By Alex Gavrish, Etalon Investment Research; author of “Wall Street Back To Basics”
After recent market decline market volatility index, VOLATILITY S&P 500 (INDEXCBOE:VIX) or the “fear index” jumped to its highest point since December 2012. Spike in volatility, uncertainty in the US equity markets, events in emerging markets as well as an overall bullish market during the last few years make many investors nervous as to what approach to take in 2014.
Writing put options on individual stocks
Focusing on fundamentals and timeless value-investing principles will serve investors well during these uncertain times. Combining value and fundamental valuation approach with a conservative options strategy can provide additional downside protection while generating attractive income. The approach involves selling insurance policies (put options) against the decline of individual equities. By selling such an insurance policy you agree to buy the stock of a specific company at a certain price during some period of time, which can be anywhere between a month to one year or even longer. In return for agreeing to do so, you receive a premium, just like an insurance company. In case the stock price declines below the price at which you have agreed to purchase it, you will have to purchase and own the stock.
Both academic and business literature have proven that the approach of selling put options achieves better results than market averages over long periods of time with a volatility that is significantly lower than that of the market. The Chicago Board of Options Exchange (CBOE) has developed a Put Write S&P 500 (.INX) Index, which measures the performance of a strategy wherein one sells an at-the-money put option with a maturity of one month on the S&P 500 Index, and continues to do this consistently each month. This strategy has outperformed both S&P 500 Index as well as Buy Write S&P 500 Index (a strategy of selling covered call options).
Example of a position
Let’s take a look at a possible position using Cisco Systems, Inc. (NASDAQ:CSCO), a network equipment provider, which I highlighted in one of my previous articles. Cisco is valued at an EV/EBITDA multiple of x6.1 (FY 2013) and pays an annual dividend of 3.2%. Based on February 3rd 2014 closing prices, one could sell an out-of-the-money put option with a maturity of about one year (January 17, 2015) and exercise price of $20 for a premium of $1.55. By doing this, investor agrees to purchase Cisco shares for $20 per share in case the stock price declines below $20. Actual cost and breakeven price of shares for the investor would be $18.45 as the investor receives $1.55 per share in premium upfront. In percentage terms, a decline of 14% from current stock price is required to get to this price – a nice downside cushion during uncertain times. If, on the other hand, Cisco shares will trade sideways or rise, investor will earn an annual premium income of about 7.8% for taking the risk.
However, as always with these strategies comes high risk. Investors should consult their investment advisor before making any trades.