Putting Stock Market Volatility in Your Favor
Earlier this week, my colleague Robert Rapier discussed why stock market volatility spikes during the last week of June. That’s because all index exchange-traded funds (ETFs) must re-balance their portfolios to be in sync with the exact weighting of the index.
The S&P 500 Index has the most ETF money tracking it, which means large-cap stocks tend to be more affected by this re-balancing than smaller stocks. Also, the S&P is “cap-weighted.” That means bigger stocks comprise a proportionately larger portion of the index.
For example, the three largest stocks in the S&P 500 – Microsoft (NSDQ: MSFT), Apple (NSDQ: AAPL), and Amazon (NSDQ: AMZN) – account for 10% of its value. However, they comprise less than 1% of the total number of holdings.
The day after Robert’s article ran, Scott Chan explained how trading options can actually improve your odds of beating the market.
With a properly designed options strategy, you can keep your losses small while letting your winners magnify in value.
The “dirty little secret” of options trading is that most options expire worthless. That’s because speculators will buy options that only make money if the underlying stock makes a big move in a short period of time.
Today, I will tie those two articles together by providing an example of how you can use increased volatility and options trading to your advantage. Here’s how you do it.
Three Step Approach
First, you need to identify a stock that has been particularly volatile lately. The more volatile a stock, the larger the premium an options seller can demand from the buyer.
Second, you have to decide if you will sell or buy an option to open your trade. Now, I’m going to let you in on another secret about options trading. Since most options expire worthless, you can make a lot of money selling options.
Third, you must choose between selling a call or put option to open your trade. A call option increases in value when the price of the underlying stock goes up. A put option gains value when the price of the underlying stock drops.
To make that final decision, I’ll share one more secret of the options trading business with you. Most investors are eternal optimists. They believe the stock market will always go up. Consequently, they don’t pay as much attention to the downside.
For that reason, selling a put option to open your trade puts the odds of success most strongly in your favor. That may sound like a risky thing to do, but it’s actually one of the most reliable ways to earn double-digit annual returns in the stock market.
You may not make as much profit on an individual trade as you might buying call options. But since your success rate is higher, you can make more money over time.
That said, this type of trade is not without risk. If you sell a put on a stock and it plunges in value, you may end up having to buy it at a higher price than where it is currently trading.
However, if you have done your homework, you should be okay. Only sell put options against stocks with strong fundamentals. Good stocks don’t stay down very long.
Going Against the Herd
I’ll reveal yet another stock market secret. Most investors tend to extrapolate a stock’s recent direction indefinitely into the future. For that reason, stocks that have fallen hard recently tend to be viewed as riskier than stocks that have run up in value.
Six months ago, stock market analysts were predicting shares of Tesla (NSDQ: TSLA) would soon rise above $400. That was when TSLA was trading a little below its all-time high price at $350. Today, it can be bought for around $225; that’s a loss of 35%.
Conversely, you couldn’t find many investors willing to buy Xerox (NYSE: XRX) at the start of this year when its share price dipped below $20. Now priced at $35, you could have bagged a 75% profit in less than six months if you had the guts to go against the herd.
Speaking of herd mentality, the health care industry has been getting a lot of media attention lately, most of it bad. That’s due in part to presidential candidate Bernie Sanders promoting his “Medicare for All” plan, which would severely limit profits for most medical companies.
In particular, drug manufacturer Bristol-Myers Squibb (NYSE: BMY) has taken a beating. Since cresting above $62 on October 1, BMY has fallen to $45. That’s a decline of 27% in just nine months.
A few days ago, you could have sold a put option on BMY that expires in three months at a strike price of $43 for a premium of 50 cents, or $50 per contract (one contract is based on 100 shares of stock). You get to keep the $50, regardless of how BMY trades after that.
Either Way, You Win
If BMY never drops below $43 by September 20, the contract expires worthless. Congratulations, you just made $50 for doing almost nothing! But what if BMY does fall below $43 before your option expires?
For that to happen, BMY would have to drop another 8% from where it is now. I don’t think that is likely, especially if its proposed acquisition of immunotherapy developer Celgene (NSDQ: CELG) gains regulatory approval.
However, if BMY does fall below $43 before expiration, you would have to buy the stock at that price. That’s the bad news. The good news? If that happens, you’ll own BMY at a share price that equates to about nine times forward earnings. That’s cheap.
Also, as long as you own those shares, you are entitled to receive BMY’s dividend that would equate to a 3.5% annual yield at that price. That income is in addition to the options premium you received when you opened the contract.
When managed correctly, this strategy produces a steady stream of income that far exceeds what you can earn from bonds. Too good to be true?
Yes, if you don’t know what you’re doing. But I know someone who made 49 trades of this sort last year… and made money on every single one of them!
I can’t divulge the details of that trading strategy here, but I can tell you where you can find them. My colleague is lifting the veil on this proven approach, but only for a limited time. Click here to learn more.