While I am a value investor at heart, I am not averse to making some money acting opportunistically if a good opportunity presents itself. I think such a time is at hand.
The recent coronavirus scare has sent the market careening down over 10% lower in just over a week as fear has spiked. Too much fear can sink stocks well below where they should be. When investors get greedy, they can bid up stock prices way too much.
It is the nature of the market that it gyrates between fear and greed over time.
When fear increases, volatility spikes. This can be seen in the Volatility Index, or VIX, chart below. The real-time market index represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 Index options, it provides a measure of market risk and investors' sentiments. It is also known by other names like "Fear Gauge" or "Fear Index."
The S&P 100 Energy Index has already lost over 20% going into 2020, which is bear market territory, following the outbreak of the novel coronavirus and the likely knock-on effect on crude demand growth. The market has overreacted in my view, making energy stocks look cheap at current levels.
One way investors can make money when fear and volatility spike is to sell fear.
They can do this by selling at or near the money puts on Exxon Mobil Corp. (XOM, Financial), the largest oil and gas company in the world. My reasoning is that in about six months' time, the coronavirus issue will likely be in the rear-view mirror.
Selling puts provides an investment opportunity to receive premiums as immediate income on a stock that you may wish to own at a lower price. If the option expires when the share price is above the strike price, then the seller retains the full premium credit. If the share price is below the strike, the seller is obligated to buy shares at the designated strike price, which could result in losing money on the trade. Naked puts are also called cash secured puts, because the value of the contract if exercised at the strike price is often held aside in a margin account, or cash is required to cover the trade in a non-margin account.
While the option math is beyond the scope of this article, apart from the stock price itself, option pricing depends on several factors, such as time to expiry, interest, dividends and volatility. As the stock falls, market participants rush to protect their position by buying puts, making puts expensive at the strike price. All else being equal, the higher the volatility of the underlying asset (i.e., the stock), the higher the price for both call and put options. This happens because higher volatility increases both the up potential and down potential. The upside helps calls and the downside helps put options. We can think of volatility as a number representing the emotion of the market.
I sold the following put today, and the person I sold to paid me $4.55 per share. If on Sept. 18, 2020 the stock is above $50, I get to keep the $4.55. If the stock closes below $50, I will have to buy the stock at $50. As you can see in the chart below, Exxon's implied volatility is over 35% currently. As a reference, the volatility over the last year was less than 20% and GuruFocus reports the volatility as 22.79.
The sudden increase in volatility, together with the decline in the stock price, has caused option premiums to rise.
Buy selling puts, I have the opportunity to monetize the fear in the market. I could, however, be wrong and will be forced to buy the shares. But if so, I am happy to own Exxon below $50 a share. Its a solid company with a wide moat that pays a dividend of 6.7% , while the 10-year Treasury has a yield of less than 1%. If I am right come September, I will have an annualized return of around 17%.
Disclosure: Long Exxon Mobil.
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