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A Strategy for a Nascent Rally and High Volatility

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As several of the factors that weighed on the market in the last quarter of 2018 seem to be going away, stocks have been rallying slowly and many investors who may have been holding some cash on the sidelines are probably wondering whether it’s time to start buying some of the stocks that were beaten down last year.

US economic conditions are still quite strong, interest rate concerns have largely been eased by the language of the Fed, the US-China trade talks appear to be headed in the right direction, and oil prices have even rebounded off of recent lows in expectation of global growth.

Also, although it’s lower than the levels we saw during the biggest broad market declines at the end of December, the CBOE Volatility Index (VIX) is still right around 20% - significantly higher than multi-year averages.

Translation: option premiums remain somewhat expensive.

Let’s say you’re not sure you want to buy all the way back in at these levels. You wish you bought the very lowest levels a few weeks ago, but you’re also a little apprehensive about the strength of the rally in the near future.  Here’s a strategy for easing back into long positions while also capitalizing on high implied options vols:

Buy half of the shares and sell a strangle.

It’s a combination of two strategies we’ve discussed before – the cash-covered put and a covered call.

Example:

(We’ll use Apple (AAPL - Free Report) , but the strategy works with basically any stock.)

The p/l profile for buying 200 shares of Apple at the current price of $153.30/share looks like this:

Instead of buying 200 shares of Apple, you buy 100 shares and keep the balance in cash. You also sell an out of the money call and an out of the money put.

If the stock declines, the short put will be assigned and you will purchase an additional 100 shares at the strike price, bringing the total to 200 long shares but at a lower average price than if you had purchased them all at the same time.

If the shares stay inside the range of the call and put strike prices, you’ll collect the entire premium you collected by selling the strangle and will still own 100 shares of stock.  At that point you can decide whether you want to buy more Apple shares, invest the remainder of the cash elsewhere or keep the cash on the sidelines as “dry powder” for a future opportunity.

If the stock rallies through the strike of the call, the call will be assigned and you’ll sell the 100 shares for a quick profit – the difference between the stock price when you bought the shares and the strike price, plus the premium collected by selling the strangle.

The p/l profile for buying 100 shares of Apple (AAPL - Free Report) at the current price of $153.30/share and selling the February 140-160 strangle for the current market price of $5.60/spread looks like this:

You’ll want to pick a strike for the put just under recent lows and a strike for the call that represents your personal best-case scenario estimate for stock appreciation at expiration.

Versus simply buying 200 shares right away, you shallow out the downside risk and create a nice fat pocket of profitability if the shares stay right around the current price or rally modestly.

Obviously, you are giving up some of the upside potential if the stock were to rally hard. If you think that’s likely, this is not the trade for you.  Buy all the shares instead.

If you like how conditions are shaping up for the markets but aren’t ready to push all the chips in just yet, this strategy gets you some long exposure as well as the possibility of quick profits if the markets go sideways for a while.

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