Emergency Management Report: Dealing with Volatile and Bearish Markets

10/21/2014 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman of TheBlueCollarInvestor.com highlights several options strategies for both experienced and newbie option traders to remember in order to manage existing positions or to initiate new positions, given the current extreme market conditions.

With the stock market declining over 5% in the past month as a result of geopolitical and global concerns—exacerbated by the fears of an Ebola epidemic—we find ourselves in a position that may lead to panic in our investment decisions. The stock market seemed to stabilize a bit on Friday but we are not out of the woods yet based on just that one day. Whether you are an experienced investor who has “been there, done that” or a newbie who is experiencing this discomfort for the first time, patience and non-emotional responses are the most prudent. In this article I will highlight strategies to manage existing positions in these extreme circumstances and strategies to initiate new positions for those who want to “stay in the game.”

Managing Existing Positions

1. We always buy back the option when it approaches our 20%/10% guidelines (declines in value to 20% or 10% of initial sale value depending on when in the contract cycle that decline takes place). This frees us up to sell another option or to close our long stock position.

2. When market tone is negative (which it currently is) and equity technicals are also negative, we sell the stock. Many investors will also use a percentage price decline to dictate when to sell a stock. This percentage will usually range between 8% to 10% of the initial stock purchase price. Once sold, a personal decision needs to be made as to whether you want to “stay in the game” and enter a new position. See below for some strategies to consider. Many investors are more comfortable staying in cash until a firm bottom is identified.

3. Rolling Down:

Rolling down occurs when we buy back a previously sold option (buy-to-close our short position) and simultaneously sell another option at a lower strike price in the same contract month (open a new short position).

We lean towards implementing a rolling down strategy when the market tone and technicals are mixed to negative. I would also be more inclined to use this strategy later, rather than earlier, in the contract period (late in week 2 and week 3, rather than week 1 of a 1-month contract).

Entering New Positions—Staying in the Game

For those who have a higher risk tolerance and want to remain in the market, it is prudent to implement strategies that are appropriate for current market conditions, especially extreme ones like we are experiencing now. Selling out-of-the-money strikes may work out but it makes little sense to take an aggressive stance until the market tone improves and stabilizes. Here are a few strategies that will allow us to generate an initial profit and provide us with some protection of that profit:

1. Sell Only In-the-Money Strikes:

If we buy 100 shares of XYZ for $32 and sell a $30 call for $3.50, we have sold an in-the-money call option because the strike price of the call option ($30) is lower than current price of XYZ ($32).  The sale of this call option obligates us to sell 100 shares of XYZ for $30/share (or $3,000 in total) if the option is exercised.  Should XYZ increase in price from $32 to $40, we make no additional income due to our obligation to sell our shares @ $30. The option premium we receive from the sale of this option has $2 of intrinsic value ($32-$30). The remainder of the option premium is solely time value, which represents our true initial profit (ROO). Thus, if we received $3.50 in total option premium from the sale of the $30 call option, the $3.50 premium we receive consists of $2 of intrinsic value and $1.50 ($3.50-$2) of time value.  Because our true profit is represented by time value only, in this example we generated an option profit of $1.50/share or $150 per contract, which represents a 5% ROO (the $2 intrinsic value “buys down” our cost basis to $30) per share). The protection of that 5% initial profit is the intrinsic value divided by the current market value or $2/$32 = 6.25%.

NEXT PAGE: Three More Options Strategies to Remember

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2. Buy Protective Puts—the Collar Strategy:

As safe a strategy as covered call writing is, there is some risk; the risk is in purchasing the stock, not in selling the option. For this reason, some investors who sell covered calls also buy protective puts to alleviate some of the risk. A protective put is a put option that is purchased for an underlying stock that is already owned by the put buyer. It defends against a decrease in the share price of the underlying security. When a protective put is used in conjunction with covered call writing, the strategy is referred to as a collar strategy. A collar is the simultaneous purchase of a protective put option and the sale of a covered call option. In a true collar strategy, the puts and calls are both out-of-the-money and have the same expiration dates and an equal number of contracts. Thus, we sell an out-of-the-money call and add additional downside protection for the underlying equity by purchasing a protective put option. This strategy protects against catastrophic share devaluation but also decreases our initial option profits.             

3. Sell Out-of-the Money Cash-Secured Puts:

With this strategy we are selling the right, but not the obligation, for the buyer of the put to sell a stock to us at a specified price, by a specified date. In return for undertaking this obligation, we also receive a premium. For example, a stock is trading at $32 per share and we sell a $30 out-of-the-money put for $1.50, receiving a return of $150 per contract. The returns in these scenarios are generally similar to the returns of generated from selling covered calls, and if the put is exercised, we are required to buy the stock for $30, meaning we purchase the shares at a cost basis of $28.50 ($30 less the $1.50 premium). Some investors consider this “buying at a discount” from the original $32 share price. We can then write a covered call on the newly-acquired shares.

4. Use Inverse ETFs:

Inverse ETFs use derivatives to bet against the direction of financial markets. These are known as short or bear ETFs and will make money if markets decline in value. They will lose money, however, if markets move against the bet.  Covered call writers who have a bearish market outlook may find these funds useful.

Many sophisticated covered call writers can benefit from the use of inverse ETFs in the short run when the market is bearish.

Inverse ETFs with options to consider:

PSQ: short QQQ
DOG: short Dow 30
SH: short S&P 500
RWM: short Russell 2000
 
Summary:

What is transpiring now is an aberration. Market forces are being torn between both positive local economic news, and negative geopolitical and global economic influences. This will pass because it always does. The greatest error we can make is to act emotionally without employing the critical investment parameters that will make us all succeed in the long run…fundamental, technical, and common sense principles. In challenging times, there may not be great choices to make but there will always be the best choices to make under the circumstances.

By Alan Ellman of TheBlueCollarInvestor.com

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