Context is everything. Since the beginning of 2007, Citigroup has dropped approximately 50%, Bear Stearns has dropped approximately 55%, Under Armour and Macy’s are down approximately 40%, the Bank Index is down over 30% and yet the S&P 500 is down about 7%.
When you read about the calamity of recent stock market declines, keep in mind that despite these massive drops in specific stocks, the overall market has held up relatively well. Although many may attribute this relative strength to the increased weighting of energy companies in the S&P 500 (on the back of higher oil prices), the the result remains the same.
In the midst of negative reports and declining stock prices, sometimes it’s comforting to console oneself by seeing how others are doing. For example, the severity of the decline in the Irish stock market over the past few months was such that its collective valuation has been eclipsed by that of IBM this week! The famed Celtic Tiger appears to be endangered as the Irish Stock Exchange dropped over 30% in recent months.
So, as bad as many will purport the situation to be, it can always be worse! More importantly, money can always be made!
When I began trading the stock market, I received a piece of advice that I have never forgotten "You should never make a trading decision based on emotion". We often talk of greed and fear in these articles but we don’t often discuss BOREDOM!.
From the time we are young, most of us hate doing nothing. It’s sooooooo boring! As we grow up, we learn the value of working hard and we are conditioned to believe that the harder we work the better we will do. While this is generally true (just look at how much effort Phil puts in and how well he does!), there is often value to doing nothing!
Most traders feel they need to be clicking buttons every day to make money. Not true! Phil has often espoused the value of his long-term virtual portfolio, which requires very little effort indeed and yet has produced fantastic returns. That philosophy is central to the core approach undertaken by Stock and Option Trades also. In our search for instant gratification, boring long-term trades are generally ignored by most – often to their peril!
In markets like these, the trusty long-term approach allows those with a broader perspective to relax and trust that cycles occur and that the ugly view of today will soon turn into a rosy view in the future.
The reason so many dismiss this long-term approach is it’s B-O-R-I-N-G!
But the greatest investors in the world have proven the value of taking this approach. We believe a considerable fraction of a porfolio should be dedicated to such trades. The shorter term trades are fun and can do extremely well but a solid foundation is needed to build a towering structure. The bottom line is you should not make a trading decision based on boredom. With that background, how can we make money doing nothing?
Notice how the volume picked up considerably over the past few months of volatility and during downtrends
I have stated on numerous occassions that we expected volatility to be higher on a relative basis this year than on many others and it has certainly started out that way. With that background, NYSE Euronext should benefit long-term from higher trading volumes that have not been factored into analyst models.
Let’s assume we were interested in a long-term position, we could purchase the stock and hold it in expectation that it will appreciate from its current level, $72.67 per share. But why bother holding the stock alone when it pays a small dividend of approximately 1% in the hope of it rising at some point. Why not proactively generate income by holding the stock position, effectively paying ourselves a second dividend by employing options.
A covered call strategy enables us to pay ourselves a certain amount over a certain time period. It also means we take less money out of our pockets than simply purchasing a stock and it means agreeing to a certain profit for the duration of the trade. Let’s look at NYSE Euronext (NYX) to learn more.
The stock is trading at $72.67. A short call for January 2009 at strike 80 produces a credit of $9.80. The total cost in the trade is:
Total Cost = $62.87
Consider the following scenario. If the stock ends up at $72.67 in 362 days at January 2009 expiration, the out-of-the-money short call option will expire worthless. That means by forking over $62.87 at the start of the trade, we ended up with $9.80 at the end of the trade. That is equivalent to a return on invested capital of 15%.
But what if the stock dropped?
At expiration, the short call will still expire worthless if the stock is below $80 (the short call strike price). So, if the stock drops all the way to the cost basis, $62.87, we will have lost no money overall. Obviously $9.80 has been lost on the stock, but that has been offset by $9.80 pocketed when the short call expired worthless.
If the stock drops below $62.87, we would be losing money overall. Essentially the short call provides a cushion for a term, during which we can relax in the knowledge that even if the stock drops another $9.80, we will not lose money at expiration. Below that level we would indeed be losing money. As a result, it is imperative to have a good understanding of the fair valuation of the company. Obviously, this is not a smart trade if we believed the stock could end the year anywhere below $62.87.
Let’s now assume the stock rallies to $80 per share. At expiration, the short call will again expire worthless, producing an option profit of $9.80, while the stock will also gain in value from $72.67 to $80, thereby producing a stock gain of $7.37. The total gain produced would be $17.13 per share.
This would still be on a cost basis of $62.87. Hence, a $17.13 per share profit on a capital outlay of $62.87, resulting in a 27% return.
Now what if the stock goes higher? What if the stock went to $100 per share?
Too bad! The $17.13 per share profit is also the maximum profit that can be generated. If the stock is above $80 (the short call strike price) at expiration, the short call will be assigned. This simply means that the trader is obligated to sell stock at $80 per share and will receive the short call credit, $9.80, for so doing. Indeed, any time a short option is assigned, a trader gets to keep the credit received for selling the option in exchange for fulfilling the option contract terms (for a short call this means selling stock at the given strike price).
Unless the trader believes the stock will rise more than $9.80 above $80 (i.e. $89.80), this trade is more attractive than simply holding the stock and hoping it will rise. Most people prefer the ‘hope’ game because they succumb to greed. They argue that if the stock rose to $100 per share, they would have been much better off than placing a short call at strike 80. In fact, they would be an additional $10.20 better off.
There are lots of ways of dealing with this in practice. All have sacrifices and compromises that must be accepted. In fact, the covered call implicity has positive and negative attributes that must be considered prior to trade entry.
The benefit of entering the trade is a cushion exists immediately just in case the stock keeps dropping. In fact, the stock can drop approximately 13% in the example above and the trader is no worse off. However, in exchange for this safety, the trader must be comfortable with a maximum return of 27%. If you want to shoot for higher returns, you could choose higher strike prices, but your cushion will be less because the credit received from higher strike options will be lower.
Obviously, in the example above, the stock only has to rise 10% in a year to make a 27% return on capital. As a result, this trade is very attractive to non-greedy traders! If a trader believed the stock could move beyond $92 (a 27% move from where the stock currently resides), then this is not an attractive trade, but the trader would have to give up the cushion and hope the stock moves to produce the return.
The trade on NYX is but one example of many that could have been chosen. Ultimately, it is a good idea to choose a stock with which you are familiar. Whether a covered call is chosen or not is up to you. In this market, choose wisely!
Take care out there!
OptionSage
