The current bull market is over four years old. That age seems to be the time when most bull markets begin to fade, but I’m betting this one is different. The main reason is that the preceding recession was deeper than the usual decline and that means the recovery should be longer as a reversion to the mean pulls prices higher. In most recoveries, profits grow faster and P/E multiples expand faster. This creates a situation where greed takes over and common sense value investing is abandoned.
In the current recovery, profits have grown much more slowly than is typical. This has allowed P/E multiples to expand along with profit growth, but it hasn’t sent the market into bubble territory yet. By most accounts, stocks are close to fairly priced now when compared to historical averages. That gives more upside potential, notwithstanding an unforeseen macroeconomic event. Being in a bull market does not mean stocks can’t drop hard quickly. It means that they will recover before the losses get out of control.
The charts haven’t looked good lately with the moving averages losing support of their respective indexes. This mixed bag of decent fundamentals and less than optimal charts leads me to believe we’re in for another minor correction, but one that we’ll recover from before the end of the year. I plan on buying into any dip over 5% to ride the recovery.
This theory is the reason behind today’s trade. While SSO was trading at $85.11, 20 cents above its low of the day, I sold two SSO December $78 naked puts for $3.20 each and received $638.93 after commission. The big risk in this trade is if the S&P 500 falls into a bear market and catches me off guard. The upside is that the market can drop some, stay flat or go higher and I’ll make a full profit. Before the last little correction, I started holding back some cash to catch the dip, but stocks didn’t fall as far as I thought they would and I missed the bottom. By selling these puts out-of-the-money, I’m forcing myself to buy according to the plan I have now, not based on what could change emotionally for me during a further drop in prices.
I would rather have not had to go all of the way out to December for these puts, but the next closest contracts were in September and the premiums didn’t give me the cushion I wanted for the risk that comes with a leveraged ETF. I contemplated strikes ranging from $77 to $80 and decided I should go with a bigger buffer before a loss at the cost of making a smaller profit.
The previous correction took SSO down to $72.45. I don’t think we’re going to get a repeat of this low mark, but if we do, I’ll have a paper loss of only $472 or 3.01% while SSO will have fallen 14.89% (or ~7.5% for the S&P 500). Coincidentally, if SSO closed the year at $72.35, it would equal a yearly gain of 20% for the leveraged ETF. My forecast at the beginning of the year was for the S&P 500 to gain 10% on the year. I’ve since raised my expectations, but if the index gained 10%, the double leveraged ETF should be close to 20% higher and I will have made a decent trade by selling so far out-of-the-money puts.
A 50% retracement of the recent leg of the rally would drop SSO down to around $79.65, above my strike. This area is also close to where SSO gapped higher on July 8, which could offer an added reason for support. Sticking with Fibonacci lines, a 61.8% retracement would see a reversal around $77.90, almost right on my strike with plenty of profit left in my puts once time value has melted away.
SSO Naked Put Risk/Reward Breakdown
- Potential profit: $638.93
- Potential return: 4.10%, 11.5% annualized
- Breakeven price: $74.81
- Downside protection: 12.11% (equal to about 6% on S&P 500)
- Recent high: $87.07 on 8/2/13
- Cushion from recent high: 14.09%
- Expected support: $79.65 and then $77.90
- Position close goal/limit: Plan to stick with it through expiration and take assignment for long-term hold. My cost should be low enough that I can manage the position with covered calls if I have to.
I didn’t even realize it until I had finished writing, but this is my first trade of the month. I’ve been waiting for stock prices to drop further and lost my patience today. Technically, this trade sends me deeper to the over-invested side, but I don’t think a few of my positions have much of a chance of being assigned. Those include UCO, QCOM and UWM. QCOM options expire on Friday and will add more cash back to my account as I sell 200 shares from my covered calls being assigned. I’ll also free up cash from my QCOM put expiring worthless. I might close my UCO and UWM puts early to lock in the profits. The rest of my positions are closer-to-the-money with only DIS in-the-money.