Maybe there is no free lunch, but there can be a free ride in the stock market. Suppose you have a nice million-dollar portfolio, half in bonds and half in equities. And suppose after reading up a bit and doing some research, you are convinced that the S&P index is not going to go up more than 10 percent over the next two months.
The S&P index is a nice bundle of 500 diversified stocks that kind of tracks the Dow Jones, not exactly, about 1/8th of the price. So when the S&P moves 8 points, the DJ moves about 64 points, but not exactly.
That’s the time to sell a call spread. After reading a number of economic reports lately, I am only mildly bullish on large cap U.S. equities for the rest of this year.
So while the market was up this month I sold 10 September calls on the S&P index, called the “SPY,” 1,400 calls for $1,700 and bought the same options but at a strike price of 1,410 paying $360. I ended up with a net premium of about $1,150. The purchase of the 1,410s is a hedge against a sudden jump in the market above 1,400.
Here is the good news. If the S&P does not go over $1,400 by the third Friday in September, I just get to keep the $1,150. That sounds good. But if the market does go up, while I have a risk of $4,000 in possible losses on this trade, I will make much more on the increase in my stock portfolio. So I can’t lose.
But there’s more. Suppose the market does go up and I might lose up to $4,000, even though I make more on the rest of the portfolio. I don’t have to take the loss. I can buy back the September 1,400 calls for a loss and sell back the 1,410 calls for a small profit, taking a nice loss for tax purposes, and at the same time sell a new call spread at higher numbers, such as 1,410s hedged with the 1,420s, and bring in a new premium. If I do that as soon as the market hits 1,400, the chances are good that the new premium will be almost as much as the loss. So I get a free ride: if the market goes down I pick up a premium, but of course lose some value in my equities that I would have lost anyway. If the market goes up, I get a tax loss plus an increase in value of my stocks. Isn’t the stock market wonderful?
Notice that I’m not predicting that the market will go down between now and September, although it might. What this trade relies on for profitability is that the market will not go up very much during the next few weeks.
While profits are doing well in the large cap sector, there are also a number of negative things happening in the world that can affect prices. The Eurozone might fall apart. Spain might go into bankruptcy. Chinese imports are already falling. Some companies, like Facebook, are not showing well. All of this creates a psychology in the market that is negative and holds down prices.
But even when I think that most stock prices will not go up, there are always exceptions. A couple of months ago I bought some Xerox stock because its way down but the company seems to be improving. I bought the copper ETF, because I read an article about how the world is consistently using more copper than is being produced. Copper has continued to decline since I invested in it, but I’m holding on.
And so it goes for this week. Some advisors are recommending an investment in the “VIX,” which is the volatility index. They think that we are going into a period of higher volatility, and that causes the VIX to go up.
I never invest in the VIX because it has a built-in decline mechanism. But to each his own. That’s one of the things that makes the market so much fun.
For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.