Volatility really can be your friend

By: Steven M. Sears, President and COO

All investors have this in common, regardless of what they own in their portfolios: they are held hostage by time and volatility.

It is therefore critical that investors learn to proactively deal with those two facts so that the financial market’s inevitable outbursts are of little consequence to their investment returns.

On Wall Street, it is well known that most people think that they are long-term investors, but they act like bad short-term traders. They “greed in” to securities when prices are rising, and they “panic out” when prices are falling. Studies of stock and bond holding periods repeatedly show that investors often own stocks for no more than 4.2 years, which means they tend to be constantly out of synch with the standard five-year market cycle that tends to see the birth of bull markets, the demise, and rebirth.

It is hard to constantly move in synch with the stock market’s tempos, and the conventional wisdom is that investors should not even try. What they can do, however, is position themselves to take advantage of short-term volatility in the stock market with the judicious use of bearish puts and bullish call options while allowing their long-term stock holdings to continue to mature.

We call this approach time arbitrage. The strategy can be used to generate incremental income from stocks that have declined or that an investor wants to sell at a higher price.

The approach also can be used to buy stocks at lower prices.

For example:

Say you want to buy a stock for $50, but the stock is trading for $65. You like the stock, but you are uncomfortable purchasing the stock at $65, which is close to the stock’s 52-week high price. But if the stock were at a lower price, you’d buy. This is where the power of put options can help investors reshape stock prices.

By selling a $50 put and choosing an expiration cycle within one to three months, an investor can essentially get paid by the options market just for agreeing to buy the stock at a certain price and within a certain time. Should the stock price remain above the put strike, an investor can keep the money received for selling the put. But if the stock price is at, or below, the strike price at expiration, investors are obligated to buy the stock at the strike price or to cover the put or adjust the position.

For those reasons, investors must generally be ever mindful of the risks of selling puts to buy stocks at below-market prices. In general, only sell puts on stocks that you are willing to own and that you can afford to buy.

In another example:

For example, imagine that you bought hypothetical company XYZ for $40 per share, following a very sharp 60% decline from a 52-week high. You may like the stock, but analyst ratings are mixed, and you recognize that it may take some time before the stock price fully recovers.

Typically, when a stock drops rapidly, option prices tend to increase due to an increase in expected volatility.  In this example, assume you could sell an XYZ call option with a strike price of 50 that expires in 6 weeks for about $0.80 per share, roughly 2% of the stock price.  Putting this in perspective, assume that the hypothetical quarterly XYZ dividend is only $0.24 per share, an indicated annual yield of about 2.4%.

As in the concentrated stock example, if XYZ shares are above $50 when the call expires, you would sell your stock above the market and realize a 27% gain based on an effective sale price of $50.80 (strike price plus option sale price).  If XYZ is below $50, you would keep your shares, keep the proceeds of the option sale, and could repeat the process by selling another call option.

Our approach is an options-centric way to express one of Warren Buffett’s most famous dictums. The great investor said that the secret to investing was to be greedy when others are fearful and fearful when others are greedy. Our time arbitrage strategy attempts to empower investors to do just that.

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