A few weeks ago, an article in the Wall Street Journal was titled “Stocks are Frothy but there is no Bubble”. What does one do when the market is frothy? In my opinion, frothy means that the market is overpriced, maybe not bubbling, but overpriced. From that article the author identified that the forward looking price to earnings ratio for the S&P 500 rose from 12 times earnings to over 17 in the past five years. I like to think of this simply, the price of the market is approximately 50% more expensive than it was five years ago.
The stock market might not pop, but it can still fall pretty hard. – Justin Lahart
So what does one do when they believe that the market is overpriced? How do they participate in the stock market and preserve capital? What can be done to continue to get returns anticipating a market drop?
My personal method is to sell puts on an Index ETF. Remember from previous posts that selling puts allows you to gain cash on a security by providing an opportunity to another investor to sell their shares of the company at a predetermined price. The other investor uses this as a way to preserve capital. You get the benefit of current cash from the transaction and if things go well for you, the contract expires worthless and you pocket the cash from the transaction. If things do not work out in your favor, you still get the opportunity to purchase the company/security at a lower price than today’s going rate.
Let me share a simple example. IJH, the S&P 400 Index ETF that I wrote about previously is selling at about 171/share, the investor selling puts can sell a contract expiring in about four months setting the transaction price at 153 for about 1.75. Remember that each contract represents the right to buy or sell 100 shares of a security. Therefore, in this example, the seller gets $175 for the transaction and will purchase the underlying security for 153/share if it falls to that level. Basically, you are locking in the opportunity to purchase at a lower rate and being compensated for maintaining the cash for such a transaction.
This strategy does offer some downside, in order to play the entire transaction out, you must maintain the value of the put in cash. Therefore, for the example above, the seller is unable to use the $15,300 in cash for the next four months until the contract expires or is bought back.
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