In today’s volatile market, bonds are emerging as a more appealing option than stocks. Many investors are finding solace in money-market funds or short-term government bonds, which offer a satisfying yield of 5% or more. Even the 10-year Treasury bond is currently yielding around 4.3%.
After enduring numerous market upheavals over the years – from the Asian contagion in 1998 to the bursting of the internet bubble in 2000, and the global financial crisis of 2008-09, to the recent Covid meltdown – investors are craving a reasonable risk-free return. This desire only intensifies as global central banks raise interest rates to combat inflation.
While the cash return falls below the stock market’s long-term average of approximately 9%, there is an opportunity for investors to enhance their yields without significantly increasing their risk. Welcome to the equity options market.
Exploring Opportunities in the Equity Options Market
Here’s how it works: allocate 80% or 90% of your cash into bonds and reserve the remaining amount to be invested in an interest-bearing account eligible for financing options strategies. With this setup, you can sell puts on a blue-chip stock that you believe is worth owning for the long term.
At present, these puts – which grant the buyer the right to sell the stock at a specific price – offer attractive premiums due to increased buyer demand for downside protection. By utilizing a special brokerage account, you will have the ability to purchase the stock if it falls below the strike price.
Consider selling puts that are about 10% out-of-the-money and have an expiration period of four to six weeks. This approach can generate approximately a 1% monthly return on the cash that secures the put.
The Benefits: Yield Enhancement and Fear-Premium Monetization
The ultimate outcome is twofold: investors can enjoy attractive fixed-income yields while also profiting from the rising fear-premiums in put options. The majority of an investor’s funds are safely invested in bonds, and the money reserved for financing cash-secured put sales is held in an account that offers high-interest rates. The put premium becomes an additional bonus.
In conclusion, bonds have become an alluring choice for investors seeking stability and a reasonable risk-free return. By strategically navigating the equity options market, it is possible to enhance yields while capitalizing on fear-premiums. So why not explore this avenue and make your investments work harder for you?
The Risk of Selling Cash-Secured Puts
Selling cash-secured puts carries a risk that is akin to buying stocks – the potential for financial loss. Various factors such as a significant drop in the stock market due to unexpected Federal Reserve rate hikes, an economic downturn in China, or a decline in corporate earnings can overshadow long-term investment objectives.
Investors must take into account their individual temperament and risk tolerance levels while also keeping a close eye on the yield of the 10-Year Treasury bond. This particular yield is considered to hold the key to the stock market’s future.
Historically, it has been observed that whenever the 10-year yields reach or exceed 4%, stocks tend to react unfavorably. Such high yields disrupt the widely-used valuation models that assess multiyear earnings.
Stocks in leading big technology companies, whose equity prices reflect the perceived value of long-term revenue streams, are especially susceptible to swings in valuation. Should yields continue to rise – although it is uncertain whether this will be the case – stock prices are likely to decline.
With a blended approach that combines bonds and options, investors can adopt a time arbitrage strategy that allows them to navigate through uncertain market conditions.
During these unstable times in the stock market, it is crucial to exercise caution when selecting strike prices and expiration dates. Moreover, it is advisable to refrain from selling puts on a stock that you are not prepared to own.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.