We are finally over our watch levels, now let’s see if they hold!
Our watch levels for our next set of bullish market plays have been Dow 9,600, S&P 1,030, Nasdaq 2,038, NYSE 6,700 and Russell 577 and now they form a floor we will be able to watch so we’ll know when to be worried that the rally is running out of steam. Only 2 33% (off the top) levels remain and that’s 1,056 on the S&P and 6,959 on the NYSE and we will be officially raising our mid-point from Dow 8,650 to 9,500, which will make 9,000 our new expected floor on the Dow and that means we should be buying here! There’s no point in having watch levels if we don’t act on them and the best was to work our way into new bullish positions is with our famous Buy/Write Strategy – simply the best way to initiate new stock positions for the average investor.
Given that it is now much less likely that the market drops more than 10% from here, picking up stocks for 20% below their current price is a sensible way to begin building some new positions. By picking value names and concentrating on plays that give us much better prices than the ones paid by the average retail investor using very basic option strategies we can stay ahead of the game and buy with some comfort. This strategy, which we call a "buy/write", as we buy the stock and write options against it, is one of our most effective tools for dealing with a uncertain markets.
Not only does the Buy/Write Strategy give you an initial discount on your ownership of a stock, but you can use variations on this strategy to give yourself another 10-20% three to four times a year! If you have a retirement account that allows you to write covered calls and sell puts in it (check with your broker, of course, some do, some don’t) why wouldn’t you want to generate an additional discount off the stocks you plan to hold long-term? If you plan on accumulating a stock over time, why on earth would you even consider paying "retail" when we can teach you a simple method that can put money in your pocket?
We no longer have the absolute bargains we used to have but there are still plenty of stocks that are trading at 50% off their highs and, if this rally is going to continue, that spells huge opportunity for us. It is always important to select stocks that have strong underlying fundamentals which we intend to hold long-term.
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. I will give a few examples here and, if you sign up for our newsletter service, The PSW Report, using this link, you will be able to read more about this strategy as we follow it along and build new positions through the end of the year but new trades and our new Buy List will only be available with Basic and Premium Memberships. How does this strategy work? It’s very simple and here are a couple of examples using stocks you probably want anyway:
Let’s say, for our first example, we want to buy BAC at $17.22. If our goal is to buy 200 shares we buy instead 100 shares and also sell the Jan $15 puts for $1.30. Additionally, we sell the Jan $17.50 calls for $2.10. The two sold contracts reduce our net basis to just $13.82 and we have taken on two obligations. The call we sold, obligates us to sell our stock for $17.50 on Jan 15th (option expiration day) IF the price of BAC closes above $17.50 on Jan 15th. We have sold someone an OPTION TO BUY our stock for $17.50 on that date, which they will exercise if the price of BAC is above $17.50. Whether they exercise the options we sold or not, we keep the $2.10 they paid us and they would have to give us another $17.50 in cash to complete the contract. Our second obligation is on the put we sold. By accepting money for the put, we have agreed that, in exchange for $1.65, the put holder can "put" the stock to us (force us to buy it from them) for $15. They can do this at ANY time prior to Jan 15th, no matter what the price of the stock but, of course, if the stock stays over $15, there would be no point for them to put it to us at a discount.
So, if BAC finishes the expiration period above $17.50, we will have our 100 shares called away at $17.50 and our put holder will expire worthless. The profit on that trade would be $3.68 per share against our net outlay of $13.82, a 26% profit in 4 months. Should, on the other hand, the stock be put to us below $15, then our caller would be expiring worthless but we will be forced to pay $15 for 100 additional shares of BAC, regardless of what price it’s currently trading at. With our original 100 shares at net $13.82 and 100 more at $15, our new net basis would be $14.41 – which is 16.3% lower than the current price.
This is a simple example over a short period. The key is to pick stocks that are:
- Trading near lows and are undervalued
- Fairly volatile
- NOT likely to go bankrupt
- 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 BAC is a relatively good deal at $17.22 – why not commit to buying it for $14.41 instead? Also, to take a more advanced view, the trade doesn’t end on Jan 15th. You have a $14.41 basis in Bank of America, who may one day begin paying dividends again. If they do, that’s another 3% return on your money. Additionally, you can continue to sell calls against the stock. Let’s say BAC falls all the way to $12 (down 30%) and you are stuck in it at $14.41. You can still sell $15 calls for about .25 a month. While this is not absolute, I can see that the Oct $20 calls, which are $2.78 out of the money are selling for .25 so it’s not a big stretch to assume we can pick up a quarter for the $15s if BAC dips to $12.
With a .25 lower basis of $14.16 after selling another call, we don’t mind being called away at $15 (up 6%) and, if we sell just .25 12 times during the year, that’s an ADDITIONAL $3 return per share or a 21% return on our $14.41 investment while we wait (profitably) for BAC to come back in value.
Another application of this strategy is to hedge against riskier trades like biotech. We like PARD but they have trial results coming up in the next few months and they could go up or down 50% on any given night. Buying that stock for $7.77 and selling the Jan, 2011 $10 calls for $3.30 and the Dec 2010 $5 puts for $1.60 puts us into that stock for just $2.87 out of pocket. That’s a 63% discount on the stock and, if we are called away at $10 on Jan 21st, 2011, it will be with a 248% proft. If the study goes poorly and PARD drops like a rock and is below $5 on Dec 18th, 2010, we would be obligated to buy another round at $5, which would give us an average entry of $3.94, which is 49% LESS than it’s trading for today.
How often does someone come to you with a way to buy a stock at a 49% discount that can pay you a 200% profit if it simply holds its price for 15 months?
We identify dozens of trades like this every single week over at Philstockworld. While you can do this with any stock, we are able to identify unique option opportunities that make certain stocks a little more favorable than others and we can teach you to do it too. It’s not just Biotechs that can give you such outrageously good risk/reward profiles, here’s a way to play C long term:
If you think C is too big to fail and will actually survive the next 15 months, you can buy that stock for $4.75 and sell the Jan, 2011 $5 puts and calls for a total of $2.90. That very simply is a net entry of $1.85 and a profit of 170% if called away in 15 months. Should C remain below $5 through Jan 21st, 2011, then another round of shares will be put to you at $5 and your average entry would be $3.43, a 27.8% discount off the current price.
At this point you may be saying to yourself: "If I can learn to buy all my stocks for 27.8% discounts, I bet I can improve my trading performance." That’s exactly what hedge funds do and there’s no reason you can’t learn to do it as well! The great thing is – there is always an option.
What if the stock goes down - you may wonder? As we mentioned, if BAC falls to $12 on option expiration day, you are still (assuming you make no adjustment) obligated to buy another round at $15. Your average entry would be $14.41 but, guess what? You can do it all over again and give yourself another 20% discount, dropping your basis to $11.50 or lower. Of course you may end up with 400 shares at $11.50 but, since you started out willing to buy 200 shares at $14.41 ($2,882) and you ended up with 400 shares at $11.50 ($4,600) with the stock at, say, $10 ($4,000) you are down just $600 (15%), not bad for a stock that fell 42% from $17.22 since you first bought it!
We have featured over 100 of these plays in past months in member chat and on our Buy List 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!) a long-term 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!
Again, if you sign up for our newsletter service, The PSW Report, using this link, we will be featuring some of these trades weekly and if you want live Alerts of Trade Ideas as we identify them or you want to view our daily trading chat live, then check out a Basic or Premium Membership – It’s a good time to stop watching other people make money and get into the game.