Not a day goes by when there isn’t yet another high profile market analyst doing his or her imitation of John the Baptist, crying out in the wilderness to repent of being long this supposedly grossly overvalued stock market. The headline this weekend in The Wall Street Journal “Biggest Weekly Loss Since April for S&P 500” sounds like there must have been some serious sell off that had investors running for the exits. Unfortunately, fear sells better than hope, but, rather than get emotional, let’s examine the facts about the current market and let the numbers speak for themselves.
For the week, the S&P declined by 0.79%. That’s right…not even 1%. We’re talking about a loss of 16 points for the index, opening last Monday at 1,984 and closing Friday at 1,967. The big news of the week was Lebron James’ announcement that he’s returning to the Cleveland Cavaliers, which overshadowed strong earnings from Alcoa (AA) and in-line numbers from Wells Fargo (WFC). That’s how devoid the stock market was of economic data, M&A and business related news.
And then came Monday’s better-than-expected earnings from Citigroup (C) that has restored almost all of last week’s headline-grabbing losses in the first hour of trading, but will unlikely receive the same kind of emotional headline from the WSJ. Within the numbers at Wells Fargo and Citi was the fact that corporate lending saw a strong 4% uptick. This is a real nugget of good news for the financial sector that has sorely lagged the broad stock market for the past six months.
Even more promising is the prospect of corporate lending by the regional banks, with the analyst community predicting as much as a 9%-10% annual pace. If this forecast turns out to be reality, then the financial sector will come alive like a sleeping giant and move to the front of the leadership pack on expectations of accelerating profits fueled by loan demand and the prospect of higher interest rates going into 2015.
The S&P 500 is trading 15.6 times its expected earnings for the next twelve months, above its average of 13.9 for the past ten years. But the past decade included two wars in Iraq, Katrina and the Great Recession. So, to say that 15.6 times forward earnings during a time of economic recovery is too high doesn’t warrant the angst that we read from the bearish camp.
Second-quarter earnings for companies in the S&P 500 are projected to rise about 4.6% from the year before and sales are expected to rise about 2.7% from the prior year. We will know soon enough how accurate these estimates are as no less than 50 S&P companies are set to report Q2 results this week. If Alcoa, Wells Fargo and Citigroup are any indication of what’s in store, then it’s no surprise Monday’s session was solidly higher – and what we can expect in the short term.
Given that trajectory, it’s a perfect time to sell some premium in this stock market, as I recommend doing in my Cash Machine Trader portfolio. A favored bullish strategy of mine is selling naked puts on low-cost stocks. The methodology is “sell to open a put option high, then buy it back to cover low,” with the thesis being that as a stock’s share increases in price, the value of a put option decreases.
Let’s look at how this works with a recommendation you can act on today provided you have either enough cash in your account or a margin account in place (though a margin account isn’t necessary to carry out a naked put strategy).
Kulicke and Soffa Industries (KLIC) is a leading semiconductor equipment maker based in Singapore. Forward estimates for revenue and earnings are accelerating, the stock has $7.80 per share in cash alone and the balance sheet has no debt.
The outlook for the chip industry got a boost when Intel (INTC) raised revenue guidance recently, which should spill over into chip equipment providers’ business momentum for the current quarter. After Kulicke and Soffabeat estimates in Q2 and provided strong guidance, KLIC stock has a very good shot at trading north of $15 in the current tech-heavy, Nasdaq-leading rally.
My best way to play a bullish bet on KLIC is to sell to open a naked put in it.
Sell to open the KLIC Aug. $15 puts at $0.90 or more, good till canceled. When you sell to open a put option, just as with any transaction in which you’re the seller, you collect money from the sale. It will appear in your account as a credit of about $90 per each put option you sell ($0.90 x the 100 shares that each put option corresponds to = $90.00).
Currently, the KLIC Aug. $15 puts are trading around $1.00. My expectation is that as KLIC rises into August expiration, the value of those puts will drift lower, possibly all the way to zero. If the puts are trading at or near zero on August expiration, you don’t have to do anything else and simply keep the $90 per contract that you collected.
If the KLIC Aug. $15 puts are trading around, say, $0.50 on August expiration, you simply buy them back to close (or cover) and you would get to keep $40 of the original $90 that you collected.
And if the KLIC Aug. $15 puts are trading higher at August expiration, that means that KLIC stock is likely trading lower than the $15 strike price. In that case, it’s likely you’ll be “put” the shares. This means that whoever bought the put you sold is electing to exercise it and is forcing you to buy the shares at the “agreed-upon” strike price of $15.
Because a put option corresponds to 100 shares of the underlying stock, if you were “put” the shares, you would need a cash output of $1,500 for each put contract that you sold to open. This is why it’s extremely important to open naked puts on inexpensive stocks and only sell as many put contracts that equate to the number of shares you’re comfortable owning. Naked puts can also be executed in margin accounts, but as noted above, as long as you have enough free cash on hand to cover the cost of the shares, most progressive brokers will allow you to do naked puts in cash accounts.
If you are put the shares and take ownership, then you can simply hold onto them and sell them at a point where you have a profit from your cost basis. If we take the trade above and pretend we have been put the shares, our cost basis would be $14.10 per share (the $15 strike price – the $0.90 premium we collected at the start of the trade = a $14.10 cost basis per share).
I encourage you to take advantage of strategies that involve selling premium into this market, like the ones we do in Cash Machine Trader. It’s an ideal market for it, as I’ll take my cue from Alcoa and Citi and presume that the earnings parade from the majority of those companies that make up the S&P will have a nice drum beat to it.
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