Strategy #1: I said, "If you own stocks that you like, and you aren't sure what to do with them when they spike higher, sell covered calls when you get that spike in price.  Selling a third party the right to buy your stock at the current price in the form of a contract that expires in a couple of months is a great way to collect income."

It had been a while since he sold covered calls so I helped him brush up by giving him a quick course on how to do this effectively.

Since the market has been somewhat manic-depressive lately, it's offering big opportunities in the form of covered call writing. The majority of stocks that spike higher lately have only come back to their average prices.

Solution #2: Since he told me that he owns a major stock position that he thinks might trade lower, but didn't want to sell yet it because of a big short-term tax consequence, I said you can use what's called an "Equity Collar."

Immediately I thought about the Tycoon Report readers.

An Equity Collar is the simultaneous purchase of a put option, and writing of a call option.  Both are done out of the money and both usually have the same expiration date.

Sometimes this was done when a company executive who we managed money for wanted to hedge against a market downturn and had a reason for not selling stock such as not wanting to send the wrong kind of signal to management or other shareholders.

I gave my cousin a brief example of how this is done.

We'll call his stock position XYZ.  

I said to him: "XYZ stock is trading at $45, and you want to hedge against a drop in price, correct? Since you think it still has a chance to trade higher, you don't want to simply buy the protective puts which trade at $3.20.  That is a huge amount of money that you would lose if the stock trades higher or even if it trades flat!"

I said:  "Let's check out the April $40 puts and the April $50 calls."  I chose these two since XYZ was right in the middle at $45.00.  The options were trading at $3.20 and $5.20 respectively.  

I chose the April options because he mentioned that he wanted to avoid the short-term tax consequence.  This strategy involved selling call options whereas he would be contracting his obligation to sell his stock at a higher price.  Selling the stock at a higher price isn't the worst outcome of course, but I knew he wanted to avoid selling if possible. 

When you sell call options that have a significant amount of time before expiration, they are less likely to be exercised.  Said differently, he was less likely to be “called away” from his XYZ stock by selling the April call options, as opposed to call options with an earlier expiration date.

"If you sell the April $50 calls (to open,) then you will take in $5.20 per share as a premium.  If you buy the April Puts (to open,) then you will spend $3.20 per share. If you do both at the same time, the result will be that you receive a total credit of $2.00 per share altogether.  ($5.20 received - $3.20 spent = $2.00.)

The Result:

If the stock trades lower like you think it will, you are essentially "short" the call at $5.20, which will trade lower as the stock price trades lower. It will also trade lower as you get closer to expiration in April.  This will benefit you, because you can purchase the call that you sold, and the difference between $5.20 (where you sold it) and the price that you pay when you purchase it becomes a profit."

"The put that you bought should begin to trade higher, and once the stock breaks $40, the put should increase significantly in value."

"The two changes in price of the two options should help to significantly offset the paper loss of the stock position.  You could buy back the call option (to close) and sell the put option (to close) which would give you two short-term profits.  But if you want to benefit from a long-term gain on the stock (tax purposes,) you should consider holding the put option, and then exercising the put (using it to sell XYZ at $40.00) once you have a long-term gain on the stock as opposed to a short-term gain.

He completely grasped the idea. Thank the Lord, because his breath was killing me (sorry Adam!)

He asked "What if I'm wrong, and the stock trades up?  Do I lose?"

So I told him: "If the stock trades higher, you don't necessarily lose, but if the stock trades over $50.00, then you might be obligated to sell the stock at $50.00, due to the fact that you sold (or wrote) the call option.  You'll still keep the extra $2.00 (which in his case is a short term gain,) and you'll have a $5.00 increase in the stock price giving you $7.00/share more than your stock is worth today, so I don't think you'll be upset."

He said he could accept that and, if that was his biggest problem, he'd consider himself lucky.

The third scenario, of course, was the stock trading between $40 and $50.

In that case, both options would expire worthless and Adam would make $2.00 extra (credit) on his option position (remember that he would have received the $2.00 credit: the difference between the $5.20 that he took in when he sold (or wrote) the call option, and the $3.20 that he spent on his protective put.)   You would then calculate the outcome by taking the movement in the stock's price, and then adding that $2.00 credit on the option position. 

In other words, if XYZ traded up to $48.00/share, that is a $3.00 increase from $45.00, plus the $2.00 credit that you received.  That is a total of $5.00 increase in value of your position.  But if XYZ traded down to $41.00, your stock will have lost $4.00 in value.  If you add the $2.00 credit from the option position, that would only be a $2.00 loss in value.   Either way, it's better than only owning the stock. 

Remember, you can always implement this strategy temporarily.  Adam was not locked into this strategy until April.  You can create an equity collar while you weather the potential storm, and when you feel that the coast is clear, you can always undo this option position by:

  1. Buying back the call option (which you originally sold) to close.   
  2. Selling the put option that (which you had originally bought) to close. 

If you decided to sell the underlying stock at some point, you should be absolutely sure to FIRST buy back the call option that you have sold.

I hope that my family conversations and experience translate into a nice healthy blood pressure and profits in your accounts.  Your health should come before money, and you shouldn't stress too hard about the stock market.

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