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Michael Fowlkes' Analyst Insights

InvestorsObserver
Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

 

August 3, 2015 - How to Profit in a Stagnant Market

The earnings season is winding down, and while some stocks were able to impress Wall Street, there have been plenty big name companies in the Dow Jones that disappointed.

Before Alcoa (AA) kicked off the earnings season on July 8, the Dow was sitting at 17,515.42. As of the time of writing this article, the Dow is at 17,745.98, marking a 1.3% decline, a clear indicator that the current earnings season has been weaker than hoped, but not bad enough to drive markets sharply lower.

The biggest drain on the index has been negative reactions to reports from Apple (AAPL), IBM (IBM), and United Technologies (UTX). All three stocks ran into serious selling pressure after their reports, and with the Dow consisting of just 30 stocks, weakness in any one stock will easily pull down the overall index.

A couple of the better performing stocks were Johnson & Johnson (JNJ), JPMorgan (JPM) and McDonald's (MCD). These stocks helped bring some stability to the index, and keep the damage to a minimum following the big disappointments from the company's mentioned above.

As expected, one of the more common themes this earnings season has been the negative impact of currency conversion on large multi-national companies. The strong dollar may be a positive indicator for the health of the overall U.S. economy, but it leads to lower international sales when companies are forced to exchange overseas sales back into the dollar.

The fact that the Dow Jones is little changed since the start of the earnings season really should come as no surprise. If you look back at 2015 on the whole, you can clearly see that the market is stuck in a fairly tight sideways channel, as investors have struggled to find good reasons to push the market in one direction or the other.

On one hand we have a string of disappointing earnings reports. On the other hand, we recently got news that U.S. economic growth accelerated in the recent quarter, mainly as a result of strong consumer spending. The housing recovery continues to progress, albeit at a slower pace, but the big unknown is how well the recovery will hold up when the Federal Reserve finally decides to lift interest rates (which is expected to occur in September).

There are plausible reasons on both sides of the debate as to whether stocks should move higher or not, and as a result the market has been rather stagnant. Valuations are not a major concern right now, with valuations a little on the high side, but not to a degree that would send the market into a panic or suggest that we are in any sort of bubble.

What I expect is that the market will continue trading sideways through the latter part of the year. Given this outlook, I see little reason to set up a stock-only trade on the Dow Jones, and would prefer to play the index with a covered call trade that allows for a profit even if the index trades flat to slightly lower.

We are going to look at setting up a December $181 covered call on DIA using real-time prices to illustrate how effective the strategy can be in a sideways market.

DIA is currently trading at $177.29.

Charts courtesy of www.stockcharts.com 

To set up the covered call, you would buy shares of DIA (typically in 100 share lots, scale as appropriate) and sell the December $181 call for a debit of no less than $173.90.

By buying DIA shares and simultaneously selling the December $181 call, you have managed to lower your cost basis on your shares to $173.90, which now becomes the break-even point on the trade, and represents a 1.9% discount to the current share price.

As long as DIA trades above $181 on December 18 when the sold call expires, the sold call will be assigned and the market will exercise its right to buy the DIA shares for $181. This results in a 4.1% profit, and with the trade open 140 days, the trade has an annualized return of 10.6% (for comparison purposes only).

As with any investment, there is always the risk that DIA could trade below $181 at December expiration. Should this be the case, as long as DIA does not fall below $173.90, the shares can be sold for a slight profit. Alternatively, you could sell another call against your shares to lower the cost basis further, or just hold the DIA shares and wait for a rise in price before unloading the position.

The worst possible outcome would be for DIA to trade below our break-even $173.90 at December expiration. In this scenario, the trade would be in trouble, and we would have to realize a loss if we unloaded shares. However, another possible move would be to sell another call to lower the cost basis on the position.

Even if the worst-case scenario occurs, and DIA is below $173.90 at expiration, the covered call strategy allows for the shares to have a cost basis lower than the overall market, which is the whole point, and the primary reason why the strategy is perfect to use in a stagnant market when large swings one direction or the other are not expected.

 

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