How to Play the Market’s Rally Without Paying Top Dollar


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Covid-19 has created a curious phenomenon in the stock market: upside regret.

Investors are increasingly watching stock prices trade ever higher and some are envious of the gains even though unemployment is at historic highs, and the U.S. economy has been decimated by a virus.

Amid this incredible rally—and an even more incredible economic support program from the U.S. government—investors are forced to confront the reality that many have missed out on this historic gain if they reduced risk and took profits because the Covid-19 virus scared them out of the market.

The stock market is sending a curious message. In mid-February, the S&P 500 index peaked around 3,393.52, and then the index lost about 35% over the next month. A snapback rally began in late March, and the index has since retraced a huge chunk of its losses over the past two months.

The performance has created challenges for investors who must decide how to best control stocks without paying top dollar just in case the recent market advance reverses course. Consider Facebook (ticker: FB).

In early April, we recommended Facebook as a company that would emerge as a winner of the Covid-19 chaos. The stock has since raced to a record high as the world digitizes personal and professional relationships. Now, it is time to reset the position, or to create a new one for interested investors who want a piece of the action.

Rather than just buying the stock as it dances around a record high level, it is arguably more prudent to use an options strategy that creates a margin of safety.

To balance risk and reward, Investors can use a “risk-reversal” strategy that entails selling a put and buying a call with a higher strike price but similar expiration. The strategy positions investors to buy Facebook stock on a decline, while harnessing the stock to profit from future gains.

With Facebook’s stock at $234.88, investors can sell the August $230 put for $15.35 and buy the August $240 call for $15.10. The expiration captures second-quarter earnings, which should be released in late July if last year’s report is an indication of timing.

Should the stock be $270 at expiration, the call is worth $30. If the stock declines, and is below the put strike price at expiration, investors are obligated to cover the put or buy the stock. The key risk is that the stock is sharply lower and investors are then obligated to buy the stock at the higher put strike price, or cover the put at a loss.

During the year, Facebook’s stock has ranged from $137.10 to $237.20. Shares are up about 15% this year

In early April, we recommended the same strategy when Facebook was at $173.33 and sentiment was mixed to negative. At the time, we recommended selling the May $160 put for $4.90 and buying the May $180 call for $6.50 in anticipation the company reported sold first-quarter earnings. The stock has since surged, and anyone who held the recommended options through May expiration booked a handsome profit.

On May 15, Facebook’s stock was $210.88, and the call was worth $30.88, and the put expired worthless, increasing the profit to $35.78.

Now, Facebook’s stock is even higher, supported by a new e-commerce platform, Facebook Shops , and a similar program that will launch later this year on Instagram.

The initiative should steady and support Facebook’s stock price throughout the summer.

To be sure, the commentariat likes to rightfully note that the major technology stocks are increasingly responsible for leading the market higher. They like to opine that this creates great risks if something should happen to upset the group’s equilibrium. These concerns have been true for a long time, but Covid-19 has changed the dynamic.

Many institutional investors are hiding in the so-called FAANG stocks rather than creating new positions during economically uncertain times. Instead of taking on unknown risks in new positions, these institutional investors are reportedly adding to existing positions in Alphabet (GOOG), (AMZN), Apple, (AAPL), and Netflix (NFLX). The group has thus become a bastion of defensiveness, which should steady the group, particularly into the next batch of earnings reports.

Originally Posted on May 26, 2020 – How to Play the Market’s Rally Without Paying Top Dollar

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