If this market hasn’t convinced you that buy and hold is a gamble - I don’t know what will.
Holding any stock for more than a day has been a sure recipe for heartache (sometimes just an hour will do it) but we have been having a good time, during our member sessions, bottom fishing and concentrating on plays that give us much better prices than the ones paid by the average retail investor.
There are, of course, many, many stocks trading at multi-year lows and it’s still important to select ones that have strong underlying fundamentals that we actually don’t mind holding long-term but, as long as you are willing to own 200 shares of a stock – this system can reliably give you a 10-20% discount off the current market price. It’s simple, easy to follow and is ideal for trading in a volatile market.
Of course when we buy any stock or long-term option position, we should be scaling in. In other words – we don’t assume our timing is perfect and we enter a position in stages. In our strategy section I discuss the 20% entries and the various rules for that so I won’t get into it here but, effectively, selling puts and calls against a stock entry is a way of automatically following the scaling system without having to monitor your position that closely.
Let’s say, for example, we want to buy C at $10.80. If our goal is to buy 200 shares we buy instead 100 shares and also sell the Dec $10 put for $1.15. Additionally, we sell the Dec $10 call for $2.05. The two sold contracts reduce our net basis to just $7.60 and we have taken on two obligations. The call we sold, obligates us to sell our stock for $10 on Dec 19th IF the price of C closes above $10 on Dec 19th. Our second obligation is on the put we sold. By accepting money for the put, we have agreed that the put holder can "put" the stock to us for $10. They can do this at any time prior to Dec 20th, no matter what the price of the stock but, of course, if the stock stays over $10, there would be no point for them to put it to us at a discount.
So, if C finishes the expiration period above $10, we will have our 100 shares called away at $20 and our put holder will expire worthless. The profit on that trade would be $2.40 per share against our net outlay of $7.60, a 31% profit in 6 weeks. Should, on the other hand, the stock be put to us below $10, then our caller would be expiring worthless but we will be forced to pay $10 for 100 additional shares of C, regardless of what price it’s currently trading at. With our original 100 shares at $7.60 and 100 more at $10, our new net basis would be $8.80 – which is 18.5% lower than the current price.
This is a simple example over a single month. The key is to pick stocks that are:
- Trading near lows
- Fairly volatile
- NOT likely to go bankrupt/Undervalued
- Either pay dividends or have good growth
- Have a clear path of continuing contracts to write
- You don’t mind owning long-term
In short, if you think C is near a bottom at $10.80 – why not commit to buying it for $8.80 instead? Also, to take a more advanced view, the trade doesn’t end on Dec 19th. You have a $8.80 basis in CitiGroup, who may or may not continue to pay a .64 dividend. If they do, that’s a 7.25% return on your money. Additionally, you can continue to sell calls against the stock. Let’s say C falls all the way to $5 and you are stuck in it at $8.80. You can still sell $10 calls for .10 or more. While this is not absolute, I can see that the Dec $20 calls, which are $9.20 out of the money are selling for .15 so it’s not a big stretch to assume we can pick up a dime for the $10s if C dips to $5.
With a basis of $8.80, we don’t mind being called away at $10 and, if we sell just .10 12 times during the year, that’s an ADDITIONAL $1.20 return per share or a 13.6% return on our $8.80 investment while we wait (profitably) for C to come back in value.
Also, these plays are not static at all! Edro had a DRYS play he initiated this month that we adjusted during member chat today. He bought the stock for $16.10, sold the $15 calls for $2.61 and sold the $15 puts for $1.98. That made his net basis $11.51 (a 28% discount off the price at the time!) but, with DRYS now at $10.34, it seems like a virtual certainty that another round of the stock will be put to him at $15. That would give him an average cost basis of $13.26, almost 30% more than the current price. This is pretty much a worst-case scenario on a stock that plunged 35% since he bought it.
The great thing is – there is always an option – In this case, there is no point in Edro having the stock put to him for $15. Using today’s closing prices (we adjusted it mid-day) the Nov $15 puts he sold are now $5.20 but he can roll the puts to the Dec $12.50 puts, which are $4.25 for .95. So, rather than taking $15 out of pocket to buy another round of DRYS on Nov 21st, he can put off his forced purchase to Dec 19th AND lower the price to $12.50 by adding .95 to his current basis of $11.51. Now, if the additional shares are put to him for $12.50, his average cost would be $12.48, an additional .78 discount off his November basis, even after spending the additional 95 cents.
Of course, that’s still the worst-case, if the stock is put to him in December. There’s always January! Meanwhile, Dec $12.50 calls can be sold for $1.97 at the moment but he needs to wait for the Nov calls he sold to expire. Let’s say he gets $1.50 for those – that lowers his basis on the first round (assuming he spent the .95 for the roll) down to $10.98. That means that getting called away at $12.50 is a slightly less sexy 14% profit, but it sure beats a loss! Now if the additional shares are put to him at $12.50, the Dec net cost basis would be $11.74.
This is the strategy we use with something we DON’T want to own (and, after dropping 35%, you can see why our opinion of DRYS may have changed), but I want to keep in perspective that if Edro loved DRYS and was happy with his Nov basis of $13.26, despite the market’s current price of $10.24, then he could simply sell the Dec $15 calls for $1.25, which by itself would lower his basis to $12.01 and would net a 25% profit if called away on Dec 21st. If Edro can collect just $1 per month in premium sales for the next 12 months, his ROI would be 100% – that’s why I selected DRYS in the first place: It’s undervalued, it’s not likely to go bankrupt, they are trading near lows, they are volatile enough to reliably give us good premiums to sell month after month and I certainly don’t mind owning them long-term.
We have featured over 100 of these plays in the past month in member chat and, in this scary and volatile market, they are one of the best ways for you to capitalize on the volatility while hedging the risk on your upside plays and positioning yourself for a (we hope!) recovery. If the market does end up flatlining however, we are positioning ourselves in stocks at good prices that can generate a very reasonable monthly income – which will keep us flexible in a challenging market!