Volatile yet going nowhere – that is the theme so far for the S&P 500 year to date as we are in our second earnings season of the year. While the
overall index is close to flat for the year, we have had many trading days that have been volatile on an intraday basis – moves in excess of 1.5% during a
day. As you might imagine, the prognosticators are back in force with their predictions for 2014 and beyond in the markets. Some are rather bullish calling
for the S&P 500 to hit 2000 or beyond this year. Others are predicting a market top and a precipitous fall to levels not seen in years. Who will be
right and who will be wrong? Only time will tell. What is most important is how we as investors/traders handle any market situation – present or future –
through effective risk management skills and plans.
All trading and investing decisions begin with the expectation of future equity price behavior. We know that equities do not go up – or down – in straight
lines forever. The most recent leg of the bull market took the S&P to all-time highs just a few weeks ago on the expectation that the underlying
economic conditions will continue to improve for the foreseeable future. For the past several months, economic data has been “soft” in many areas including
manufacturing, housing and retail sales. Much of this has been written off to terribly inclement weather plaguing much of the Eastern half of the country.
Who wants to spend time at a car lot looking for a new car when temperatures are frigid and snow is falling?! It stands to reason that if weather is truly
the culprit here, then demand in many areas will simply pull forward to the spring/summer time frame. I believe that is what the market is banking on as we
continue to slowly grind our way higher. The question for the markets then becomes what may happen if this “soft patch” isn’t just weather but a true
slowdown in economic activity. If economic data does not resume its positive trajectory going into the spring/summer, the market may become concerned about
valuations being potentially extended. The other side of the coin is quite possible, as well. If data does improve – the weather “excuse” was more than
justified – then markets can continue their bullish ascent. What is a trader/investor to do when the future outlook become somewhat cloudy? Hedge!
Owning shares of an individual equity or ETF works only in a bullish trend. Since equities spend a fair amount of time either consolidating recent moves
(stagnant trend) or in pullback mode (bearish trend), it stands to reason that we can improve overall trading performance by opening up multiple trends for
success. One way to do this is to create a covered call. By selling a call option against your shares, you open up the trade to multiple trend
possibilities for success. Here’s an example on the SPY, the ETF that serves as a proxy for the S&P 500:
Buy 100 shares of the SPY at $185.01/share
Sell a May 2014 185 short call – take in a credit of $ 2.76/share
Cost basis in this trade = $182.25/share
Maximum reward in the trade = $185.00-182.25 = 2.75/share – 1.5% return in 31 days
The short call gives you to obligation to sell your shares upon May option expiration (May 16, 2014) if the SPY is trading above $185/share. Therefore, a
very bullish or somewhat bullish trend will give you your maximum reward. If the SPY remains under $185, you will keep the credit you received for selling
your short call providing you profit while maintaining share ownership. If you just owned shares and the SPY was stagnant, you would only be at breakeven.
By selling this call, you added a piece to the trade that benefits from a stagnant trend. If the SPY were to pull back slightly, you can maintain some
degree of profitability as long as it remains above your cost basis of $182.25. This in effect gives you a small hedge against bearish price action.
I believe 2014 has been and will continue to be a more challenging year for investors than was 2013. Having the peace of mind that successful hedging
provides enables me to continue to be profitable in my trading while sleeping well at night. What a winning combination!