August 14, 2014
Just finished listening to a debate on CNBC relating to the likelihood of a 10% market correction even though this market is generally considered healthy and probably is headed higher.
Lets leave out Vlad Putin , third world debt, surprise terrorist attacks etc, all of which have the capability of triggering a temporary selloff.
Lets say you have $ 97,400 of IRA money invested in the market ETF , ” SPY,” , ( 500 shares ) and you are nervous because of all that correction talk.
Leaving all other equity and ETFs aside, ( assuming all boats go out with the tide ), the two obvious paths to follow are
1 ) You can bail out of SPY , ( $ 194.84 per share ) and invest the proceeds in money market, CDs or other instruments yielding probably less than 1% and thereby insure your capital will shrink in purchasing power.
2 ) You can leave your investment alone assuming the market will come back if it sells off. ( the wait can be 10 years or longer )
3) You can establish a tighter than normal ” stop loss ” that will allow your investment to run and get you out reasonably intact if there is a sudden drop.
If you follow any of the above three courses you will be considered an ” investor ”
But, what would you be called if you followed the path outlined below ?
Here’s the deal.
You sell your 500 shares of SPY and allow your broker to segregate $87,500 of the sale proceeds from your control to protect his firm against what you intend to do next.
You sell ( write ) 5 Put contracts on SPY….namely the December expiry $175 contract. ( 5 Puts = 500 shares ). This gives your counter party the right to assign 500 shares of SPY to you at a price of $175 if by December 19 the price of SPY is $175 or less. ( todays price $ 194.84 ). He hopes that by December 19 the price of SPY is ….say $156 per share….a 20% correction. He would buy 500 shares somewhere at $156 and turn around and sell them to you at the $175 price you agreed to. ( you assumed the correction would not be more than 10% ) and you liked the premium you received for selling a Put at that level……$1,225 ( $2.45 for each of the 500 shares ). You were paid that money upfront when your broker simultaneously closed down your access to $87,500 of your money to make certain you had sufficient funds to buy the 500 shares of SPY at $175 if they get assigned..
The day the Put contract expires, December 19, ( providing you didn’t buy back the contract in the interim ) you will either recognize the gain of $1,225 ( because the Put expired worthless ), or your broker will use the $87,500 set aside, to purchase the 500 SPY assigned to your account. In any case , you keep the $1,225.
Let’s say you get assigned the shares. You now have two possible paths. You can sell the 500 SPY and recognize a loss of $ 9,500 or, you can sit with the shares hoping that the market rebounds to at least $175 or beyond. If you hold tight you will collect a $3.75 annual dividend per share ( 1.8% per annum ). Of course there is nothing to say the market won’t continue to head even lower at that point.
But, if the correction comes , and its only 10%, you will look brilliant for having been paid $1,225 to have bought SPY at $175 per share instead of sitting with it at $194.84. and taking the ride to $175.
One thing is for sure, I’d rather own SPY at $175 than at $194.84.
If you told anyone about this transaction you would probably be considered a ” speculator ” .. at best , because you ” play ” with options,.
I don’t agree with this characterization. Why buy SPY today @ $195 if you think there is any chance of a correction. Why not get paid to buy SPY now but at the price you wish it was today ?
Over the years, I have lost a LOT of money writing Put options on individual stocks. My most recent loss was on J.P. Morgan, delivered to me at $52.50 per share. And then , they reduced the dividend. So there I sat with 500 shares well above the market and no way out for years and years. That is the danger of writing ( selling ) Put (assignment ) options on individual stocks. I think writing an option on a share that combines the top 500 stocks in the US stock market is far less risky on a relative basis.
The person to whom you sold the Put has the possibility of a much larger return on his $1,225 investment, But, his risk of failure is greater also. As soon as you inject December 19 into the risk equation, the odds change in your favor. Its one thing to say a bridge will collapse because you think its unsound. But, its quite another thing to ” bet ” on the collapse by December 19…..unless you intend to intervene or know something not in common knowledge that tilts the odds irreversibly in your favor.
It all boils down to your appetite for risk…. and your psyche. There ARE alternatives to low interest rates. Is it better to be totally ” safe ” ie. receive money market type interest rates that don’t even come close to covering mild inflation, ….a sure loser…..OR, risk being accused of ” playing ” with options for being paid $1,225 ( 4.2 % per annum) up front to buy SPY at a price 10% lower than today’s price !
What do you think ?
Richard Maurice Gore