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Thursday, August 6, 2009

Sell Off Ahead? 25 Ways to Profit & Protect from a Stock Market Correction

People keep calling me a bear, but I'm just being conservative. Given the rally we've had, I think it's a great time to take profits. I was selling a lot of covered calls for the August expiration Thursday, as we approached market close. I'm getting conservative because I think we're due for a pull back on the major indices.

Reason 1: The recent activity in the Volatility Index (VIX) is telling me a short-term sell off may be near.

Historically the VIX and the S&P 500 have a negative relationship (as one increases the other decreases and vice versa). However the 5 day chart above shows both have increased together in recent trading. This signals a sell off may be near in my opinion, or at least a lot of traders are betting on a sell off short term.

Reason 2: Simple profit taking. The unemployment data coming out Friday, whether it's better or worse than expected, I believe profits will be taken. If it's better than expected data, I believe it will sell off because it is already factored into this recent market rally, and if it's worse than expected data... It should send a signal that the market may be overvalued considering the worst may not be behind us.

Reason 3: Earnings season is coming to an end. With the majority of companies beating estimates (simply because revisions have been set extremely low), it has certainly contributed to this ongoing rally. I believe the "better than expected" earnings quarter has inflated these stocks too fast on a short term basis.

The Strategy:
As I stated earlier, I've been selling covered calls on many of my stocks to protect my position. I've also stated in my blog recently, that this market can continue to rally, as there's still a lot of cash on the sidelines. Selling covered calls is a great way to create income off the shares in your portfolio, as well as allow for an additional gain as well. Selling covered calls is ideal for this type of speculation, which is why I have decided to outline 25 ideas in this article. To learn more about this strategy, and stock options in general click here. I will use the 25 largest stocks (by market cap) in the S&P 500 for my analysis.

To understand the table, I will give a detailed example of Goldman Sachs (GS) below.

Sell the Goldman Sachs (NYSE:GS) in the money August 165 strike call option. The premium received from the call option would give a downside protection of 3.00%. If the stock is assigned at options expiration on August 22, 2009 the total return from this position would be 1.95%.

A more bullish approach would be to write out the Goldman Sachs 170 Call option. This approach would protect to the downside 1.54%, and if the stock is assigned at expiration it would return 3.49% (in 15 calendar days).

The August options expiration is 15 calendar days away, so it may be best to monitor the position and buy back the call option on weakness of the underlying stock, if the stock rallies after it is purchased back, write it back out for a higher premium etc... The weekend will take some premium away from these option contracts as well which is another positive to being the seller of these options. According to the current Theta, the 165 call option will lose roughly $25 per contract, and the 170 call option will lose roughly $23 per contract sitting inactive over the weekend.

Company Ticker Strike Return % Downside %
Exxon Mobil Corporation NYSE:XOM 70 1.72 1.33
Microsoft Corporation NASDAQ:MSFT 23 1.24 3.20
Wal-Mart Stores, Inc. NYSE:WMT 50 2.92 0.84
Johnson & Johnson NYSE:JNJ 60 1.45 1.33
The Procter & Gamble Company NYSE:PG 52.5 3.19 1.17
International Business Machines Corp. NYSE:IBM 115 1.12 3.15
AT&T Inc. NYSE:T 26 2.90 1.14
Apple Inc. NASDAQ:AAPL 165 2.62 1.95
JPMorgan Chase & Co. NYSE:JPM 41 3.53 2.92
Google Inc. NASDAQ:GOOG 450 1.99 2.07
Chevron Corporation NYSE:CVX 70 2.35 1.27
General Electric Company NYSE:GE 14 2.31 4.47
Cisco Systems, Inc. NASDAQ:CSCO 22 1.84 3.14
Bank of America Corporation NYSE:BAC 17 5.21 3.41
Wells Fargo & Company NYSE:WFC 28 3.97 3.86
The Coca-Cola Company NYSE:KO 50 2.19 0.95
Oracle Corporation NASDAQ:ORCL 21 1.84 2.83
Intel Corporation NASDAQ:INTC 19 3.37 1.76
Pfizer Inc. NYSE:PFE 16 3.10 1.77
Hewlett-Packard Company NYSE:HPQ 42.5 3.46 2.77
Philip Morris International Inc. NYSE:PM 47 1.72 1.70
Verizon Communications Inc. NYSE:VZ 31 1.94 1.81
PepsiCo, Inc. NYSE:PEP 57.5 1.50 2.08
Goldman Sachs Group, Inc. NYSE:GS 170 3.49 1.54
QUALCOMM, Inc. NASDAQ:QCOM 46 2.81 1.82

To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here. As an owner of both Goldman Sachs and Bank of America shares, I've written some / will be writing more in the days to come, as the volatility of the underlying stock gives a very nice premium, even on out of the money options and 2 weeks until expiration.

As the Volatility index is creeping back up, call option premiums should increase in value overall, protecting and giving an even higher return. I use this strategy to write my shares out on strength, and purchase them back on weakness (if I am profitable). For example: using this strategy has allowed me to cost average my position on Caterpillar (NYSE:CAT) down to $4.88 a share. Patience is the key to succeed with this strategy. If the stock gets called out, and you miss some of the upside, you can always use the buy/write option strategy to get the stock back for the following month. With the VIX at historic highs and call premiums exploding, selling deep in the money covered calls on my shares from September to December allowed me to trump the market, and actually make a profit.

All of these options expire on August 22; therefore the last trading day is Friday, August 21, 2009.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

This strategy will give protection if the market sells off, as well as provide a return if the market continues to rally. If the stock is not assigned, this strategy is a great way to create additional income for your portfolio. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Instead of spending additional money on put protection, this strategy allows income to flow to your portfolio providing protection on the position.

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