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It's the best of all possible worlds for long-term investors—even as options on the market's "fear gauge" are priced as if the S&P 500 will move about 4% each day into November.
That kind of movement seems hard to imagine, but opportunistic investors can take advantage of the extreme fear priced into the options market by selling put options to increase the yields of stocks that pay high dividends, or to cost-effectively buy shares.
While some people are panicking about the outlook for the stock market and the economy, the options market is paying patient investors to sell high and buy low. The prices of many put options, which increase in value when stocks decline, are unusually high because so many people are purchasing them to hedge their own stocks.
"The premiums offset a good bit of the risk here. You can't pick the bottom, but I'm comfortable owning certain stocks after selling hyped options premiums," says Michael Schwartz, Oppenheimer & Co.'s chief options strategist.
Consider Coca-Cola (KO). The blue-chip stock has a 2.7% dividend yield. The stock is at $67.34 and holding steady below a 52-week high of $71.77 set earlier in the month. Investors who want to buy the stock, or who already own it and want to increase returns, can consider selling the January $62.50 put for $2.16. The money received for selling the put is yours to keep if the stock doesn't decline below $62.50. If it does, put sellers are obligated to buy the stock.
Similar dynamics exist for call sellers. Coca-Cola's February $70 call trades for $2.63. Investors can buy the stock and sell the call.
These opportunities exist because the options market is pricing a broad-market correction. On Thursday, the S&P 500 plunged, and the Chicago Board Options Exchange's Volatility Index (VIX) spiked above 40. And investors paid top dollar to buy VIX calls that would rise in value if the stock market crashed and VIX hit 50 to 60 before November expiration. On Friday, trading volumes slowed, but the volatility dynamics were the same and will likely stay that way until European or Washington policy makers find a magic wand for the global economy.
Volatility is how the options market prices the future. "Known unknowns" roiling the market include, but aren't limited to, the possible collapse of the European Union, fear the Federal Reserve is out of bullets in the fight to rescue the economy, and concern that slowdowns in America, Europe and China could hurt corporate earnings, without which stock prices tend to decline.
In times like this, market makers often sharply increase implied volatility levels in their pricing models to compensate themselves for the risk of selling puts to scared investors. It's amazing that people who wouldn't pay double the normal price for a cup of coffee have no problem paying top dollar for puts. That fact is why many seasoned investors like selling puts on quality stocks.
Another market dynamic also is at work. Late September is when the Street shifts from trading O.P.M. to its own money. Everyone starts focusing on annual bonuses based on the returns earned on Other People's Money, and that influences the tone of the tape. This leads the Street to reduce risk. Market gyrations become much more personal, because market bumps now personally affect fund managers, strategists, analysts and traders.
The arrival of bonus season doesn't obviate the world's woes. It is mentioned only to note that time and fear are allies of long-term investors, just as they can be enemies for Wall Streeters who live and die in three-month quarterly windows.
The secret to these strategies is selling only as many options as you can afford to cover. Every call or put equals 100 shares of stock. Don't sell five puts if you cannot buy 500 shares of stock. You want to stick your hand in Wall Street's wallet—not the other way around.
Comments: steve.sears@barrons.com; http://twitter.com/sm_sears
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