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Option Strategist: The Perfect, Yet Simple, Formula for this Imperfect Market

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Joseph Kunkle

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A simple options-trading strategy combined with time-tested cash flow analysis could be the winning formula for generating profits now in individual stocks – all without the worry of perfectly timing a market bottom.

There’s no doubt the markets are turbulent. Every day there is talk on trading floors about how low the market can really go. Traders see the market volatility index (VIX) near all-time highs, huge intraday moves in individual stocks, and enormous uncertainty about the length and depth of a global recession. They worry about slowing earnings growth, contracting margins, and struggling international operations. The broader market is in for a “valuation reality check” as it should be for companies trading at very high multiples to forward earnings while we are heading into what could be a multi-quarter recession

That’s why a cash flow-focused put-selling strategy makes sense. It is a way to be like Warren Buffet in being greedy when others are fearful, but to do so in a very focused way. Buffet himself has been actively selling puts against his position in Burlington Northern Santa Fe (BNI), a double long. It allows you to target the individual stocks with strong balance sheets that can exit a multi-quarter recession strongly, and to do so with a measure of protection.

Focusing on cash is simply common sense. Cash is most stable asset there is in today’s market. And companies with a strong balance sheet that can consistently generate free cash flow are the ones that don’t have to worry about paying off debt. What’s more, they’re likely the blue-chip names that will rebound first.

THE STRATEGY:

It works like this: Sell out of the money (or near the money) puts on companies with strong balance sheets that are trading at a low price to free cash flow metric with the intention of buying them back at a cheaper price or better yet, having them expire worthless. 

There are several key benefits.

If the market rallies, you are making money as stocks rebound and get further from the strike, while also benefiting from a falling VIX that takes volatility premium out of the contracts, allowing you to buy the puts back (to close) at a big discount. 

If the market continues to fall, you are protected by having positions in the names that have the least amount of downside. And with the VIX trading as if it is exhausted, you can still see some volatility decay that will lower the prices of the puts. 

Also, due to the current call-put skew, the puts value will decline more rapidly than the calls value will rise as the market moves higher.

PUTTING IT IN PRACTICE:

Screening the entire optionable stock universe of tradable names, with Price/Free Cash Flow of less than 5, Long Term Debt/Equity of less than 0.5, positive operating margins, a quick ratio greater than 1, and forecasted positive EPS growth for next year, we are left with 23 companies.

Applying some simple technical analysis to look through these names that have some longer term support levels at current prices the following are the stocks we would be selling puts against:

Benchmark Electronics (BHE): Sell December $10 puts for $1.20

BHP Billiton (BHP): Sell December $30 puts for $4.50

CF Industries (CF): Sell December $30 puts for $2.30

Emcor Group (EME): Sell December $15 puts for $1.45

JDA Software (JDAS): Sell December $12.5 puts for $1.15

Legg Mason (LM): Sell December $15 puts for $2.85

Perini Corp (PCR): Sell December $15 puts for $2.25

Lam Research (LRCX): Sell December $17.5 puts for $1.70

URS Corp (URS): Sell December $20 puts for $2.35

Western Digital (WDC) Sell December $10 puts for $0.60

* These look like the best contracts for these companies, although if you are more risk adverse you can sell further out of the money puts for a smaller credit.

About the author:

Joseph Kunkle
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.5/5 (11 votes)

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