March 23, 2020
The Market downturn has you sitting on stocks way below cost
For many of us the recent downturn in the short term, destroyed our portfolios and left many positions underwater. Before you go throwing in the towel , or worse, start revenge trading take note that this market has some interesting things going on you should be factoring into your plans before making any moves.
Volatility is sky high
In the chart above you will see a bright orange line, this represents the implied volatility. In most cases over the last few years it has rarely spiked to levels above 50. This chart is highlighting that the IV (Implied Volatility) is holding over 60 points at this time. What does that mean? It means fear, it means uncertainty and most importantly for you traders, it means there is a lot of premium in the options. To translate for the lay person- it means that the price of buying and selling options is really high. This can be massively disruptive to your trades if not factored correctly. See the following examples to illustrate:
Trader A buys a put before the stock goes into a tailspin for $4.00 and today that put can be sold for $32.00 = amazing trade and awesome result for trader A
Trader B sells a call before the stock goes into a tailspin for $4.00 and today that call can be bought for $19.00 = horrible outcome and losing trade for Trader B
What happened here?
Both traders essentially picked the right direction and the stock fell just as both predicted. So why was Trader B handed a losing trade despite being right?
The short answer is the expansion in volatility ( or Vol Expansion), which in short means that as the price of the stock went down the cost of the options increased.
So how does Trader B get out of the situation?
Trader B needs to have enough time pass that the volatility begins to contract. Once the volatility contracts the premium that's in those options should get sucked out and once it's gone victory can be claimed, the position can now be bought back for a lower price. If Trader B doesn't have time then the likely scenario is that the trade will need to be rolled ( to gain time ). This means accepting a loss on the original and opening a new position taking advantage of the higher volatility to hopefully gain enough premium to cover both the loss of the previous position he just rolled out of and secure credit against the new position. This comes with a lot of risk because now in order to have a winning trade he basically has to have enough premium to cover what was once his old trade plus his new trade and be able to buy out of the position with something left in the tank.
Establishing a new starting point
Take a look at the dark black line on that graph above, that's a 30 day moving average and what you'll notice is that it's very very far from where the current stock price is. Why do I bring this up? Because a lot of people use 30-day moving averages as a sort of a guideline to help them stay focused on where the trend is and where they can expect any minute dips or temporary gains to fall back to over a short period of time. People who trade like this often believe in the idea reversion to the mean. That concept implies that a person is basing their trade on the idea that the stock price will continually move in a line that tracks the trend. hence the moving average - it's not to say that that's an exact science and relays on the traders intimate knowledge of the stock to be successful. What it does imply is that if you can filter out the temporary ups and downs, the overall movement should be traceable as upward trending , downward trending or flat. As long as you can trace that line and keep your trades in line with it ,you should have always have a directional advantage.
Well, that's clearly not the case right now! In fact right now the moving averages are so far off course that most people likely feel that their charts are worthless. That's not to say that they are, but it does mean a lot of people going to have to reset or start over. Let's go back to my original point if you're if you're an experienced trader your charts likely go back far enough that you've seen massive dips. You've been there to see the January 2018 dip, you've been there to see some of the 2008 and 2009 carnage in the stock market and in that case your charts probably have some version of this factored in. So where do we go from here? Let's start with analyzing exactly what was impacted the most on our portfolio and for many of us that will be our cost basis.
If you're like most traders out there, this downturn has sunk your portfolio to levels you haven't seen since you probably started. What you're also noticing is that what you paid for those stocks is more than what they are worth now. If you had options positions on, particularly naked options, there's a good chance that you're going to be assigned a lot of stock at values far above its current value. So what can you do? what tricks, what skillful maneuvering, and game planning should be done as you review your positions and start to get back into the market to try to recoup these losses.
I say its time to utilize the most basic of options strategies!
It's time to put the covered call in play. For anyone that does not understand what a covered call is let me explain.
With calls, one strategy is simply to sell a naked call option. This is an extremely popular strategy because it reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price.
To execute the strategy, you take the underlying stock that you already have or were just assigned as you normally would, and simultaneously write (or sell) a call option on those same shares.
In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the stock’s value when the stock price drops.
Why do I like this strategy
I like the strategy because it does two things it protects your position in the event of a stock goes down. Selling a call in this situation also has utility if the stock goes up.
Let's examine both scenarios
Let's say you bought the call on those shares at this point you're still holding some downside risk if the stock was the fall in price further you would be at risk of losing your position as well as the premium paid for that call option but you would essentially double up on your gains should the stock go up. It would be a two-for-one gain.
Now let's say you sold the call at the top of your cost basis. In this situation, should the stock go up but maybe not reach your cost basis you would profit by collecting the premium that you sold on the position as well as watch your stock gain value. You essentially double up the value of the gain. In the event that the stock continue to lose ground and fall in value, you would recoup some of that loss through the premium collected by selling the option.
That's what makes this strategy so attractive. It allows you two options for making money whether the stock goes up or down.
Now what is the risk in the event that you sold a call against the position? You would be forced to sell that stock at a set price. If you're following good fundamentals you'd be selling at a price that would be at or above your cost basis to lock in a profit. There are situations where you can't sell a call at your cost basis. A perfect example of this is Boeing.
The drastic move downward for Boeing has resulted in the premium being taken completely out anywhere near where Boeing was only a month ago. Let's assume you bought Boeing shares at $360 back in February, but now Boeing is currently priced around $98. There won't likely be any options of value that you could sell in terms of calls at 360. All the value will be at in the "near money" options likely somewhere between $130 and $75. This means your options in this case are limited. In order to collect premium you have to decide whether you will sell an option that is near the money and has the potential to be a losing trade should the be a period of sustained volativity. Should Boeing see another swing upward due to some external Force such as government bailout, Reverse market correction or any type of improvement in the supply chain management, then all of a sudden the position that you've just chosen could wind up being a losing trade and further adding to the cost basis on your overall portfolio.
All that being said nothing comes easy and nothing is gained without risk.
This is an age of chance and for many of us, this is a brand new frontier regarding the stock market. We haven't had a sustained bear market since the 80's and in many cases a lot of the traders that are joining in the market today weren't even born until the 90's. Today's market requires careful consideration careful planning and in some cases mentorship from people who've been through similar situations.
This is a time where you need to review your portfolio carefully and ask yourself are these stocks valuable to me in the long run? are these still winners in my book? If your portfolio is full of stocks that you were simply trying to short-term play then there's a good chance you may need to get out of those positions and get into positions you're willing to stick with for a long time. My experience it's no different from anyone else's when the market goes down. I see my portfolio go down as well. my gut tells me that we're not through this that the supply chain it's still not fixed and that because of this event there will be changes on how we see our goods and services delivered both internationally and domestically. I feel that the world is on the brink of a great change and with that change we will see our markets change as well.
I wish all of you luck in your trading and I hope that this strategy is something you can utilize in your portfolios to help you get back to even or take you beyond.