March 23, 2015 - How to Lower Your Risk While Setting Up a Trade on SPY
The current earnings season is winding down, with just a handful of big companies left to report. As is always the case, there were plenty of both positive and negative reports, but the general view of the earnings seasons was positive.
Now that earnings are behind us, the markets are going to be mostly influenced by world events and economic data. The two primary things that are going to drive the markets are the dollar and oil.
Oil remains weak, but it appears to have at least hit a point where there is not much additional downside. The dollar remains very strong, but that strength will come under pressure through the remainder of the year as the Federal Reserve determines whether or not the time is right to begin lifting interest rates.
What I believe is going to happen is that over the next few months oil prices will stabilize, but not make any sharp moves one direction or another. There is always the possibility of political unrest in the Middle East driving prices higher, but barring any huge geopolitical unrest, oil prices should remain constrained until demand catches back up with supply, which will take a while.
On the dollar front, I believe the Federal Reserve will do its part to keep the greenback from rising much more from its current state. It has already removed the word "patient" from its pledge on lifting interest rates, and while it has yet to move on interest rates, it is obvious that a change in coming. Rates may not rise until after the summer, but they most likely will before the end of the year, and traders will likely keep the dollar where it is until that occurs. Europe is lowering interest rates, which normally would weaken the euro even more versus the dollar. I believe the Fed will keep an eye on exchange rates in addition to inflation and unemployment when making decisions about what to do with interest rates.
A strong dollar is not good for American companies that have significant operations overseas, and it is likely to have a negative impact on first quarter earnings, which will start being released mid April. Most companies in their recent quarterly reports mentioned the impacts, but the impacts on the current quarter will lead to a volatile earnings season, and could be even worse when earnings from the second quarter start rolling in during July.
What this means is that the long-term outlook for the market remains good, but we are likely to see some disappointments in the next earnings season as a result of unfavorable currency conversions by the nation's largest international companies.
With the recent wave of quarterly reports being mostly positive, I think that the S&P is likely to move higher in the next three months. However, there is a chance that the index will trade relatively flat, as Wall Street braces itself for the impact that the strong dollar has on first-quarter results.
A good way to capture the assumed stability of the market between now and the next earnings season would be a covered call trade on SPDR S&P 500 ETF (SPY). SPY is set up to track the overall S&P 500, so it should rise a bit with the overall market, but using the covered call strategy allows us to lower our cost basis on any trade, and build in some downside protection just in case the market does trend lower. We will look at a June covered call, so the trade will close ahead of the next earnings season, so it would not have to endure a volatile earnings season on the horizon.
Charts courtesy of www.stockcharts.com
I like the June $214 covered call on SPY. To set up this trade, you would buy SPY shares (typically 100 shares, scale as appropriate), and sell the June $214 call for no less than $3.60 per share. SPY is trading at $209.65, but that price is offset by the $3.60 you earn on selling the call, so the cost basis on your SPY shares is lowered to $206.05.
If SPY is trading above $214 at June expiration (June 19), the position will be assigned, and the market will exercise its option to buy your SPY at $214 per share. Therefore, your target return on the trade is $7.95 per share, which is 4.0% profit.
However, if SPY is trading below $214 at expiration, the options will expire worthless, and you will be left holding your SPY shares. As long as SPY does not fall below your $206.05 cost basis, you can elect to sell your shares for a slight gain, hold on to your shares, or keep your shares and sell another call against them to lower your cost basis even further.
As you can see, there really is not a bad outcome. The worst case scenario is that you keep your SPY shares, but managed to lower your cost on the shares by $3.60 per share versus today's trading price.
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