Over the past several weeks, the combination of rising stocks and falling bonds has led to an unusual and extreme precedent between the two asset classes.
While there isn't necessarily any fixed correlation between the movements of stocks and bonds, they generally move within at least one standard deviation of each other.
Stick with me because this is EXTREMELY important.
So, if one standard deviation is considered "normal," two is extreme and three is well, historic. And that's exactly what we are witnessing today.
Just take a look at the chart below from esteemed analyst Jason Goepfert.
Earlier this week, the Stock/Bond ratio hit 2.96, one of the highest readings seen in the last 50 years. In fact, it's only happened twice over the past six years. Both times that has led to intermediate-term declines.
So, knowing that we could be entering into a potential lull, how can we use a portion of our portfolio to protect and drive income over the next several months?
The answer: credit spreads.
It's a simple and straight-forward concept that I discussed in my most recent. Credit spreads, more specifically bear call spreads, allow you to create your own income - a monthly paycheck, if you will - while protecting against potential market declines. How? When you sell a credit spread, you collect cash (credit) up front while simultaneously transferring risk to the buyer.
Best of all, you can create your own income targets when selling credit spreads. And the sum of all of your so-called targets - when set properly - gives you a targeted monthly income.
A bear call spread is a credit spread composed of a short (sold) call at a lower strike price and a long call at a higher strike price. The nature of call pricing tells us that the higher-strike purchased call will cost less than the money collected from the lower-strike sold call. That's why this spread involves a cash inflow, or credit, to you.
The ideal outcome is for the underlying stock price to stay below the strike price of the sold call through option expiration. In this case, the spread expires worthless, allowing you to keep the premium collected upfront.
The basic premise of the strategy is easy. You choose the probability of the trade. Increasing the probability of success will decrease your potential profits, and vice versa.
Getting back to Apple, I'm sure most of you remember when the stock surged above $700 back in mid-September 2012. Amid the excitement, analysts were calling for the shares to race to $1,000 by year-end. I, on the other hand, noticed the stock had pushed into a "very overbought" state. As a result, I thought the shares were well overdue for a pullback, at least temporarily. (The same exact situation is happening in Apple and the S&P 500 right now.)
So with Apple trading at $690, I chose a short strike for my bear call spread that met my risk/return objectives.
Because I prefer a win rate - or probability of success - in the 70%-95% range, I invested in the Oct12 750/755 bear call spread. In other words, I sold the 750 call and bought the 755 call, with both options set to expire on the third Friday of October.
I also like to give myself a decent margin for error because it increases my probability of success. For this example, the 750 strike allowed for a $60, or 8.7%, cushion to the upside. In other words, Apple could have gained nearly 9% before October expiration and the spread still would have expired worthless, allowing me to keep all the credit.
The Oct12 AAPL 750/755 bear call spread met my expectations, bringing in a credit of $0.62, or $62 per contract.
As a result:
The max gain on the trade - 14.2% (this is based on the margin required to open this spread)
Probability of success - 86.6%
Apple would have to move above $750.62 for the trade to start losing value. As long as the stock price stays below $750.62 through October option expiration, the trade would be successful.
Nine days later I closed the trade for almost the maximum gain. A 10%-12% profit in less than two weeks on a fairly conservative trade ... not bad.
I've been doing this same type of income-based trade for almost two years now and have made over 20% in Apple while the stock is down roughly 20% during the same period.
Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders' tool belt. And I can use credit spreads as often as I like.
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