Given the news surrounding the stock market “meltdown” in October, you would think that this event was one of the most telegraphed corrections in history.
However, when you hype corrections by citing the U.S. Federal Reserve Board’s exit from quantitative easing, negative seasonal tendencies and fears of an Ebola outbreak, investors typically clamor for safety – although this time, that didn’t appear to be the case so much.
Based on data from the Chicago Board Options Exchange’s volatility index (VIX), which spiked in reaction to the sell-off but not close to levels that would infer panic, retail investors apparently stayed the course. The trick is to get your clients back into the game after a correction, which is easier said than done.
To overcome investor sentiment, you might suggest a “covered strangle” as a strategy to take advantage of current volatility while allowing your clients to dollar-cost average their way into equities. But to get clients to buy in, you have to make a case for buying equities.
On that point, most market-watching technicians believe that the 1800 level on the S&P 500 composite index was the bottom. The number crunchers – also known as “fundamental analysts” – are focusing on third-quarter earnings; and there were positive surprises early on from the U.S. banking sector, notably J.P. Morgan Chase & Co. and Bank of America. Unfortunately, much better than expected earnings by the banks was overshadowed by weak loan growth, which is central to the bullish thesis.
The bullish case rests on the premise that equities are not expensive: price-to-earnings multiples are in line with historical norms; dividend yields are above average; balance sheets are flush with cash; and stock buybacks continue at a brisk pace. These are reasonable metrics.
However, looking at U.S. equities relative to gross domestic product (GDP), the broader U.S. stock market is well above historical norms. That’s probably because there has been no viable alternative when you consider that the after-tax yield on bonds is not keeping pace with inflation and there is pricing risk in bonds should interest rates increase.
In short, there are two possible scenarios for 2015: the U.S. sees significant expansion in GDP, which hinges on loan growth; or the U.S. continues to languish at 2% GDP growth into the foreseeable future. In the latter scenario, stocks may drift without the benefit of liquidity infusions from the Fed.
A covered strangle strategy raises the probability of a positive outcome regardless of the scenario. Here’s why: a covered strangle involves buying shares in a quality company that has exhibited decent volatility. At the same time, you would write out-of-the-money calls and puts against these shares. Because the underlying stock has exhibited above-average volatility, your client is collecting above-average premiums from the sale of the two options.
Take American Airlines Group Inc. as an example, whose stock recently closed at US$44.50. Suppose your client had the wherewithal to buy 1,000 shares of that stock; but, rather than buying all the shares today, offer to buy 500 shares at current prices, while setting aside the remaining capital to buy another 500 shares at some point in the future.
To put some meat on this strategy’s skeleton, buy 500 shares of American Airlines at US$44.50, for a capital risk of US$22,250. Simultaneously, sell American Airlines February 45 calls at US$3.20 and American Airlines February 42 puts at US$2.80. Thus, the total premium received is US$6 a share. The February 45 call obligates you to sell your initial 500 shares at US$45 and the February 42 put obligates you to buy an additional 500 shares at US$42 by the February expiration.
Your client should set aside US$18,000 in capital plus the US$3,000 premium to cover the short February 42 put. The bottom line is that your client is committing US$40,250 of his or her own capital to implement this strategy.
We know with certainty that one of the two options will expire worthless at the February expiration and that one options contract could be assigned. If the stock is trading above US$45 at expiration, the calls will be exercised and your client will receive US$45 a share plus US$6 a share in premium income. The four-month total return on the out-of-pocket capital (US$40,250) is 15.53%.
If the stock is trading below US$42 at expiration, the put will be assigned, thus requiring the purchase of an additional 500 shares at US$42. In this scenario, your client will have invested his or her entire capital commitment (US$40,250) but will end up with 1,000 shares at an average cost of US$40.25.
That average cost is well below the 200-day moving average for American Airlines stock.
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