Animal House 1978 - Chip Diller/Kevin Bacon
In the 1987 stock market crash, I saw the hands of one the most powerful men on Wall Street tremble as he pressed the keys of his Quotron – as the Dow fell from around 2,500 to about 1,750 – 10 days later, it rose above 2,000. Today we are over 10,000. Take a deep breath, markets go up and they go down.
Now is the time to decide if you are a trader or an investor. If you are a trader, STOP HERE and go somewhere else. You will not read anything here that is of interest to you. If you are an investor read on.
Breathe deeply; if you have not seen markets undulate wildly wait. If you have, let us move on.
Directional plays are difficult but we are in this for the long hall and our strategy works in all environments. Picking good stocks and working them for all we can is a strategy for wealth creation not instant wealth. The market movement is temporary and has created opportunity for us. Let us explore the possibilities.
The Vix has risen
It remains low compared to a few months ago but volatility is up for the past few months. At today’s close of 27.46, it is below the 52-week average of 31.72. Keep in mind this is the mathematical average and we can devise all kinds of fancy formulas to tell us what we already know by looking at these two numbers, the VIX is still relatively low for the past year. Keep in mind that the VIX, as previously explained, is an indicator and may not be representative of any particular stock that we would look at. Nevertheless, it is something, an indicator, in a world where information is not available.
Now let us progress to looking for ideas that we like. This is where we can express our fears and optimism in the market and for a particular stock. A good example is ADP. I will take you through some value prepositions and structured thoughts. It will be long-winded and boring for those only interested in doing a trade. This is the educational portion of the strategy and as I have written in earlier posts, an educated investor is our best customer. If you just want to trade, skip to the trading section below.
The folks at ADP provide a service and are in my mind basically an annuity company. They provide work for a fee and keep their clients forever. Boring but stable and profitable. Not too much excitement and they pay a nice dividend. The stocks 52-week range is 26.46 – 45.74. The current price of 38.81 is about an 8.0% premium to the 52-week mathematical average. The dividend is 3.5% next paid on Sept 8. Current P/E is 16.14 and the forward P/E is 14.76. So far so good. Furthermore, the analysts who count like the stock for the same reasons we do, it is boring.
Now I will give you two ways to play the stock. Markets goes up and markets goes down. Choose your scenario. Feeling lucky? Take the strike above the spot price. Feeling cautious? Take the strike below the spot price.
Selling calls above the spot or current price seems to be a more common practice than I ever thought. There is nothing wrong with doing this but I see it as an optimistic practice. Stocks go up and down. Nothing new. Selling out of the money calls or calls that are currently above the spot or current stock price allows for an expectation that the stock will go up in value. Nothing wrong with this view. I do not always like selling calls that are above the spot or current market price of the stock. I will explain why.
I have had an ongoing disagreement with one of my colleagues on selling in the money calls. These are calls with strike prices below the current spot or market price of the stock. The pricing of calls is a mathematical process that involves using two non-mathematical inputs, volatility and bid offer spread. These two items are sentiment driven and are priced based on what buyers and sellers are willing to pay for each or rather their opinion of value. When a stock is “in the money” to an option the instability of the option is dampened by the amount it is “in the money”. In this case the dampening amount is the 0.81¢/ the stock is in the money. This equates to 67.50% of the premium and 2.09% of the stock price. Let us take a close look using ADP.
ADP spot price 38.81/share
Price of September 38.00/ calls 1.20/
Price of September 39.00/ calls 0.60/
The 38.00 calls are “in the money” by 0.81¢/
The 39.00 calls are “out of the money” by 0.39¢/
The net receipt for the 38.00/ calls is 0.39¢/
The net receipt for the 39.00/ calls is 0.60¢/
The stand still returns (SSR) for each is:
September 38.00/ calls = 1.00%
September 39.00/ calls = 1.55%
Let us look at return scenarios:
In this example you will get 0.55% more by selling the out of the money calls. The question is why would you want to sell the in the money 38.00 calls? The answer is IF I am bearish and think the stock will decline in price I have a cushion of $1.20/ by selling the in the money calls where I only get a 0.60¢ cushion if I sell the 39.00/ calls.
If I sell the in the money 38.00/ calls my breakeven becomes 37.61/ or a decline of 3.10%. If I sell the 39.00/ calls my breakeven is 38.21/ or a decline of 1.55%. Therefore, selling the 38.00/ calls is a bearish tactic while selling the 39.00/ calls is somewhat bullish.
If I got called on the 39.00/ calls my overall return would be 2.55% broken down by income from the sale of the call of 0.60¢ or 1.55% stock appreciation of 0.39¢/ or 1.00%. Sure beats a poke in the eye by a sharp stick. However, the stock would have to appreciate in this crazy volatile market, and honestly the price to call is actually 39.60/. The reason for this is that the buyer of the option needs to cover the cost of the option premium of 0.60¢/ in order to call the stock away. If this happened, my overall return would increase by an additional 1.55%. Overall, not bad.
For the 38.00/ in the call option the price to call would theoretically be 36.80/. The reason if that the buyer of the call is willing to pay 1.20/. Therefore to call the stock they would have to earn back the premium they paid for the call. In this case their break even would be the strike price of 38.00/ minus the price p[aid for the call of 1.20/ or a net price of 36.80/ or a 5.185 decline from the current price.
Keep in mind that these two scenarios are not balanced. Sometimes they are and the risk reward profiles are compelling. Another factor is that ADP pays its dividend on September 8. At an estimated annual rate of 3.5% or 0.88% per quarter, this is also a factor. I would add this to my down side protection that would drive my breakeven lower by another 034¢/. Pricing theory tells us that the dividend is already reflected in the stock price. (I will let the rocket scientists explain that one!)
Personally, I would sell the in the money for ½ my position and the out of the money for the other half and look to dollar cost average.
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