- There’s uncertainty and volatility in the markets due to the Brexit, the European economy and an ugly presidential election season.
- The history of the market shows that you can expect bumps up and down forever.
- The economy is strong enough to withstand this noise.
It’s been a rocky summer market… Britain voted to leave the European Union, and an ugly presidential election still lies ahead.
How can you not just stay ahead of the market, but also generate cash?
You need a solid strategy for the rest of 2016. The tactic is simple: Roll puts to generate cash during a market downturn.
Base your strategy for the rest of the year on this tactic, and keep your portfolio healthy.
Trading Through a Downturn
Let’s say you sell an $80 put. The stock goes to $77.50. Your broker screen is flashing red. You feel you’re down on the stock if it’s assigned to you.
This sequence of events—selling a put and watching the share price go down—will happen. Don’t panic.
- If you sold a put with an $80 strike, your real cost basis is not $77.50, if put the shares. It’s lower as you’ve collected premium from the sale of the put.
- If the stock sells off sharply, you have choices to make—all of them with a potentially positive and profitable outcome.
What are these choices?
- Roll strike-to-strike, assuming the share price will quickly rebound.
- Roll to a lower strike price if you have concerns about the movement of the stock. Or if you believe being assigned shares is the equivalent of undergoing a root canal without novocaine.
- Accept shares and sell calls.
- Take a loss.
Remember… There are two goals when rolling: capital preservation and cash generation. Let’s take a closer look at these four possibilities.
Rolling strike-to-strike: If the share price is within 5% of the strike price, consider this approach. And with volatile stocks, you can generate a lot of cash if the stock price is within 10% of the strike price.
You can do this week-to-week as needed. Many people take this approach when they have a short-term focus and want to exit a position without losing money.
Rolling to a lower strike price: This tactic requires a longer-term commitment to a stock, unless the underlying stock is volatile, as in oil-related stocks. I do this when I see a stock trading lower for several weeks or months. I prefer lowering exposure to the stock should it take too long to rebound.
Accepting shares and selling calls: I rarely recommend this. When I do, it’s part of a larger set of recommendations that include rolling or taking a loss.
Accepting shares is appropriate when the stock is trading more than 15% below the share price and/or the put selling premiums from the put you sell when rolling doesn’t generate incremental cash. In this case, accepting shares and selling calls is a superior tactic, as seen by members of my coaching services.
Taking a loss: If you pick stocks correctly and believe that rolling will work over time, you’ll rarely have to consider taking a loss.
When do you decide to take that loss? When the potential gain from moving the capital to support a different position is greater than the loss: The company story changes from positive to negative, or Wall Street investors and traders change their view of the stock in such a way as to make it dead money.
The Coming Months
Assume the market will have bumps up and down forever—that’s based on history. This raises two questions.
- How does a downturn impact my stocks?
- How do I trade through this?
The measure of individual stocks in relation to the movement of the indices is called implied correlation. The higher the number, the more likely an individual stock will trade as an index trades.
Implied correlation was at generational lows before the Chinese yuan devaluation last summer. It fell a few weeks after, spiked again in January, and is falling again.
When you select a stock for your portfolio, just check the chart and see how it has traded against the S&P 500 for the past year and the past three years.
Regardless of what you find when looking at these charts, if you sell calls and the stock heads south, you should do the simple math and roll the call down.
What’s on the horizon?
The economy is walking, not running, due to growing uncertainty over the European economy and the uncertainty created by an amazingly ugly presidential election season. Uncertainty inhibits business capital investment and hiring.
The economy is strong enough to withstand this political noise. Once there’s clarity about the election—I believe there will be by Labor Day—investors will start making decisions about stocks. For example, predictions of a Clinton victory will hit companies exposed to too many employees making minimum wage.
The Fed will sit on its hands due to softening economic data and awareness of the uncertainty in the economy.
You can trade through any of this…
Focus on undervalued stocks with rich call premiums and pockets of strong consumer spending (travel, athletic wear, food. And as always, trade best-in-class stocks.