An options strategy to protect against falling stocks

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Hormel Foods, the maker of Spam, has a reputation for doing well when times are tough.

Daniel Acker/Bloomberg

The Tower of Babel has nothing on Wall Street.

Every day, pundits and street-marketing machines tout and denounce so many potential risks and rewards that it’s often impossible to make sense of the passing scene.

On Monday, stocks rebounded and investor sentiment was broadly positive. But Tuesday’s release of the consumer price index was not the CPI’s Happy Day touted by some pundits.

The economic report was worse than expected and stocks plunged because the Federal Reserve no longer has any pretensions to reduce the pace of interest rate hikes. Investors brace for those who are more aggressive than expected.

This should come as no surprise to anyone who lives in the real world. Inflation, as anyone who buys groceries knows, remains a major problem. For people living in the financial bubble, consider Goldman Sachs. The bank is expected to start reducing its workforce to reflect the current environment.

So far this year, we’ve detailed a few different approaches to navigating this time of market transition.

We advocated writing call options on Ì shares to improve returns. We suggested watching the


Cboe Volatility Index

and selling put options on blue-chip stocks when the VIX hits 30 to profit from extreme fear.

We urged investors to “buy the dips and sell the tears” to take advantage of any near-term rally that may occur as the Fed normalizes monetary policy. We advocated for hedge portfolios when it was cheap and stocks were higher.

Rather than shouting aboard the noise machine that is often wrong but never questioned, options investors can monetize short-term volatility in a variety of ways to express long-term investment themes.

The 50/50 strategy offers a different way to manage risk and potential returns. Investors who want to buy stocks but are worried about falling prices can buy half the stock they want, while selling put options on the other half to potentially buy more at lower prices.

Consider

Hormel Foods

(symbol: HRL). The creator of Spam has a reputation for doing well when times are tough. When people try to save money, it often benefits less expensive foods.

With Hormel at $46.17, investors could buy 500 shares and sell five $40 January put options for around $1. The strategy requires buying shares at an effective price of $39, which would reduce the cost base of the entire position to an average of $42.50. Over the past 52 weeks, Hormel shares have ranged from $40.48 to $55.11.

Michael Schwartz, Oppenheimer’s chief options strategist, says investors are better off trying to use time to their advantage than trying to time the market. “Many investors don’t know what’s coming next, so using strategies that help monetize uncertainty is a way for long-term investors to potentially capitalize on it,” he says.

These strategies are ways for investors to engage in what we have long called “temporal arbitrage”. Investors who are comfortable with options can use puts and calls to take advantage of short-term volatility in anticipation that tomorrow may be less dramatic than today’s challenges.

Anyone who considers this approach is likely to achieve better results than those who try to play around with one-size-fits-all economic reports or simplistic views of technical analysis.

Play the long game. Trade the market you have, not the one you think exists. Be realistic. Manage your risk. Ignore the noise and focus on well-run companies, especially when current financial conditions weigh on their stock prices.

Steven M. Sears is President and Chief Operating Officer of Options Solutions, a company specializing in asset management. Neither he nor the company has a position in the options or the underlying securities mentioned in this column.

E-mail: [email protected]