You like the market’s potential. You believe that things in Europe will stabilize, and October 2011 will go down as the best one-month percentage rally in the U.S. stock market since 1974. It’s amazing what a sigh of relief will do for traders’ psyches.
The challenge for your clients is their personal fear gauge. They have watched their portfolios oscillate throughout 2011 and, despite October’s rally, have yet to see positive year-to-date performance numbers. Trying to get those clients to take a position is like trying to get someone to attach a bungee cord to their feet and jump off the CN Tower.
And don’t expect analysts to be definitive. In fact, they will utter well-rehearsed doublespeak laced with caveats, such as: “I am bullish on the market but would like to see a pullback before jumping in.” In other words: “I have no immediate actionable strategy.”
Of course, as an investment advisor, you need something to take to your clients now — an actionable strategy that allows them to dip their toes into waters filled with caveats. To that end, your clients could look to the options market — specifically, at a strategy of selling cash-secured puts. More specifically, an actionable strategy such as buying on a pullback.
When a client sells a put option, it is an obligation to buy the underlying security at a specific price. Presumably, if the client is in the “buy on a pullback” camp, this means accepting an exercise price that is lower than current market value.
Canadian energy companies are an excellent case study. In recent months, the price of oil and the attendant performance of energy stocks have been highly correlated to the broader stock market.
If your clients believe in a positive outcome in Europe, then energy stocks could be the sector for them. Examples include major Canadian energy producers such as Suncor Energy Inc. (symbol: SU; recent price: $32.95) or Canadian Natural Resources Ltd. (symbol: CNQ; recent price: $36.45).
If clients like the energy sector on a pullback, they could sell, say, SU January 32 puts at $1.75 a share. The sale of this put obligates them to buy SU at $32 a share until the third Friday in January 2012.
What makes this an actionable “buy on a pullback” strategy is: if the shares are put to your clients, their actual cost is $32 minus the $1.75 a share premium received for the put transaction, which equals $30.25 a share.
Clients could employ a similar strategy with CNQ, in which they would sell the January 36 puts at $2.10. The actual cost to buy CNQ shares, should the put be exercised, is $33.90 ($36 strike price minus the $2.10 premium = $33.90).
The term “cash-secured” implies that your clients hold sufficient cash or cash equivalents (money market funds, treasury bills, etc.) to buy the shares if they are put to your clients. With SU, clients would set aside $3,025 of their own capital plus the $175 premium from the sale of the put to secure their ability to buy 100 shares (each option contract obligates the holder to buy 100 shares of the underlying stock) at the $32 per strike price. In essence, your clients are keeping cash on the sidelines to buy into the market on a pullback — and that defines only the obligation side of the strategy.
The real advantage occurs if the stock price remains where it is or rises. (Note that it is currently above the strike price of the put.) If SU is above the strike price of the put at expiration, the put will not be exercised and will expire worthless. So, your clients get to keep their premium while merely dipping their toes into the water. IE