Options: Buy or Sell?

Options trading is booming. People are bored sitting at home during quarantine and are turning their attention to the stock market and specifically options trading. Easy to use platforms such as Robinhood have helped to facilitate significant growth in options volume. It has emerged that Japanese giant SoftBank bought $4 Billion of options during recent weeks and that helped fuel the approximately 75% rise in the Nasdaq 100 index since the depths of March 2020.

Options Prices

If the volume of options trading is up, what do you think that means for the price of the options being traded? As with any other product, if the demand rises, then the price rises, all other things being equal. If the number of bidders for a particular call option at a particular strike price and expiration goes up, then the price to buy that call option will go up. The opposite is true as well. Quants will point you to the Black-Scholes Option Pricing Model to figure out what a call option is really worth, but in reality an option is worth what someone else will pay for it on the open market, and that goes back to simple supply and demand. If you believe that the stock or index that underlies the option stands a good chance of going up, then it may make sense to buy the call option. But, at present, you will pay a premium to do so.

Buy or Sell?

Consider this, however: If the sales price of a product is inflated, as option prices currently are, does it make sense to be a buyer in an inflated market or to be a seller? What I am saying here is that now is a great time to be a covered call seller, or writer, because option premiums are inflated. “Covered” calls involve owning the underlying stock or index and then selling calls at inflated prices and pocketing the premiums that you get from the sale. Typically a call seller will sell calls with strike prices at or above the current price of the underlying stock. For instance, you may want to sell a call with a strike price that is 1% higher than the current price of the underlying security. You pocket the premium that you sold the call option for no matter what happens next. At the expiration of the option, if the price of the underlying is below the strike price of the option, then you keep your stock as well as the option premium. If the price of the underlying at expiration is higher than the strike price, then you still keep your option premium but you have to “put” the underlying stock to the call option owner at the strike price, not at the actual price of the underlying. That’s your risk: you give up some potential upside in return for current cash in the form of the option premium. With option premium prices inflated presently, selling sounds like a good deal to me.

Don’t Be Naked

Don’t be naked, by which I mean don’t sell option premiums, either calls or puts, without owning the underlying security. Naked selling is very risky. If you like to be naked, then go ahead and buy options – don’t sell them naked.

IMO

Right now, options are like the new, hot restaurant that just opened. All of the beautiful people are there hanging out and it is tough to get a seat. Since the restaurant is in high demand, it boosts its prices up. Do you believe it is a good investment to try to “buy” a seat at this hot new place called the options market? Or might a be a good idea to avoid it for now and wait until the hype dies down a bit so that you can partake at a more reasonable price? My restaurant analogy falls short with respect to my covered call strategy (you can’t “short” future seats at the restaurant, at least not yet). However, I hope you get the picture: Be fearful when others are greedy. Be careful if you decide to trade options if you are new to the game, and please don’t jump in naked.

Sustainability and Volatility

“Sustainability” has been a buzzword for many years. It comes from the effort to save the environment – don’t be wasteful, be sustainable – and it now is applicable to many aspects of our economy and our society. Colleges and college students are big on sustainability. Investors search for companies whose business models are economical, sustainable with respect to their ability internally to generate sufficient capital to maintain operations, and not wasteful.

Volatility

Volatility is another word that has become en vogue especially for the stock market and especially this year. The VIX Index, which measures stock market volatility, spiked to 80 in March, a level last seen during the 2008 Financial Crisis. While the VIX has trended down since then, it has not broken below 20, and it has jumped back up during the last week.

Can’t Have Both

One of the reasons the stock market has been volatile this year is because the economic situation that we currently find ourselves in is not sustainable. Business shutdowns, working from home, no travel, extended furloughs and unemployment benefits, wearing masks, children unable to go to school – none of these are sustainable. We can all make a go of it all temporarily in the spirit of remaining healthy and saving lives, but this is not something we can abide by for the long term. Because the current situation is not sustainable and because there is so much uncertainty about treatments, vaccines, and their efficacy, investors don’t know when the economy will emerge on the other side and find its own water level, or if it ever will.

The Interim

In the interim, investors have moved forward by plowing money into companies that do well in the “stay at home” economy and by avoiding stocks that need the pre-Covid economy to return. For instance, Amazon has soared while traditional retail has hit the skids or even, like Lord & Taylor and Saks, filed bankruptcy. However, I view the “stay at home” economy model as something that is temporary, and though perhaps we will not go back to 100% the same model we had just back earlier this year, we will need to get back to a great extent in order to grow our economy and to “sustain” all of the derivatives that feed on a growing economy such as large government-run institutions.

Not Sustainable

We citizens are trying to make the best of this bad situation, but it is not sustainable with respect to the way civilization conducted its business from the dawn of such up until March 2020. Landlords need tenants to move back into their buildings and pay rent so that mortgages are paid. Online school is perhaps nice for some but doesn’t offer the social interaction that in-person school does and is not the answer for all of society in the long run. Working parents need their kids to go back to school so that they can get a move on with their own lives.

IMO

Millennials have taken to the concept of sustainability through their environmental predisposition now want it in all other aspects of their lives. The problem with life is that stuff happens, and Covid is “stuff” that is anything but sustainable. Covid means uncertainty in all aspects of work and life and that leads to volatility. I believe that as long as Covid is a factor in our economy, we will have volatility in the equity markets. Investors will need to get comfortable with this higher level of volatility if they want to invest in equities. The alternative asset classes of cash or bonds don’t offer adequate returns. We need to return to a society and an economy that substantially resembles pre-Covid so that it and we can sustain what it had become.

50-Day Moving Average

Investing these days is not for the faint of heart! After going nearly straight up since late March, stock markets have tumbled over the past week. Yesterday, the S&P 500 Index closed 2.8% lower and the tech-heavy Nasdaq 100 Index closed about 4.8% lower, touching its 50-Day moving average in the process.

Source: Stockcharts.com

50-Day Moving Average

Rather than to delve into the reasons why I think the stock market does what it does, let’s discuss the 50-Day moving average and why it may be significant. The “simple” moving average is calculated by taking the closing price over the previous 50 trading days, dividing that number by 50, and plotting the result over time. The moving average gives you a better sense of the direction of a market than does looking at day-to-day data. The 50-day moving average is a technical indicator of strength or weakness. An upward-sloping line indicates strength, and vice-versa. The exponential or logarithmic moving averages are variations that some believe are more useful than the simple moving average.

Buy, Sell, or Hold?

Does this mean one should buy a stock (or an index or index fund) if its current price is above an upward-sloping moving average, or sell if is below the moving average? What if the moving average is downward-sloping? What should an investor do then? There are no hard and fast answers to these questions, but you could backtest all of those possibilities and perhaps come up with a killer trading algorithm.

Resistance or Support

Another “use” of the 50-Day moving average is as an indication of support or resistance. In the current case of the Nasdaq 100 Index falling to touch its 50-Day moving average, we can look over the next few trading days to see if the moving average becomes a support level. Some investors may see a dip to the 50-Day moving average as a buying opportunity. If enough investors see it as such and buy, then one could view it as a support level and drive the price higher. On the other hand, if the Nasdaq 100 index falls significantly below the 50-Day, then it will have breached an important support level and it could fall significantly more. It would mean that the markets are so weak that there are not enough buyers that want to buy the stock even at the key support level.

IMO

In the chart of the Nasdaq 100 Index above, the 50-Day moving average is the blue line. Let’s watch over the next several trading days to see if the index moves up or down from here. If it moves up, we can conclude that the 50-Day will have provided support to the index and that the upward trend continues. If not, then we might say, “Watch out below!”. It could get ugly if that is the case.

Exxon Exit

Earlier this week, ExxonMobil (XOM) was jettisoned from the Dow Jones Industrial Average. Chew on that for a bit! Only 7 years ago, Exxon had the largest market cap in the country. Now? Their current market cap of about $163 Billion puts them in about 44th place. The DJIA is for the top 30 stocks only, so out you go, Exxon! (The Dow doesn’t solely consider market cap for the components of its index but it is important).

Oil Sector Woes

XOM’s removal from the DJIA is due mostly to its main product, crude oil. The price of oil has been depressed because of a number of factors, including:

  • Stagnant demand for oil and oil products pre-Covid;
  • Plunge in demand due to Covid economic shutdown and slow reopening;
  • Improved drilling technology that has led to easier access to proven reserves; and
  • Geopolitical issues among major oil countries such as Russia and Iran.

All of these have worked to keep the price of oil down. Currently the spot price of a barrel of West Texas Intermediate Crude is about $42. XOM doesn’t make money selling oil at that price; it needs oil to be 50% higher or more according to some estimates.

XOM-Specific

XOM has a higher per-barrel breakeven cost because it has a higher overhead cost than other major oil companies. Translation: XOM’s management ranks are bloated and other costs such as pension obligations mean they need oil to be a lot higher than it currently is in order to make money. Old-industry companies such as XOM with ageing and large bureaucracies don’t fare well in today’s stock market because they are large supertanker companies that are difficult to adapt to change.

Future Technology

Investors on the whole look to the future more than to the past. “What have you done for me lately?” fits where XOM shareholders are now. It is no accident that XOM’s fall from the DJIA has coincided with Tesla’s skyrocketing stock performance. Investors look to their crystal balls and see highways filled with electric (non-gasoline-burning) cars. Younger investors in particular are concerned about the environment and the narrative that XOM is part of the old economy which is bad for the environment while Tesla is part of the new economy which will be more environment-friendly is another reason XOM’s stock has hit the skids and it has lost its place in the DJIA.

New Economy

I view XOM’s move from #1 to #44 more from the standpoint that the US economy has transformed a great deal just in the last 10 years. Apple’s iPhone really has changed everything. It allows users to search anything (think Google) in the palm of their hand. It allows users to purchase what they need (think Amazon) and have it delivered to their front door. Except perhaps for the diesel oil that the trucks use to deliver what you order to your door, none of this is bullish for the price of oil. These “new economy” stocks have soared while oil majors such as XOM have remained stagnant or trended downward.

Covid

The last nail in XOM’s coffin may be Covid and the economic shutdown. (I am grossly overexaggerating here: Oil isn’t dead, XOM isn’t dead yet, and not everyone is driving a Tesla). If we are moving now toward a work-at-home economy, that is not good for gasoline consumption and hence not good for XOM. Oil demand forecasts are in flux now because the forecasters don’t know what the post-Covid economy will look like or how long it will take to get there. Unsure demand forecasts will work to keep the price of a barrel of oil depressed. As commuters return to their cars and as travelers return to the airlines this crystal ball may become more clear but that ball is pretty cloudy right now.

IMO

Some investors might see a falling XOM as an opportunity. I don’t, and I would not recommend speculating on XOM as an individual stock. I see other oil majors as more appealing. On the other hand, I believe the “demise of oil” narrative as inaccurate in the long term. Oil will be an important part of our economy for years to come and companies in the oil sector, including XOM, will figure out a way to make money. Oil is not dead, XOM is not dead, but they both have major issues that need to be dealt with by management teams that aren’t afraid to make difficult calls. Time will tell if XOM can get back on the right track even with the issues within its sector.

Play Doubleheaders

Major League Baseball has been back in play for about a month now, with a little more than a month to go in the regular season. MLB’s restart has not been without incident: Many players have tested positive for Covid, and most teams by now have had games, perhaps several games, postponed due to positive Covid tests either by players on their own team or by players on opponents’ teams. Yet, rather than shut down the season entirely for all teams, MLB has opted to continue to play through the positive tests, and to make up games previously postponed by positive Covid tests by playing future “doubleheaders”, or two games in one day. This mentality has allowed MLB to soldier through and have a so-far successful season despite the setbacks. Therein lies a lesson for the rest of sports and the rest of the economy.

Play On Despite Setbacks

The lesson is that you need to keep playing on despite the setbacks. In your career, with your children, with your investment portfolio, and in your life, there will always be setbacks. Rather than to shut everything down when a setback occurs, you have to deal with it and keep moving on toward your goal. Your life is about more than just one thing. If the one thing isn’t working right for the time being, then walk on your other three legs while the fourth one heals. In MLB, rather than to shut down the entire league as Covid cases presented themselves, they shut down only the players and the teams directly affected, and then only for a relatively short period, like a week or less, depending on the severity of the outbreak. Plenty of available Covid tests are key to this strategy. Once the affected team heals, they are back on the diamond.

Compartmentalize

For us, another lesson is that we all have to be able to compartmentalize, meaning that we have to deal with the various aspects of our lives in different ways according to their order of importance at that particular time. Struggling with something at your job? Perhaps you can put that on hold for a bit while you go and work on a different task. You have young kids at home running amok and you are still trying to earn a paycheck? Unless you need to, which is a big Unless, put the job on hold at least until you get your kids back into some routine so that you can work. Took a hit in your investment or retirement portfolio due to the Covid shutdown? Hopefully your portfolio has recovered somewhat s the indexes have risen, but if not, then think about why you have lost money and make some adjustments to the way you invest. And, as difficult as it might be, if you are mentally down due to one aspect of your life, you cannot let that bad taste affect everything else in your life. Otherwise your entirety will suffer.

Play Doubleheaders

Back to the MLB analogy, if you have put an aspect of your life on hold, go back and double up for a short period of time so that you get that aspect back on track. For instance, if you took time off from work to deal with your family during Covid, maybe you can go back and finish what you put on hold once you return, or at least you can get back up to speed quickly and hit the pavement running. Making up for past negligence often don’t take nearly as much time to make up as it would have taken in real time. Perhaps you already know what the final score is and you just need to get your task to that final score.

IMO

Perhaps now is the time for you to address your address your financial planning needs, or perhaps even to create a financial plan for the first time. If so, it might really help to signal to your bullpen and call in a Certified Financial PlannerĀ® such as me to help with the planning process. In any event, the point of this blog is to exhort people to keep pushing forward despite the obstacles life puts in our way. The process by which Major League Baseball has held this very strange season is just the latest real life metaphor for this piece of advice.