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Trading stocks, even in declining markets

Trading stocks, even in declining markets

The Dow Jones Industrial Average is effectively at the same level now as it was 12 years ago, about 11,000. In that time, the bellwether index reached its highest historical point of 14,164 in October 2007 and fell as low as 7,062 in February 2009. 

Regardless, a US dollar invested in the Dow in 1999 is worth virtually the same today. But you would have $2.01 if you put your money in an interest-bearing bank account at 6 per cent.

While the last 12 years have been dismal in performance overall, and indeed gut-wrenching during severe declines, stocks are known as a reliable long-term investment and have proved to outperform most asset classes overtime.

For instance, the Dow was at 776 in August 1982. While that level was a 23-per cent decline from 10 years prior, the index has soared more than 1,300 per cent since that month in ’82 – and gained 1,700 per cent when it was at its high in 2007. Therefore, a dollar invested in 1982 would be worth $14.25, much higher than the $5.75 earned through 6-per cent interest from a bank.

Admittedly, a pure “buy and hold” strategy – simply buying stocks and holding on to them in expectation they will appreciate over time – has become less effective given the sharp declines in markets and the increased volatility. That’s especially true if an investor needs to liquidate stock positions during the extreme dips.

However, there is in these situations a strategy that provides limited downside risk protection in times when markets are declining: covered call option writing.

A holder of a stock can write or sell a call option on the underlying security, which gives the buyer the right to purchase the security at a certain price (what’s known as the strike price) during a certain length of time, as the option eventually expires. The buyer pays a price for this right, or a premium, which the writer of the option pockets.

The value of a call option has two components. The intrinsic value is the amount by which the strike price is “in money”, or below the market price of the underlying security. Time value is the amount by which the option price exceeds its intrinsic value. For example, if the underlying stock is trading at $55 and a call option with a strike price of $50 is trading at $7, the intrinsic value is $5 and the time value is $2.

A holder of the underlying stock can write a covered call for time periods spanning days to years. The longer the term of the option, the higher the premium received. Intervals of strike prices are generally set by exchanges where options are traded; the higher the market price of the stock, the wider the interval.

Hewlett-Packard, the world leader in printers, was trading at around $50 in February. A writer of an October 35 call would have fetched a $17 premium for an option that is trading at $0.02 today.

The writer would have believed a severe correction was on the way and thus wrote the call “deep in the money”. While the writer lost $27 in value as the stock is now around $23, the writer can offset the unrealised loss with a $17 realised gain on the option written, for a total loss of $10 instead of $27.

Even though stocks have already corrected, there is also the opportunity to write “out of the money” calls, which is when the strike price is above the market value of the underlying security. For instance, the May 2012, 30 call is trading at $1.30. Even if exercised by the buyer, the holder receives a $7 increase in the stock price and a $1.30 premium, or a 19 per cent per annum return.

Anthony Galliano is chief executive of Cambodian Investment Management.
[email protected]

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