By MONEY MORNING STAFF REPORTS, Money Morning • September 21, 2020
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Dear Red Alert Reader,
The stock market has been a very different place since setting all-time highs on Sept. 2. Volatility has kicked up, and we've seen a few days that could make us question the wisdom of remaining in the market.
The CBOE Volatility index has crept up to the high 20s in the last couple weeks. Of course, that's nowhere near the nightmarish high of 82 we saw earlier in March with the COVID-19 crash. But anything above 30 is considered high volatility under normal circumstances.
If you saw what happened in March, you know you have an advantage. Anticipating a crash, investors piled into put options for the cruise and airline industries. Tom Gentile, Money Morning's options trading strategist, recommended $40 April 17 puts on Carnival Corp. (NYSE: CCL), and investors gained more than 900%.
Carnival has fallen significantly below that $40 mark since then, now trading under $20. It could fall further. But even if it doesn't, there are plenty of similar opportunities out there.
Another lockdown could have a devastating impact on the world economy. And Israel just announced a second wave of lockdowns from COVID-19.
Here's the best options trading strategy if you're bracing for volatility.
The Options Trade for Future Lockdowns
The economy still has a long way to go to erase its pandemic decline. Despite several vaccines and therapies in formal trials, there still is no official medicine ready to combat the coronavirus.
Then there is the elephant in the room: the 2020 presidential election. Has there ever been such a political divide and suspicion about what the other side will or will not do as the results become known?
Investors want to know if all of this is causing momentary turbulence or if it is the beginning of the end. Even with the market at highs, we still read pundits forecasting gloom and doom from here to Sunday.
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More likely, the real deal will be some period of extended consolidation before the bulls can resume control. Tom Gentile also thinks there's downside risk ahead. But instead of bailing out of stocks, he wants to show you how to use options to your advantage…
Nobody really knows how long the current consolidation will last or how low it can go. You won't get far trying to time it all – selling now and then getting back in before the rising trend resumes. Ask yourself, did you sell on Sept. 2 before the Nasdaq market tanked? If you did not, chances are you will have trouble timing the current correction.
That's why put options are so powerful. For a relatively small amount of money, you can not only protect your portfolio from whatever is ahead, but even make some extra money in the process.
When you buy a put option, you get the right, but not obligation, to sell a fixed amount of stock for a fixed price by a fixed time. If the market falls sharply, then your put option rises in value, possibly offsetting any losses you may take with the underlying stock.
But the real value is that, should the market take off soon, you will still own your stocks and can profit from the gain. Your put option can be considered an insurance policy.
Now, protecting your portfolio is one thing. But if the market does move another leg lower, you can make some nice money owning puts. For starters, another sell-off will likely send volatility even higher.
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Options traders like that. The higher the volatility, the more their options are worth even before factoring in the market's price drop. You see, part of the price of any option depends on volatility. The more the merrier.
Here are some of Tom's pointers for selecting the right put option:
- Buy put options one or two strikes lower than the current stock price. For example, if Stock ABC was trading at $80 per share, the right put option could have had a $75 strike price. These "out of the money" options are cheaper.
- Give yourself time. Buy your puts between 90 and 100 days before their expiration. Here in September, that means a put expiring in December. Remember, you do not have to hold it until expiration. If you have a nice profit earlier, take it. And if the market goes the other way, cut your losses on the put.
- Consider buying puts on market index ETFs like the SPDR S&P 500 ETF (NYSE: SPY), SPDR Dow Jones Industrial Average ETF (NYSE: DIA), and the Invesco QQQ Trust (NYSE: QQQ). This takes the individual stock risk out of the equation. You won't have to pick which stock to use.
Trading options in this way could easily double your money if the market falls. That would go a long way toward bullet-proofing your portfolio and even provide a little extra return for your trouble.
If the market rallies instead, well, that's what you wanted in the first place.
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