Wednesday, August 10, 2011

WHAT, ME WORRY???:

For the first time in nearly 30 years of investing (including the 1987 Crash), at no time have I felt the panic or need to bail out of any of my 15 DITM positions. Although at the recent lows of 20%, most stocks were under water, with the Safety Net cutting losses (as well as some timely hedges -puts and Inverse ETFs), my rationale was that as long as I was receiving the dividends and milking Call premium, I would be well ahead when the downdraft was over - which it inevitably is.
The 4 or 5 worst stocks are defense and energy, along with WM.
Here is what I call a hypothetical microcosm of the market decline:
The following theoretical stock trade best illustrates how the DITM defensive strategy works in the typical market cycle:

Stock XYZ trades at $50; in its usual upward path of a normal market, it rises to $60 (stocks normally have a right translation, meaning they rise 50-60% of the time, partially due to Inflation, correct down 10-20% and trades sideways for the balance). XYZ pays a 4% dividend - $.50 a quarter.
The Investor does a Buy/Write on XYZ at $55, selling an ITM (in-the-money) covered call at $50 strike price for $6 , five months into the future ($5 for the top part of the stock to be surrendered later, and $1 option premium).

Upon reaching $60, a Bear Market sets in and it falls 25%, from $60 to $45 ! The Investor's cost basis is only $48, including the immediate and second dividends.
Meanwhile, anyone else who bought XYZ near $60 is at a huge loss - $15- and must consider selling at some point. However, our Investor, being only down $3, will hold on while receiving the dividend and milking call option premium. No panic, no fear!

5 months later, the stock has rallied back to above $50 again - a normal occurrence. As the 50-strike call expires, the Investor "steps down" and sells the $45 call another 5-6 months out (for another $6). Now the stock is paying a higher dividend %, and the Implied Volatility of the call has risen with the fear from the decline, and should they want to buy more, the stock price is now cheaper.
Bottom line: after 1 year, the stock is called away at $45. Profit/loss is as follows-
Cost: $55.
1st call sold: $6
2nd call sold: $6
4 dividends: $2
XYZ sale: $45
TOTAL: $59 - $55: $4 profit, or 7.37%, while the stock has dropped 10-15%!

Although DITM is a defensive strategy, if one considers the other possible stock scenarios, the Investor would have made a similar profit had the stock moved sideways or slightly up. Only a large rise would have profited more, and the Investor has the choice of only investing a portion (CD or money market funds) into DITM, while chasing stocks with options, ETFs, and other stocks.

More information is available at:brentleonard.com. Brent has written a print book and now an eBook on the DITM strategy, called Zero (IN) Tolerance.

1 comment:

  1. Spider:
    I've seen AGNC recommended lately, but not the best candidate for DITM. If you go out to the Dec. 27 call, only about $.30 extrinsic premium (above the ITM), so it would probably be called at ex-D date - you'd barely cover commissions. I've done HCN before with good results.
    Brent

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