Home Articles Options Writer Series — How To Handle The Current Stock Market Decline
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Options Writer Series — How To Handle The Current Stock Market Decline

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falling-stock-marketBy Warren Kaplan

The Stock Option Writer

© Warren Kaplan 2011-2014

January 26, 2016

With the stock market averages rocking everyday, one should step back and understand that there are sane ways to take advantage of the craziness of others. Two big reasons that stock prices decline is:

  1. Short sellers are allowed to sell at bid prices. Short sellers do not need to wait for an uptick, a rule that was in effect many years ago. This allowed huge hedge funds to raid and actively bring down stock prices to levels whereby the target company cannot raise capital at a reasonable price.
  2. “Investors” who bought shares on margin receive a notice that the lower stock price means they must post more cash and/or collateral. When these margin buyers cannot meet the brokerage house demand, their holdings are sold out “at the market” with no regard to the market price.

Both of those situations set up an opportunity for real investors to acquire shares at spectacular prices. The crash of stock prices in 2008-2009 with the crash of home and condo prices was one that we may not see again for decades. The home crash was due to speculation buyers owning 4-8 homes and condos for resale at a price higher than what they paid. Those speculation buyers bought on margin, via a small down payment and a huge bank loan.  The problem occurred when they could not make the monthly payments to the banks and they could not find a buyer at a higher price. Then they could not find a buyer even at a break-even price. Then they could not find a buyer at a small loss price. Meanwhile the banks were pressing them to make the contracted monthly payments.  Then home/condo values went even lower and the banks saw that the value of their collateral began to disappear and more pressure was put on the speculators. With no more homes or condos needed, there were job layoffs and so people could not make their monthly payments. So government bank examiners told the banks that they need to have more equity to back up their government loans. The “nastier” the examiners were to the banks, the “nastier” the banks were to the lenders. Home values went down as speculators and banks tried to sell homes/condos to anyone who could afford it. Many of the smaller banks failed to come up with enough collateral to satisfy examiners. Then large mortgage companies, which had borrowed billions of dollars from the public and institutions, not only had their collateral written down, they could not make their payments to their lenders. Homebuilders went out of business causing more layoffs, causing more home/condo defaults. One could buy a home well below the replacement cost. So who needed a new home when resales offered enormous value?

In the stock market, we have a constant similar situation. There are a lot of “investors” on margin. They owe the brokerage money. They are not really investors. They are speculators and like all speculators, there will come a time when a downward stock market will force them to come up with additional collateral and they won’t be able to do so. The brokerage house forces them to sell “at the market” without regard to price or value. And, it is here that true investors, who buy for cash and put securities away for a longer period of time, can get incredible bargains.  In August 2015, we had a “flash crash”.  The stock SDY went from $72.00 to a low of $44.00. This was mainly due to investors having a “stop loss” order in place. In such a case, the fall of a stock price causes a “stop loss” order to become active. The investor forgot to put in a “stop loss –limit”. When I saw the collapse in price, I was stunned and not sure if what I was seeing was true. It permeated through many stocks. GE went from roughly $27 to $20. I immediately committed some of the cash I always keep in reserve.  However, it was very difficult to decide on price at which to buy. I ended up buying SDY around $59 and GE around $21.50.  I was not sure that the transactions wouldn’t be rescinded. That happened before when a flash crash caused stock prices to get as low as $5.00. Well, all the trades were upheld and my investment account had a heck of a great buy. When the SDY returned to the $70+ area, I was able to sell covered calls with strike prices between $77 - $80 adding to the dividends I will receive. Since I bought the shares, GE has raised their dividend, I have sold many calls and have taken in more premiums, and the SDY has paid a large capital gain and continues to raise its comparative quarterly dividends.

There has been a change in the SDY philosophy. Previously, the fund held stocks of companies that were in the S&P 500 have raised their dividend every year for at least 25 years. Because the SDY (which is an ETF) was taking in too much money for such a concentrated diversification, the fund management changed to seeking companies in the S&P 1500 and that raised their dividend for at least 20 years in a row. My understanding is that the fund now has 100 companies in its portfolio. All 100 have raised their dividends every year since at least 1995.

So how is the best way to buy SDY or any stock? Pre decide at what price you really would like to own it and simply sell a put option at that price and time period.  If you would be willing to buy say SDY at $65.00 (currently $69.93), You should be able to receive $40 for a put option that ends February 19, 2016 and a put option at $65.39 that expires on April 15, 2016, you should receive about $140.00.  You can sell the April 15, 2016 put for about $55 per contract with a strike price of $60.00. Keep in mind that $60.00 represents a 15% discount from the current price and a 25% drop from the high of $80.00.  To give you prospective, that may require a 15% drop in the DJIA.  In my next article, I will discuss other ideas so that you will be building assets and come out a winner in the game.

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warrenkaplan-3Warren Kaplan has been writing options for 50 years. He has been a stockbroker, investment banker and brokerage owner.  He currently owns and operates Kaplan Asset Management, a provider of financial assistance for small to middle market businesses. He has more than a half-century of experience in dealing with financial markets, giving guidance and consulting with management, and assisting in the development of business strategies and solutions. The Company has assisted and consulted many successful companies, such as Natures Bounty (NBTY) and Action Products International (APII), helping them to go public and trade on the NASDAQ stock exchange. His philosophy is to “do something with the profits.” “If you make $100 in the stock market, take 50 percent and invest it back into the market. Then, take the other 50 percent and buy yourself something.”

Additional disclosure: I am not a registered investment adviser and I do not give investment advice. Nothing in this article should be construed as investment advice. Investors are encouraged to do their own research and seek the advice of an investment professional before investing. Writing options is not for everyone.  This article was written for informational purposes only.

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