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A “Conservative” Options Strategy for 2014:
What’s in store for 2014? Most companies seem to be doing pretty well, although the market’s P/E of 17 is a little higher than the historical average. Warren Buffett recently said that he felt it was fairly valued. Thirteen analysts surveyed by Forbes projected an average 2014 gain of just over 5% while two expected a loss of about 2%, as we discussed a couple of weeks ago. With interest rates so dreadfully low, there are not many places to put your money except in the stock market. CD’s are yielding less than 1%. Bonds are scary to buy because when interest rates inevitably rise, bond prices will collapse. The Fed’s QE program is surely propping up the market, and some tapering will likely to take place in 2014. This week’s market drop was attributed to fears that tapering will come sooner than later.
When all these factors are considered, the best prognosis for 2014 seems to be that there will not be a huge move in the market in either direction. If economic indicators such as employment numbers, corporate profits and consumer spending improve, the market might be pushed higher except that tapering will then become more likely, and that possibility will push the market lower. The two might offset one another.
This kind of a market is ideal for a strategy of multiple calendar spreads, of course, the kind that we advocate at Terry’s Tips. One portfolio I will set up for next year will use a Jan-16 at-the-money straddle as the long side (buying both a put and a call at the 180 strike price). Against those positions we will sell out-of-the-money monthly puts and calls which have a month of remaining life. The straddle will cost about $36 and in one year, will fall to about $24 if the stock doesn’t move very much (if it does move a lot in either direction, the straddle will gain in value and may be worth more than $24 in one year). Since the average monthly decay of the straddle is about $1 per month, that is how much monthly premium needs to be collected to break even on theta. I would like to provide for a greater move on the downside just in case that tapering fears prevail (I do not expect that euphoria will propel the market unusually higher, but tapering fears might push it down quite a bit at some point). By selling puts which are further out of the money, we would enjoy more downside protection.
Here is the risk profile graph for my proposed portfolio with 3 straddles (portfolio value $10,000), selling out-of-the-money January-14 puts and calls. Over most of the curve there is a gain approaching 4% for the first month (a five-week period ending January 19, 2014). Probably a 3% gain would be a better expectation for a typical month. A gain over these 5 weeks should come about if SPY falls by $8 or less or moves higher by $5 or less. This seems like a fairly generous range.
For those of you who are not familiar with these risk profile graphs (generated by thinkorswim’s free software), the P/L Day column shows the gain or loss expected if the stock were to close on January 19, 2014 at the price listed in the Stk Price column, or you can estimate the gain or loss by looking at the graph line over the various possible stock prices. I personally feel comfortable owning SPY positions which will make money each month over such a broad range of possible stock prices, and there is the possibility of changing that break-even range with mid-month adjustments should the market move more than moderately in either direction.
The word “conservative” is usually not used as an adjective in front of “options strategy,” but I believe this is a fair use of the word for this actual portfolio I will carry out at Terry’s Tips for my paying subscribers to follow if they wish (or have trades automatically executed for them in their accounts through the Auto-Trade program at thinkorswim).
There aren’t many ways that you can expect to make 3% a month in today’s market environment. This options strategy might be an exception.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
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I look forward to having you on board, and to prospering with you.
Terry
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