2018: Stop Predicting, Start Creating
Posted by Joseph Alkana
2017 was a year for the record books and we have never seen anything like it. And the records keep on coming in early 2018 with stocks around the world still surging. They even passed an incredible milestone as the MSCI World Index has gone 19 straight months without a 5 percent pullback, its longest on record. The U.S. stock market is weighted at nearly 60 percent in the MSCI index and last year was the first year in history that the popular U.S. Benchmark Index S&P 500 went all 12 months without a 3% correction; it also had the fewest 1% daily changes since 1965 and the smallest average daily change since 1964.
This may be why many individual investors expect the bull market to continue and the AAII Sentiment Survey showed optimism jumped to its highest level in seven years.
Investors may be feeling optimistic, cautious, or feeling fully bubblicious entering 2018.
Looking ahead to 2018, when the first five days of a new year are up 2% or more, the full year has been higher 15 out of 15 times. Not only has the full-year return for the S&P 500 been positive in every instance when the index gains at least 2% over the first five trading days of the year, but the average gain has been a very impressive 18.6%. One key point we want to stress is not to expect another smooth ride like we saw in 2017.
Caution is urged however as years that started off with a 2% or greater return after five days have seen an average correction of 11.1% within the year.
Santa left investors a present early in 2018. The so-called “Santa Claus rally” — a period that spans the final five days of a year and the first two days of the new year — came to Wall Street this year. And that bodes well for stocks the rest of the month and the full year.
Options Advantage: Let’s look at how investors can manage their risk using stocks alone and also using options.
The investor is bullish on the stock and/or the equity market as a whole.
This 1st strategy simply consists of buying shares of the underlying stock. The purchase price sets the cost basis, and the exit price establishes whether there is a net profit or loss on the asset. No gain or loss is final until the stock is actually sold. (However, once received, dividend income of course belongs to the stockowner.)
Some buyers are bullish in the long term, while others act in expectation of short-term gains. It is the investor's decision whether to buy and hold indefinitely, or to trade in and out in hopes of a quick profit.
If an investor is bullish in the longer run but very concerned about a near-term correction, there may be other, more suitable alternatives than a standalone long stock strategy.
Get Married aka Protective Put aka ‘Married Put’
A long put option added to long stock helps to maintain the value of the underlying asset. The choice of strike prices determines where the downside protection 'kicks in’. If the stock stays strong, the investor still gets the benefit of upside gains. (In fact, if the short-term forecast brightens before the put expires, it could be sold back to recoup some of its cost.) However, if the stock falls below the strike, as originally feared, the investor has the benefit of several choices.
One option is to exercise the put, which triggers the sale of the stock. The strike price sets the minimum exit price. If the long-term outlook has turned bearish, this could be the most prudent move.
If the worst seems to be over, an alternative for still-bullish investors is to keep the stock and sell the put. The sale should recoup some of the original premium paid, and may even result in a profit. If so, it in effect lowers the stock's cost basis.
Option Replacement: Use options to “make a down payment” on stocks you would like to own equal to the cost of the option premium.
A long call strategy typically doesn't appreciate in a 1-to-1 ratio with the stock, but pricing models often give us a reasonable estimate about how a $1 stock price change might affect the call's value, assuming other factors remain the same. What's more, the percentage gains relative to the premium can be significant if the forecast is on target.
Covered Call (Buy/Write)
An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome. It offers a small downside 'cushion' in the event the stock slides downward and can boost returns on the upside.
Predictably, this benefit comes at a cost. For as long as the short call position is open, the investor forfeits much of the stock's profit potential. If the stock price rallies above the call's strike price, the stock is increasingly likely to be called away. Since the possibility of assignment is central to this strategy, it makes more sense for investors who view assignment as a positive outcome.
Investors may do well to stop trying to predict the future and start creating it using risk-defining strategies using options.