“Invest when there’s blood in the streets” goes the old saw. Many people are saying that stocks look cheap right now, and it wouldn’t be a bad idea to invest if you’ve got a long enough time horizon (even I’ve said this). I’m not convinced the bottom is in, and am playing mostly for the downside now. Nouriel Roubini predicted another 20% downside to the current market. Now, Roubini is a great economist, but not necessarily a great stock market analyst, so the downside prediction may not hold as much weight as his other economic predictions. My predictions should hold no weight. That said, I wanted to offer a stock buying technique for those wanting to enter the market now. It’s similar to what I did with my Ford purchase, but grounded in reality.
SPY, the S&P 500 ETF, is currently priced at 88.10. That’s $8,810 for a hundred shares. Now, people like 10% annual market returns, so let’s look at options more than 10% higher than the current price, so a strike price above $97. I’m gonna pull $105 out of thin air. The bid on $105 strike price calls for December 2009 is $6.20. So, if you do a buy/write, you will pay $8,810 - $620, or $8,190. That’s a 7% discount (not nearly as good as my almost 50% discount on Ford, but Ford is a terrible investment, in my opinion). Now, your upside limit is 10,500 - 8,190 = 2,310, or a 28% gain in 14 months. You can weather a market downturn of 7% from current levels with no loss to your initial investment.
If we look at the $95 strike price, we have a discount of $1,015. That puts our purchase price at $7,795. We can absorb a market downturn of 11.5%, with a 14 month upside limit of almost 22%. Of course, with the lower strike price, there is an increased likelihood of bumping into our option and being forced to sell. But seriously, who complains about being “forced” to take a 22% profit?
I’ve ignored commissions, which could probably add $30 to the costs in the worst case.
If you don’t understand options trading, you owe it to yourself to learn more. While day-trading options is extremely risky (and fun), options can be used to manage risk. With a buy/write (or simply writing a covered call), you sacrifice some upside potential for a downside cushion. By choosing your strike price, you determine exactly how much upside potential you are willing to sacrifice. The market, in turn, decides how much downside protection it is willing to offer.
