It’s still June for stocks. And things could get worse from June, when major indices hit their lowest since the start of last year, supported by many layers of fear. Now almost every day I feel like going to the slaughterhouse. It’s no exaggeration to say that equities have taken a quadruple whammy over the last year or so. Inflation, war, Fed policies and foreign policies have each drawn attention by driving stocks lower. So much so that the last COVID-related sale we remember happened in November of last year.
With fear comes panic. With panic comes opportunity for investors with these characteristics:
- Patience and long-term vision
- Sufficient capital or cash to survive market downturns. By “survive” we mean the ability to maintain at least your current standard of living. Even if that means the market drops another 50% from here.
- Belief in the underlying action.
Amazon.com, Inc. (NASDAQ: AMZN) is one of the stocks that we believe is long term. We wrote this article in June, when the market was just as bad, suggesting investors sell put options at about 10% below the market price at the time. Luckily, Amazon has since outperformed the market easily, as Seeking Alpha has captured, as shown below. The point is not to brag about such fleeting short-term “success”, but rather to have the belief that you are supporting a company you believe in through horrible market cycles.
In the interest of full disclosure, we have initiated a stock position on Amazon during this sale. This does not mean that we do not want to increase our exposure to Amazon at attractive prices. But what is attractive and how do you get it? What if you want to buy Amazon but at a lower price? Sure, you can use a limit order, but what if the stock never reaches that point? You remain completely out of the game. This is where the sale comes in, where you immediately collect a bounty for your skin in the game.
To stay consistent with the previous article, let’s look at a strike price around 10% lower than the current market price. Interestingly, the option premium (as a percentage of the underlying cost) is currently much lower than it was in June. Let’s get into the details below.
- Strike price: $102
- Expiry date: October 7, 2022
- Premium: $0.48/share, for a total of $48.
Simply put, the sell seller gets $48 back to buy 100 shares of Amazon at $102 if the stock reaches $102 or lower by October 7, 2022. Keep in mind that time decay is in favor of the option seller, which means that as the days go by, the values of the options decrease.
What is the expected output and possible outcomes?
Come back: The premium collected ($48) for setting aside $10,200 is only 0.47% for just over a week. While any positive return in the current market is welcome, this contrasts sharply with the return of 1.25% in June for a comparable period and strike price. How is it possible? On paper, things are at least a little, much worse now than in June. So shouldn’t the option writer receive a higher premium for assuming the risk of buying the underlying stock? The only logical answer we can come up with is that the market doesn’t think the stock will go that low before the expiration date. Sounds like a positive affirmation to us.
Result #1: If Amazon stays above $102 on the expiration date, the options seller simply keeps the above mention. The option seller will not be obligated to buy the shares.
Result #2: If Amazon drops below $102 on the expiration date, the options seller will be forced to buy 100 shares at $102, regardless of where the stock is trading at that time. Keeping the net premium in mind, the average cost in this case will be $101.52 ($102 minus $0.48).
Result #3: As an options seller, one can “buy to close” at any time instead of waiting for the expiration date. This can be appealing to those who have the time and patience to play short-term options multiple times. But we usually let the option expire before choosing another channel (or another title).
Many ways to skin the cat
The string above was just an example. If you’re looking for a higher yield and a lower strike price, consider long-term options like the one below. Our sweet spot has always been between a week and a month, as this gives us enough time to react and at the same time does not tie up capital for too long.
In this example, the options seller agrees to buy 100 shares of Amazon at 100 if the stock reaches it on October 28, while receiving a premium of approximately $2.30 per share. A return of 2.3% in one month for capital set aside is something many would grab with both hands in today’s market.
Be aware of your risks and choices
Again, keep in mind that if your primary interest is to earn premiums, selling put options in bearish markets may not be the best strategy. If the market bloodbath continues, your stock may reach the strike price before you blink. However, if your interest is to buy the stock should things continue to decline, this is a sound strategy. The extra income through the premium doesn’t hurt either.
While AWS is booming, Amazon’s retail issues have been well documented. This The article captures the essence of corporate overexpansion during COVID. Amazon is also likely to face higher tax bills due to the new minimum tax sign by the President in August. Around ~$3 billion seems like pocket change for a trillion dollar empire, but it all adds up, especially when things look depressing.
We expected the option premium for this fiscal year to be much higher (in percent terms) compared to June, given how much more fragile the market looks now. Admittedly, a sample is the worst you can find, but it seems consistent at least in the Amazon chains we observed. The options market may be signaling that things are not as bad as feared, while yield shows signs of leveling off.
Be aware of your risks, never do everything, stay invested in good businesses and that too will pass. Panic is not a strategy. Good luck.