We’re about to see how much investors have become in love with their stocks over the past 20 years.
The start of the earnings season, coupled with the looming reality that the Federal Reserve will raise interest rates from historically low levels, means that many stocks that have performed well for a long time may be struggling in the face of the new realities.
To help manage whatever comes next, investors may consider using a simple options trading strategy to offset potentially stalled or plummeting stock prices that have performed well in the past but may not. not thrive in the new market environment.
By selling bullish calls on preferred stocks that are under pressure as the Fed sell-off nears expiration, investors can improve the performance of their stocks.
The strategy is simple. Sell calls that expire in a month or less, with strike prices about 10-15% above the share price. If the share price remains below the strike price, investors can keep the premium on the options.
This covered buy strategy allows people to be long-term investors, with a key twist: if the stock price is higher than the expiration strike price, investors must sell the stock, or redeem the call at a loss, or switch to another monthly expiration date.
At the moment, nothing needs to be done yet, but investors need to start thinking about new ways to manage their old stocks as the market crowd braces for higher interest rates.
We continue to believe that it makes sense to wait until the Fed concludes its two-day meeting on January 26. The meeting is expected to introduce critical information, or confirmation of expectations, to the market.
In anticipation, investors revalue stocks whose price / earnings multiples are greater than the
S&P 500 Index.
These so-called growth stocks are often under pressure or falling, while cheaper value stocks strengthen and advance.
So far, the spins appear to be largely driven by institutional investors who believe the discounted cash flow models used to value stocks mean high-tech stocks are suddenly worth less.
Essentially, the future value of cash flow is worth less if the rates are higher. Hardly anyone outside of the securities industry thinks or talks about discounted cash flow models, which likely means there will be some hard lessons for people to learn after decades of reliable stock price rises.
Mini-crises are likely to erupt in millions of portfolios as investors face the end of historically low interest rates that have long held stock prices high.
Many stocks, especially high-flight tech stocks that have long led the broader market, may no longer behave as in the past. Investors are likely to be reluctant to sell stocks that have performed so well, even if they manage to invest money in new hot sectors, especially financials and cyclicals.
There is no doubt that the stock market is changing. Investors are debating what might happen once the Fed hikes rates or brings more clarity. Rather than guessing what’s going to happen, make a plan and be prepared to react to concrete news rather than mere speculation about the future.
Some investors will not want to pay taxes on unrealized gains. Others will claim that the broader market and their favorite stocks will stabilize soon once monetary policy is normalized.
Anyone can be partly right and partly wrong, and there is little to be gained from trying to guess the outcome. Instead, if you have stocks that could be roughed up or have spat in the past few weeks, consider using the covered buy strategy.
Steven M. Sears is President and Chief Operating Officer of Options Solutions, an asset management company. Neither he nor the company has a position in the options or underlying securities mentioned in this column.
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