There is little doubt that global financial markets are distressed. In response, financial advisors are torn. Do you recommend buying today, at the risk of trying to catch a falling knife, or recommend holding cash, which guarantees zero to negative short-term inflation-adjusted returns?
The trick is to look at protective strategies that get your clients into the game while avoiding the falling knife.
The “bull put spread” is such a strategy. It offers limited risk with the appearance of sitting on the sidelines, with the added benefit of being able to trade into a stock at a price that will never be far from the lows the stock might experience.
A bull put spread involves the sale of a put at one strike price offset by the purchase of protection at a lower strike price. For example, if XYZ was trading at $50 a share, you could sell, say, a six-month $55 strike put while simultaneously buying a six-month $45 strike put. This trade is likely to net your client about a $4.50 a share credit (the difference between the premium received from the sale of the $55 strike put minus the cost of buying the protective $45 strike put).
This strategy allows your client to participate in a limited way should the stock rally (although the client will not benefit if the stock trades above $55 a share) and limits the risk should the stock fall sharply (being protected by the long $45 strike put if the stock trades below $45 per share).
The sale of a put option obligates your client to buy the shares at the strike price until expiration. Think of it as a “limit order” for which your client receives a premium for making the commitment. The purchase of a long put limits the risk so that in a worst-case scenario, your client is able to put the stock to someone else at, in this case, $45 per share. In other words, the stock could fall off the proverbial cliff and you still have a defined exit point. Moreover, should that drop happen — and assuming you still like the stock — your client could then buy it at the much lower price.
For a real-life example, look to technology stocks, which are the most likely group to deliver earnings improvement throughout the remainder of the year. If earnings really do drive stock values, better than expected results may be the tide that lifts all boats.
With that in mind, you might look at positioning your client in a best-of-class tech stock through the bull put spread. Names that come to mind at the high end are Google Inc. (symbol: GOOG; trading at US$525 a share at the time of writing) and Apple Inc. (AAPL; US$377.75). If lower-cost entry points are preferable, look at Microsoft Corp. (MSFT; US$25.80), Research in Motion Ltd. (RIM; $29.50) or Cisco Systems Inc. (CSCO; US$15.80).
Using Apple as an example; your client would sell the December 390 puts at US$34.50 and buy the AAPL December 360 puts at US$21. This bull put spread nets a credit of US$13.50 a share. If the stock is put to the client, the net cost is US$390 less the US$13.50 net credit, which equals US$376.50 — just below the level at which the stock was trading at the time of writing.
If AAPL is above US $390 at the December expiration, your client simply retains the net credit received, as both options would expire worthless. If the shares were to fall off the cliff, your client can put the shares to someone else at US$360 per share, which would amount to a maximum loss of US$16.50 per share (i.e., the difference in strike prices, US$30, minus the net credit of US$13.50 = US $16.50). Another way to look at the maximum risk is that your worst-case scenario would see your client own the stock at a price that is no more than US$16.50 above its lowest point.
If the position is in a loss come December, you could close out the initial spread and execute another spread at a lower strike price dated three months out. IE