Random price movements leave us with very little edge when it comes to reading the charts and technical’s. Nevermind fundamental analysis, which is simply impossible to explain a how stock can move violently after a news event. The market is simply designed around accumulation and distribution, seen very clearly on a price and volume chart. Yet, when these buyers and sellers are pulled in each direction by the market there is an uneasy feeling about participating.
The erratic behavior in price action shows up in the extreme volatility readings, the VIX indicator is over 20 and building momentum. For the Dow Industrial’s, just about everyday was a triple digit move in January. Stocks that deserved to go higher plummeted, and some stocks bolted higher unexpectedly. This creates doubt in the minds of investors and traders.
During this time, the implied correlation index, or the $ICJ soared higher, as one would expect. In addition, we saw increases in the skew index as the ‘smart money’ was buying heavily into out of the money puts, looking for some sort of enormous pullback.
There are a few options trading strategies to help dampen the volatility we have seen of late, especially in January. Buying protection against long stocks is always a great way to hedge market risk. Professional market players always have some protection on, this would be considered insurance against a downturn. The expectation is this insurance goes down to a low value or even zero, a cost of protecting a long group of stocks that should exceed the losses of buying protection. The insurance can be done via shorting indices, shorting futures or just buying straight market puts or spreads.
Some will say they prefer to buy volatility, but that requires a cash outlay and most really do not know what they are buying here, so if you want to protect a portfolio I would just suggest finding an index and buying these, especially if the VIX is lower and volatility pricing is cheap.
Selling premium against long stock, or covered call writing is an excellent way to immediately lock in some gains. This is a simple exercise: if you own 300 shares of Boeing stock, currently 158 a share, you would select a strike price out into the future and SELL 3 of those call options. You keep the premium and hold the stock until expiration (or maybe called before if the stock is above the strike) and you get to sit and wait for the time to expire.
When you are in a winning position in a stock and implement a covered call strategy it is one of the best and highest probability wins. I often see investors do this regularly with stocks creating their own additional dividend! Think about this: You own 500 shares of IBM stock, it’s 160. Looking out toward April we see the 170 call selling at 1.63 (as of 2/20/15). We can sell 5 of these calls, pocket $815 and wait for two months. If the stock stays under 170 by April expiration then we keep the premium AND our stock.
So, we have made $815 for two months (not including any gains/losses in the stock which is an annualized return of approximately 6% (815 X 6, divided by total stock investment of 80K) not including commissions. This is in addition to any appreciation of the stock or dividends paid out by the company! Now, of course you can be called away, but only above 170 on the stock price. Would you be disappointed with another 10 point gain on your 500 shares?
In summary, we have shown a couple of options trading strategies to protect a portfolio against some adverse moves, even violent ones. There is no exact way to eliminate all market risk (can be close), but we can certainly dampen the volatility before a selling shower hits.
Bob Lang, Senior Market Strategist and trades various option trading newsletter Explosive Options. Check out the updated site.