| After
beginning a run up in July 2006, the market
sold off beginning in late February 2007
and bottomed in in March. That advance saw
a gain of approximately 2,000 points in
the Dow Jones Industrial Averages (INDU).
Since that March bottom we're up roughly
2,000 points on the Dow - again - wthout
a major correction yet.
One, I'm expecting a correction
of 700 points or more. Like the one in February/March.
I won't go into the arcana of retracement
theory, but all markets need to correct
from time to time in order to balance long-
and short-term selling and buying pressures.
There was a short-term correction in June
of about 440 points, which bled some steam
off no doubt, but no one who (like me) believes
in retracements thinks it was enough of
a correction. I suspect more correction
is needed, and it came too soon after the
March correction. The following chart illustrates
recent corrections:
The second concern is that
the market is toppy and a new bear market
is looming. There isn't room here to talk
about the problems with our economy, but
a bull market depends for fuel on the overall
economy. The main issue
now (not the only one) is the housing market.
Americans on the whole don't save; our houses
are our piggy banks. Approximately 75% of
the increases in our Gross Domestic Product
in each of the last few years, according
to Economist John Mauldin, came from home
equity loans. That was quite the spending
spree. Now with much tighter lending standards,
that source of spending money is much reduced,
and corporate spending is not taking up
the
slack.
Note also that we've been
in a bull market since very early 2003,
over 4-1/2 years. From 7,416 to 14,000 points
for the INDU, it has been a nice run. Now,
that is a long time for a bull market. No
matter what your view about the market at
this instant, I think you will agree that
none of them lasts forever. Trust me, we
have not broken through to a new paradigm
in human nature in which bear markets have
been eliminated.
A lot of players in this
game, including huge ones, are riding the
bull rails as long as possible. But everyone
knows the end of the bull ride is coming.
A convincing spark is all that it will take
to ignite a new bear market. I think it
will happen when a slate of poor earnings
are released, although a hike in the FedFunds
rate could do it. More to the point, I wonder:
where is the economic energy to take the
market higher.
This bull market will end,
also. But when?
I don't know when a correction
is coming, much less the end of the bull
market. Sentiment indicators like put/call
ratios, the VIX and VXN and similar indicators
are of little help in calling market tops,
though very helpful in calling bottoms.
The strength of this market through what
normally are the summer doldrums has been
a surprise. Maybe the market is headed to
15,000, even - I'm hearing that sort of
thing, which is scary.
Still, the fact that we
don't know the "date" the bull
ends doesn't mean that we should ignore
the possibility, and perhaps take it into
account in writing covered calls.
The interesting thing is
that, if a correction begins soon, we will
not know immediately whether it is in fact
just a correction or the initiation of a
new bear market. I was convinced the March
sell-off was only a retracement and that
is what I told CallWriter members. I was
so convinced because 1) the housing market
blues weren't quite so blue then, and 2)
the market was due for a good retracement,
technically speaking. I could have been
surprised, of course.
We appear about due for
another correction. In fact, it may have
begun today, down 134 points on the INDU
as I type this mid-afternoon.
Reaction to the March sell-off
was very panicky. A lot of people sold the
underlyingstocks in covered call trades
at a loss and got out. Holding those stocks
a little longer would have seen them (or
at least the high-quality stocks) recover
just fine not long after the sell-off began
- the reason that call writing should be
confined to the best companies. In fact,
some really strong companies hardly sold
off at all.
Some writers even abandoned
covered writing as being too unpredictable.
But there is another strategy that should
be considered if a correction comes, or
is here now.
Before discussing the protective
put strategy below, let's look quickly at
a couple of other options.
Rolling.
The easiest way to protect the trade is
to simply roll the calls down, or down and
out. This means to buy back the short calls
and sell calls with a lower strike price.
Thus if you buy the stock at $20 and write
the 20 Call for $1.00, if a pullback in
the stock has you concerned, you could buy
back the short 20 Calls and sell 17.5 Calls.
This is only sensible if there is lots of
time value in the ITM calls and you don't
wait too long to roll down. Rolling out
a month also adds more premium. The key
of course, is whether the roll improves
your position, if called out. If it doesn't,
then do not consider rolling. End of story.
Closing.
You could also close, but I never close
a trade at a loss unless 1) I am convinced
that a much bigger loss is coming if I do
not, and 2) closing seems like a better
alternative than buying puts, rolling down
or taking other action. If a stock seems
in real trouble (it's prospects seem to
have materially deteroriated), I may close.
However, even in this circumstance, buying
the right protective put can offer great
protection and make it possible to keep
pulling call income out of the stock.
Maybe it is a macho thing.
But the entire reason for confining our
call writing to the best companies is that
we wind up with the strongest, most reliable
and resilient stocks. Therefore, stopping
out of a trade at a loss is something I
do very seldom. Now let's talk about a strategy
that has very little risk, done right.
Protective Puts.
Everyone knows that a protective put can
be purchased on the underlying stock in
a covered call. The problem with buying
a current-month put is that the put premium,
if close enough to the money to be truly
protective, will consume most of the call
premium. Not good. Plus, any long put still
leaves an exposure gap.
But consider buying a longer-term
put. For example, if you have written the
current-month JUL calls and the stock is
pulling back, consider buying a NOV, DEC
or JAN put. Sure, it will cost more than
the call premium received, but that does
not matter. The put protects the stock (up
to the put's strike price) all the way through
put expiration. This frees up the writer
to keep writing calls every month until
the put expires. Even if the stock later
moves up in price, the put still will offer
some protection. The put also eliminates
the concern that the stock is dropping.
Keep writing calls. If called out, buy the
stock again and keep writing, because the
protective put ultimately makes the stock
someone else's problem.
In addition to protecting
the stock, as the stock continues to fall
the put will become more valuable. Assume
that the stock pulls back and you believe
it has bottomed. Perhaps the stock has formed
a new base, or it went down
with a market correction and the market
is coming back - whatever. You can sell
the now-more-valuable put at a profit. Once
the stock recovers its price, the put will
be back roughly to the value at which you
bought it, but I don't hesitate to sell
the put once I think the danger is over
and the stock is recovering. After all,
trading the options can be a major part
of the return from covered call trades.
It is key not to overpay
for the long put. In our example above (buy
stock for $20, write 20C for $1.00), I would
not pay more than $3.00 to $3.50 for the
longer-term 17.50 Put once the stock began
dropping. In fact, sometimes when I close
the trade it is because protective puts
are ridiculously priced. I will not really
pay more than about 3-4x the call premium.
The multi-month protective put works best
where the puts are cheap in relation to
current-month premium. There is little point
to buying a multi-month protective put six
months out if the premium is 6x the call
premium! How likely would it be to recoup
that put premium once implied volatility
diminishes and call premiums go back to
a more normal level?
I buy puts at least three
expiration months out, because I want some
operating room, not being forced to make
a decision too soon. If the put's remaining
life is too short and the stock has not
made a recovery by put expiration, it pretty
much forces you to exercise the put - but
you have had little chance to sell calls
in the meantime, which is one of the reason
to buy puts in the first place.
Of course, at some point
during the stock's pullback we would buy
back the short calls, or let them expire
worthless if close to expiration. Once the
stock recovers its price, write more calls.
If it doesn't recover, of course, then wait
for the stock to establish a new trading
range before writing more calls. Or exercise
the put and put the trade behind you.
That is the beauty of the
multi-month protective put. It puts you
in the driver's seat.
So if the next correction
comes, onsider buying multi-month protective
puts. If the market dips for a few days
or a couple of weeks and comes back, you
can sell the multi-month put for pretty
much what you paid. If there is a
real correction, sell the put at a big profit
once confident the correction is over (close
the call, too) - before the stock recovers
all the pullback. Or exercise the put and
don't look back. It's your choice when the
trade is protected.
If you are supremely confident
that a market selling-off is just a temporary
correction, you need take no action. At
this point in the bull market, though, I'm
not sure how one could be totally confident
in that assessment. I wouldn't be. But even
if you were, doesn't the long put play simply
provide another source of return?
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