I was searching for new candidates for put selling and these days it became difficult to find some which would provide nice and juicy premiums.
It is an evidence of the market being overbought. There are three tools out there I use to watch Mr. Market mood.
The first tool is a Feed & Greed indicator on CNN Money website. See the chart below:
As you can see, the market is in overbought territory and we may expect a correction. And a correction may be violent.
The second tool I usually look at is a CBOE volatility index (VIX) itself. The index reading may be relative and if you want to use it, you have to compare it to its long term average value.
VIX index is considered to have a long term average at 20. From the chart above we can see that the index is below this average, which indicates complacency at the market. You can see two periods of 7 and 6 years when the markets were in this low territory (1990 – 1997; and 2002 – 2008 periods). In 2012 we entered this “low” period again. We may see another 6 years (until 2018) of confidence and growing markets or a correction above 20 average as is seen in 1997 – 2002 period.
A third tool are the options themselves. When investors are confident, complacent about stocks, they tend not to be buying protective puts and their price is going down. And it is our case here. Puts are very cheap and it is difficult to find contracts with nice premiums.
What is in it for you as a dividend investor?
As a dividend investor, you do not have to worry about all this at all if you choose to. It is the beauty of dividend investing as your priorities lay elsewhere – in growing income stream rather than an account balance. Any storms like this won’t be bothering you.
If, however, you are playful, have time to watch your stocks and want to squeeze more money out of your investments, those tools may help you. When the indicators indicate that the whole market is probably oversold, stocks are expensive, it may be a wise move to save cash and do not purchase new shares. Some investors want to wait for their price. During overbought markets you stay aside, save cash, and just cherry pick stocks, which are pressed down by panicking investors.
A great example of such stocks in recent days can be Kinder Morgan Partnership (KMP), Realty Income (O) or Coca-Cola (KO). Investors are selling based on rumors or bearish articles of nationwide media rather than based on fundamentals.
When the whole market collapses you will be able to find even more stocks pushed down by investors rushing to exit. Your saved cash will be a King here.
What is in it for you as an option trader?
It is a lot whole different story if you are an option trader. You want to be watching such indicators or similar. You want to be watching stocks you are trading and you want to be watching the whole market.
Although the whole market is running up and everybody is optimistic, it may be actually quite dangerous to your option trading. With expensive stocks and cheap puts your risk-reward ratio is horribly against you and there is a constant risk of a sudden market drop.
After a market collapses, it is easy to start selling puts as the probability of the market and stocks going up is a lot higher than when the markets and stocks are already way up. Yes, they may continue raising, but they may not. Such reversal may be a hot ground for you.
If the stocks start falling slowly (more like drifting, rather than collapsing) you will be able to manage your portfolio and roll down. If the market collapses and you trade at margin, then Lord be with you.
How you can prevent it? The best prevention would be selling puts against mega-cap dividend paying stocks as they tend to be slow in growth, but also in collapsing. Limit your trades and increase cash reserves (meaning don’t go all in), and select deeper OTM strikes. If you happen to select 10% or even 20% lower strike from underlying price, your chance of getting in the money is lesser. The stock would have to fall 10% or 20% and that is very unlikely with a huge dividend company, unless there is a storm, flash crash or the company goes bankrupt.
A great example of struggling premiums is Realty Income (O). Last August in 2013 I could sell a put contract at 40 strike 6 months ahead and collect 3.21 or $321 premium. Today, the same equivalent contract – September 2014 contract 40 strike will deliver me only 1.55 or $155 premium.
My Trade detail
And this is my case. I try to be all in as long as possible, but these days I have a feeling (yes, I cannot quantify this otherwise) that it is time to increase cash and slow the put selling pace.
I opened new trades and besides rolling I might not open new trades and increase my cash reserves in the near future.
03/04/2014 20:01:34 Sold 1 TASR Apr 19 2014 19.0 Put @ 0.75
03/07/2014 16:34:10 Sold 1 O Jun 21 2014 40.0 Put @ 1.11
I have a few trades “shovel ready” for next term, but will see after March expiration if I go for them or wait.