Why Market Volatility is Great for Investment Returns

Wow. It’s been a pretty crazy, up and down (mostly down) time in the stock market since the start of the new year.

I can’t say it’s surprising. What with China’s slowing growth, the price of oil dropping like a brick, Federal Reserve’s interest rate increase, and the fact that stocks have been pretty overvalued for a while now…we have been due for a correction in prices for quite some time.

A lot of you are wondering what to do in these volatile times. Many of you are scared of what’s to come or what sort of action to take next.

We see these volatile times as huge opportunities for major growth in our investment accounts.

The biggest profits will always be made during times of volatility and fear. The key is to execute strategies in the safest way possible, keeping your focus on high-quality companies and assets.

This is true no matter what stage or financial phase of life you are in—just starting out, middle of your career, nearing or already in retirement.

And it doesn’t really matter where the stock market goes from here, or where it finishes for the year. With all of what is happening on a global scale, we can be pretty sure that the fear, turbulence and big up and down days will continue for a while throughout the year.

 

3 Things to Look for Right Now

There are three things we push all of our students to be looking to do during days and weeks of down markets and increased fear:

  1. Purchase great companies that are on sale. Those whose prices have been unfairly and irrationally brought down with the market
  2. Sell puts to get into those stocks
  3. Sell covered calls against stock positions

The first one—most of you who routinely read our material or have taken our Udemy course already know. Buying great companies at bargain prices is what our stock investing strategy is based on.

Where I want to get into a bit more detail is the second item…selling puts to get into stocks.

By selling puts, it’s possible to make a significant return before you ever own a stock—while you wait for the price to drop lower than it is today. This ensures you won’t pay a price higher than it is today, and you will get paid for that luxury. You get to choose the price you want to purchase at, and you get an immediate cash deposit in your account.

Before you think that sounds too good to be true, consider that during volatile times in the market, we’re able to generate returns that are even higher than normal—sometimes two or three times higher than normal. That’s why these turbulent times create huge opportunities.

Before I proceed, let me offer a quick caution…

A lot of people think options, particularly selling puts, is dangerous. They get a bad rap because people who don’t really know how to trade them can lose a lot of money. We don’t want that to happen to you. And it won’t if you follow the next few sentences.

The selling put strategy is only to be performed on stocks that you have already decided you would love to own. Ones that you would be proud and happy owning in your portfolio. Only sell puts on those companies that you view as long-term investments and would be comfortable holding onto for the next few years. These would be stocks that you truly understand how they make their money, where their competitive advantage is, that have strong financials, and have good management teams.

This strategy is only for students who wish to remain invested in equities, and who are looking for growth. Selling puts allows you to do both:

  • Receive high premiums, earning an immediate 10%-30% annualized return (higher in extremely volatile markets) on the entirety of the funds allocated
  • Possibly buy your favorite stocks at prices far below current levels

During times of high volatility—which really means there is fear in the marketplace—you can receive abnormally large premiums on these puts. The upfront cash premium that you will receive by selling puts soars as volatility climbs. People get scared and are willing to pay high (irrational) amounts of money for the downside protection puts give them.

We are happy to be the sellers in these cases.

These periods of high volatility, as measured by the VIX index, represent the best times to take advantage of a market plunge and the resulting increase in turmoil.

Here’s the only catch. In exchange for receiving these large premiums, you simply must have available the necessary capital to buy the stock (at a price you want to own it for—below the current price).

That’s it. Same amount of risk and capital involved as purchasing the stock outright.

 

Volatility Examples from Today

Let’s run through a few examples at the open of the market on Friday—January 22, 2016. You can brush up on options lingo here if you don’t understand the next part.

Friday morning, with Apple (AAPL) selling for $98.60/share, you could sell an Apple March 2016 put with a $90 per share strike price, for about a $2.05 per share premium. This would yield an almost 15% annualized return on a stock which many people were happily buying at just under $120 only eight weeks ago.

aapl volatility

By selling this put, not only do you gain a 15% annualized return, but you now have the possibility of buying the stock at a substantial discount at $90 per share. This creates instant income in your investment account, and at the same time provides you with an opportunity to buy a wonderful company at a wonderful price.

What’s the worst that could happen here? Some would say the worst case scenario is you are “put” Apple stock and forced to buy it at $90/share.

Is that really a worst case scenario? That’s a price you would have had to felt comfortable paying for it (before ever selling the put), and if you do get “put” the stock, you collect a 2.3% dividend yield, and you could then turn around and sell covered call positions against the position. This turns into a further decrease in your basis, plus you now have the even bigger opportunity of realizing significant gains by holding Apple stock.

I say the worst case scenario here is you only get a 15% annualized return, at which time you can sell more puts, hoping to have the opportunity to be “put” Apple stock and buy it at a discount.

Of course, all of this assumes Apple is a company you love—and in which you believe that $90 is a fantastic price with a built-in margin of safety. That’s a decision you need to make.

Or take a look at Coca-Cola (KO), a blue chip stock paying a 3% dividend yield.

KO volatilityEarly Friday morning, the stock is selling for $41.50/share. But you can sell a May 2016 put, with a $38 strike price, for about a $0.75 per share premium. This yields about a 5.5% annualized return which immediately goes into your account, along with the future possibility of owning a stable company with a growing dividend at a price of $38—representing an 8.5% discount from where it trades today.

You pick the price and collect money while you wait.

Deckers Outdoor (DECK), a far smaller company which is the maker of Ugg boots, is another one current students are looking at.

DECK volatilityToday, you can sell a February 2016 put, with a $40 strike price, for $1.20/share in premium. This yields an instant 38% annualized return, along with the potential to own the company at a 12% discount to its current price of $45.50.

And volatility is nowhere near as high as it could be. Earlier this week, these option positions were yielding 50% higher returns—simply because of fear of what’s to come.

Your key as an investor is to be able to remain calm in these times, and cash in on other people’s overreactions—when they are offering us such great prices.

 

More on Being a Seller of Market Volatility

What about the third part I mentioned…selling calls against stock positions?

That will be a separate discussion, but it works in a very similar way. If you own Apple stock, for instance, you could sell a covered call against your position.

You can sell $105 calls on Apple, with a May 2016 expiration, for about $4.15/share right now. This means you collect $4.15 per share in your account, and you now have the obligation to sell Apple at $105/share—if it trades above that price. Your stock would be “called away”, meaning you would no longer own it, but you would get to lock-in a significant gain on your holding. Then you sell more puts to get back into the stock and repeat the process all over.

The higher the volatility, fear, and instability in the market—the more money you will get when selling puts and calls. Today, the VIX opened at just 24. Earlier this week, it spiked above 30. In August, the VIX spiked over 50. These represent the best times to be selling options on good, solid companies. Ideally, we want to be selling options when the VIX gets above 30.

As market volatility rises, we will continue to ramp up our selling of option positions. Bursts of volatility in the market on big down days such as Wednesday morning—when the Dow was down 550 points—are the best times to take advantage of these opportunities. Days of solid green, when the market is up and news is good—is usually not the best time to be selling options and volatility.

The market could be in for some tough times. There are countless factors that should continue to push this market down, including increasing corporate debt that will soon begin to default, long-lasting effects of the Federal Reserve’s easy monetary policy, decreased company earnings expectations…the list could go on.

The only reason this market would not drop is if our Federal Reserve, and other central banks around the globe, continue—or even ramp up—an easing monetary policy that has already been artificially inflating world markets. It’s been done for the last few years. Europe is already hinting at more of it, with Japan not too far behind. Rumors are swirling that the US Federal Reserve could step back on its interest rate increase, though my guess is they will just keep rates where they are for the foreseeable future.

Either way, all you should be looking to do is capitalize on this inevitable market volatility. If stock prices go down, it will mean an even bigger return—since more and more companies will be selling at bargain prices. But even if they don’t, you can make large amounts by simply selling volatility in the form of puts and calls.

None of these are buy, sell or hold recommendations. In fact, they are not recommendations at all, but simply should be looked at as illustrating a strategy to be utilized during times of heightened market volatility, in conjunction with a solid investing methodology.

Selling puts and calls are just one part of our entire investment philosophy and strategy. For more information, check out our stock investing course and the Investment Intel stock webinars. In the webinars, we outline these, and other strategies in real-time. You can get a free, 7-day trial just for signing up.

 

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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