A strategy you might recommend to your clients to reduce concerns about volatility in the near term is dollar-cost averaging (DCA), which allows clients to buy a little now and a little later. Using specific dollar amounts, clients buy fewer shares when prices are rising and more when prices are down. Increased volatility enhances the outcome, as more shares can be purchased at dramatically lower prices.
The challenge is that DCA presumes a client is willing to hold onto the shares for the long term. That’s not easy when markets react quickly to unforeseen events. Clients are more likely to engage in the DCA strategy if they can moderate the assumptions underpinning the strategy – specifically, that DCA is only a tool to acquire stocks for the long term.
We can enhance the DCA experience by providing an early exit alternative for a specific stock should it trade beyond its normal trading range. To do this, we begin by recognizing that options and volatility are inexorably linked.
The exit strategy under discussion is known as a “covered combination,” and the theme of that strategy is a DCA option.
The covered combination is a three-step process:
1. A client takes a position in a stock he or she plans to buy over time using DCA.
2. The client then sells an out-of-the-money covered call on the shares to establish an exit alternative.
3. Finally, the client sells an out-of-the-money, cash-secured put to buy additional shares at the put’s strike price – effectively averaging down the cost of the shares.
As an example, let’s look at shares of Ireland-based Allergan PLC (symbol: AGN; recently priced at US$195 a share). Allergan was the second-party pharmaceutical company in a deal to help New York-based Pfizer Inc. make the move to Ireland, a tax haven. That deal was stopped by the U.S. Treasury Department, which viewed the deal as a tax dodge.
Since then, Allergan has been looking to use its mounds of cash to acquire other companies with which Allergan has synergies. The shares of Allergan, which initially was thought to be an attractive acquirer, have been hit hard since the Pfizer deal fell through. That’s mainly because Allergan is dealing with the same challenges as other companies in this sector are. Specifically, there has been pushback from the U.S. government as it tries to get a handle on drug costs. As a result of the sell-off, options on Allergan’s stock have been trading at implied volatilities in the top quartile of all U.S. equities options.
Assuming your client wants to DCA into a position on AGN, the client could employ the covered combination to implement the strategy. In this case, buy 100 shares (the initial block) in AGN at US$195 a share and immediately sell one AGN May 220 call at US$8 a share. Moving to Step 3, sell one AGN May 170 put at US$8 a share. The sale of the two options nets US$16 a share (US$8 a share for the call plus US$8 a share for the put) in premium income.
The May 220 call obligates your client to sell the initial 100 AGN shares at US$220 a share until the third Friday in May 2017, the last trading day for the May series of options. (Note: options expire on the Saturday following their last trading day.)
If AGN is priced above US$220 a share at the May expiration, the call will be exercised – providing the early exit from the stock at a profit – and the AGN May 170 put will expire worthless. The US$220-a-share sale price for AGN is in addition to the US$16 premium that was received when the covered combination was established. In this best-case scenario, the six-month return is 21.02%.
But that’s only half the trade. The AGN May 170 put obligates your client to buy an additional 100 shares of AGN at US$170 until the May expiry. To meet the definition of a “cash-secured put,” your client must retain cash to purchase the additional 100 shares of AGN at US$170 a share. That concept is the basis of the DCA strategy.
If AGN is trading below US$170 a share in May 2017, your client would buy another 100 shares of the stock, which was the intention of the DCA strategy. But US$170 is not the true cost of the additional shares, as you can deduct the US$16 a share premium received from the sale of the two options. The actual cost of the second 100-share block of AGN is US$154 (US$170 strike price minus US$16-a-share premium = US$154).
Now, think about this trade combination in its entirety. You buy the first 100 shares at US$195 and the second block at US$154 (if the call is assigned). The average cost of the 200-share position is US$174.50 – about 9% below the current stock price. That’s the idea behind “averaging down.”
This strategy will appeal mostly to nervous clients who are moderately bullish on the underlying stock. Whenever you recommend buying an initial block of shares and agree to buy more at a lower price, you ought to be bullish.
The covered combination, like DCA, is a disciplined approach to investing. The underlying stock is held when the put and call are sold. Selling the two options generates an upfront fee based on the volatility of the underlying stock.
Finally, the covered combination defines purchase and sale parameters at the time the strategy is initiated. Buying half now and, perhaps, half later should appeal to clients who buy into the DCA theory.
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