Volatility! Get It While It's Freaking Hot!

By | January 13, 2016 Leave a Comment

We're Doing It Again

This might be the shortest post I've ever made, and that's because I want to get it out there before the opportunity disappears.

If you're the average investor involved in the markets, you're probably clamoring for a solution for all the red in your portfolio, appearing just after the beginning of the year, and so far, not yet abated.

Boo-hoo! So, your investments aren't performing as well as you want them to? Well, maybe it's time to shift course. Time to do something different. Time to do something you've never done before, maybe because your financial adviser (erroneously) told you to stay away.

It's time to sell some put options. It's time to cash in on the volatility dividends waiting to pad the lining of your account, if only you'd break out of your comfort shell, and do what I'm begging you to do.

It's times like these when we have the lowest-risk, highest-reward setup possible to sell put options, because the premiums are so high due to increased volatility. As volatility increases, put option prices go through the roof.

Remember the mantra, "buy low, sell high?" That applies here as well. Only, its order is reversed since we're selling initially instead of buying.

Here's what you need to do along with me.

Load 'Em Up Boys!

I'm backing up the truck on one of my old stand-by's, Cisco. CSCO is on my short list of stocks, and I'm comfortable owning the shares at any reasonable price in the low- to mid-twenties. The company's balance sheet is rock solid, and it's at the top of its industry. Read more about it here if you wish.

The stock has suffered a big selloff right alongside the rest of the market, and all the technical indicators are screaming for a market reversal over the next couple of weeks. That means, I'm expecting that over the next couple of weeks, the market should see a lot of good days. CSCO should move up right along with it.

What we're doing when we sell the put is agreeing to buy 100 shares of CSCO if the price of the stock is below a certain threshold (the "strike" price) on a future date. We get paid, upfront, to make this agreement.

The best setup right now is the February 19, $26 CSCO put option. It's offering us an instant payout of $130 per contract ($1.30 per share, which is deposited instantly into our investment account), in exchange for the obligation to buy CSCO for $26 per share if the stock is trading below $26 on February 19.

That $130 represents a fat, juicy 5% of our total purchase obligation, or 49.3% in annualized gains. To put this in perspective, we usually get around 1-2% over the same length of time (37 days) selling options.

How is this low risk, if I have to potentially buy something for more than it's trading for on the open market? Simple.

We get paid upfront for the agreement, so our cost basis on the stock is actually lowered to $24.70. Therefore, we're taking on less risk with this method than if we were to buy the stock outright. If we are obligated to buy the stock at $26, we're actually buying it at the strike price, minus the premium per share of $1.30. Make sense?

So, we make money on this trade over the next 37 days as long as CSCO is trading above $24.70 on the expiration date of the option. The stock can reverse another 1.8% from here before we even begin to lose money. If things don't start reversing, we can always chicken out and buy back the option to avoid losing money.

Since I'm confident this little decline is not the end of the world, and that the market will go up, the value of this put option will lose much of its value as CSCO increases in price, and as time ebbs closer to February 19.

These two factors are highly in our favor.

The higher CSCO goes, the cheaper the value of the put option I sell will become. This is what we want to happen. If this reversal happens quickly, the option premium will also decline quickly, and I may even be able to buy it back much cheaper than I sold it, and close the trade in a short period of time for a gain.

What If the Market Doesn't Go Up From Here? Does the Plan Fall Apart?

Of course, the market could head lower. But swings like this, which cause the price of valuable companies to just keep going down, down, down, and which don't subsequently reverse, have happened literally only less than a handful of times in the past couple of decades. There's nothing happening now to be a catalyst for that sort of cataclysm.

And even if I do end up being assigned the shares (buying them), like I said.... I'm comfortable owning this business, which is the best of its kind. And, all owning the shares will do for me is give me more income in the form of dividends, capital gains, and call options sold against the shares, to the tune of yet still 1-2% per month.

Who would complain about that?

So here we are. I've opened the February 19 $26 put option for $1.30 per share. Short and sweet. Let's see how this turns out.

Live long and invest,


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