Employing Cash in a Frothy Market

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.

Example:

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.

Being Paid to Invest

What if someone paid you to invest in securities you already wanted to own?  This post will cover one strategy that allows the investor to receive payment on investments they want to purchase.

Tom said to himself that it was not such a hollow world, after all. He had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.

-The Adventures of Tom Sawyer, Mark Twain

This is Tom’s light bulb moment for the fence painting episode.  This is the same type of light bulb moment I had when I first learned about cash secured puts.  Such a strategy is not for everyone, please understand that options trading adds an element of risk much greater than the normal stock or mutual fund investor is willing to assume.

What is a Cash Secured Put?

A cash secured put is created when an investor provides an option to sell a security at a fixed price.  The investor is paid for providing this service by the individual that buys the right to sell the security at the strike price (think sale price), this investor assumes the responsibility to purchase it at the strike price if the buyer wants to sell it.  The investor using cash secured puts is selling the put.  The individual purchasing the put is usually trying to lock in a price to sell and pays the seller a fee for tying up the underlying cash required to purchase the security.  Sellers use this strategy to provide income on a regular basis when they wish to keep their cash on hand.  Buyers use this strategy to lock in profits on an investment that has appreciated in value.

How to use Cash Secured Puts 

Selling a cash secured put to be paid to invest should start with an understanding of what price you want to purchase the underlying security.  When you determine such a price, then you sell the put at that price.  If the security falls below the price of the put, then it is considered in the money.  If it stays in the money upon expiration, then the purchase will be “put” to you and you will be required to purchase at the price indicated by the option.  Your purchase price is the stock price discounted by the sale price of the put.

A word of Caution

All option trading can be highly volatile.  Most professionals use options only as a small portion of their portfolios (1-3%).  However, this strategy can lock up a large portion of your portfolio in cash until you close out of the position.  Using this strategy to purchase an option when a company is high that later falls often forces the investor to purchase the stock at a premium to what it current price is causing them to assume the risk of the falling stock.  This makes it an extremely risky strategy to use when purchasing companies that are not investment grade.  I do not recommend using such a strategy to purchase anything but investments with the least risk.  Limiting cash secured put sales to stocks found in the Dow Jones Averages including the Industrial Average, Transport Average, and Utility average would mitigate some of this risk.  

The opportunity

A conservative application of this strategy offers an opportunity to earn approximately 2% annually while preserving cash for specific entry points.  This may not seem like a lot, however, it provides income when the investor thinks the market is overpriced.  It is a great way to make your money continue to earn when the market seems overpriced.  Your efforts are rewarded by a constant stream of cash for the security you offer the investor.

ACTION ITEM: Determine for yourself if you are willing to assume the risk of a stock falling.  Is this the right strategy for you?  If so, what will you do to limit the risk involved?