Our stock options strategies, whether writing covered calls or selling cash-secured puts (the topic on my just published book) requires us to make an overall market assessment before entering any trades. In last week’s article we evaluated bull market scenarios. In this week’s blog we will examine bear market environments. When selling covered calls we would favor in-the-money strikes to gain additional downside protection should share price decline. When selling cash-secured puts, we would favor selling out-of-the money puts (lower than the current market value of the stock). In today’s article I will use the options chain for FaceBook, Inc. to demonstrate the calculations for potential covered call writng and put-selling trades. First the options chain from May, 2014 where I have highlighted a row in pink:
Calls and puts in bear market environments
Facebook options chain
Bear market trade and calculations for covered call writing
We favor in-the-money strikes (ITM) which will generate time value returns that meet our goals along with downside protection of the option profit (different from breakeven). The deeper in-the-money we go, the greater our protection. With FB trading @ $60.84, we will view the $57.50 ITM strike:
Call premium = $5.45
Intrinsic value of the premium = $3.34
Time value of the premium = $2.11
Initial profit = $211/$5750 per contract = 3.7% (the intrinsic value “buys down” our cost basis to the strike price)
Annualized return = 31%
Downside protection of the 3.7% = $3.34/$60.84 = 5.5%
This means that we are guaranteed a 6-week return of 3.7% as long as share value does not decline by more than 5.5% by expiration Friday
Breakeven = $60.84 – $5.45 = $55.39
Bear market trade and calculations for selling cash-secured puts
We favor out-of-the-money strikes which will generate more protection against share decline and less likelihood for share assignment (shares “put” or sold to us). The deeper out-of-the-money we go, the greater our protection. With FB trading @ $60.84, we will view the $57.50 ITM strike. Note that we are using the same strike as for writing calls where the $57.50 strike is considered in-the-money. For selling puts, that same strike is considered out-of-the-money:
• Put premium = $2.13
• Initial profit = $213/$5537 per contract = 3.8% (put premium decreases our cost basis)
• Annualized return = 33%
• Downside protection of the 3.8% = $3.34/$60.84 = 5.5%
• This means that we are guaranteed a 6-week return of 3.8% as long as share value does not decline by more than 5.5% by expiration Friday
• Breakeven = $57.50 – $2.13 = $55.37
Summary
In bear market environments we favor in-the-money call options for covered call writing and out-of-the-money put options when selling cash-secured puts. The returns will be similar when going a like amount in- and out-of-the-money.
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January 9, 2015: Tempe, AZ: 7:00 – 9:00 PM
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Details and registration links to follow.
Market tone
Actions taken by the central banks in Europe, Japan and China have allayed many of the global-economic fears of our markets. Few would argue that our economy continues to expand at a moderate pace. This week’s reports support that position:
The Labor Department reported that 321,000 jobs were created in November, far surpassing the expectation of 228,000
September and October jobs stats were revised upward by 44,000
The unemployment rate remained unchanged at 5.8%
The labor force participation rate also remained steady at 62.8%
Hourly earnings for workers expanded by 0.4%/month, the best pace since June, 2013, causing the Fed to keep a close eye on inflation
The US trade deficit decreased by 0.4% in October, but still wider than anticipated
US worker productivity rose by 2.3% in the 3rd quarter, better than first reported by the Labor Department
In October, construction spending increased by 1.1%, better than the 0,5% expected
Construction spending increased by 3.3% year-over-year
The Fed’s Beige Book confirmed that we have an improving jobs environment
The ISM Non-Manufacturing Index rose to 59.3 in November, well above the 57.5 stat anticipated
The ISM Manufacturing Index came in at 58.7, slightly better than the 58.3 projected by analysts (above 50 reflects expansion)
For the week, the S&P 500 rose by 0.4%, for a year-to-date return of 14%, including dividends.
Summary
IBD: Confirmed uptrend
GMI:6/6- Buy signal since market close of October 27, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Wishing you the best in investing,
Alan (alan@thebluecollarinvestor.com)
www.thebluecollarinvestor.com