A Strategy For Making Money in a Flat Market by Scott Stolz, CFP, RICP (week 37)

 

To say the stock market has been volatile lately would be an understatement.   Yesterday, the S&P 500 was down almost 150 points in the first 30 minutes only to end the day with a gain of 56 points.  Despite these daily swings, as you can see from the chart below, the market has been relatively flat since early October.

Source: Yahoo Finance

This type of volatility can make any investor nervous – especially retirees.  I’ve had numerous conversations with my retired former colleagues since I retired last July.  And one thing that is almost universal is that hitting a home run is no longer the goal for our retirement portfolio.  The goal is now to consistently hit singles and doubles.  The fear of seeing our retirement nest egg go down significantly greatly outweighs the desire to see it increase significantly.  So, the question becomes, how do we achieve this goal in an investing environment with such uncertainty and almost daily volatility?

The conventional wisdom is to remain diversified with a heavy weight of bonds.  I know some retirees that are perfectly happy earning 3-4% on their cash and getting some income from municipal bonds.  Advisors that utilize annuities will recommend fixed indexed annuities and/or registered indexed linked annuities to offer downside protection with some market upside.  I’ve used both of those annuity solutions myself – with good success I might add.  And staying diversified is always good advice.

But today I’m going to suggest an unconventional solution that has worked very well for me over the last four months in particular.  In fact, it’s a strategy that actually works best in the very market we have today – relatively flat with high daily volatility.  The first step is to identify 2 or 3 stocks that you would like to buy if only they were a little cheaper.  You then sell someone the right to sell those stocks to you at that cheaper price (put options) within a stated period of time.  If the stocks(s) are trading at or below that agreed upon price (the exercise price) on the specific agreed upon date (the exercise date), then you have to buy that stock.  If it doesn’t you get to keep the money you sold this option for. 

I’m sure some of you are going, what was that again?  This is not uncommon.  The concept of selling an option to buy or sell a stock rather than just outright buying or selling the stock is often a difficult concept to comprehend.  So let me give you a specific example.

I’ve mostly been using NVIDIA for this strategy.  Why NVIDIA?  Because it’s a stock I’d be happy to own (if only it was a little cheaper) and it can move a lot from day to day.  This daily volatility increases the option price and therefore allows me to be paid more for giving the right to someone to sell it to me.  Given the market uncertainty, I typically select an exercise period of 2-3 weeks out, but you can choose a date as short as 1 day or as long as 2 ½ years. The longer the time period, the more you will be paid. 

NVIDIA closed yesterday at $182.65.  As I write this blog, I can sell the right for someone to sell me 100 shares of NVIDIA at a price of $175 anytime between now and March 27 and get paid $400 ($4 per share for each of the 100 shares).  If when the market closes on March 27, NVIDIA is $175 or less, I have to buy all 100 shares at $175.  Since I received $4 per share by selling the option, I’m really buying the stock for $171.  If on the other hand, NVIDIA is selling for more than $175, I just keep the $400. I’ve now made this type of trade on NVIDIA 8 times since mid-November.  I’ve made the equivalent of $19.63 per share on the combined trades.  Only once have a had to buy the stock.  On that occasion, the stock closed at $0.35 below my agreed upon stock price.  I received almost $3 for giving someone the option to sell the stock to me, so even that trade was profitable.  On top of that, the stock traded $4 higher the following trading day, so I made a little money when I sold the stock.  In summary, thus far, I’ve made the equivalent of $19.63 a share in just the last 4 months on a stock that has been stuck in a trading range between $171 and $207.

Some Things to Consider Before Using this Strategy

1.      Your account must be approved for this type of options trading. 

2.      You must keep cash in your account equal to the potential sales price.  For example, if I give someone the right to sell me 100 shares of NVIDIA at $175, I have to have $17,500 in cash in the account.  Holding securities of that amount is not sufficient.  It must be cash.

3.      Options always come in 100 share increments, so you must be committed to buying at least 100 shares of the stock you use.

4.      Only use stock that you are willing to own and only sell the option at a price you are willing to pay.  There’s nothing worse than being forced to buy a stock you don’t really want at a price you don’t really want to pay.

5.      If the stock tanks before your exercise date, you are likely to regret the trade – even if it’s a stock you were happy to own.  It’s easy to second guess yourself on this strategy.  However, I would suggest that’s true even if you just buy the stock.  But this is another reason I stick to time periods of just 2-3 weeks.

6.      You have to be willing to give up the big gains.  I’ve also used Eli Lilly for this strategy only to see it go from $750 to $1100.  I obviously never had to buy the stock, but that also means I’ve given up significant potential gains.  However, remember that this strategy is about getting singles and doubles – not hitting home runs.

7.      This strategy is much less effective in a stock market that is falling month after month.  You will find yourself continually buying more stock as that stock falls in price.  You can and should remind yourself that you at least bought the stock at a lower price than it was and you got paid to buy it, but that will likely not make you feel much better if the stock then falls another 20-50%.  I would also suggest that there aren’t many strategies that do well in such a market.