Exercise Your Options on the Fiscal Cliff

 | Dec 13, 2012 | 1:00 PM EST
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This whole fiscal cliff situation is funny. The financial media broadcasts a daily countdown to the "cliff" as if the world will undergo a seismic change if no agreement is reached by Dec. 31. You hear many television interviews with financial types who raise concerns about the stock market if we go over a cliff. You hear the talk about how businesses will stop buying, selling, hiring, spending and investing. Yet here we are, with perhaps two more working weeks in December and the market -- collectively thousands of investors voting each day -- is showing no concern, at least for now. By my last count, I believe there were fewer than 25 stocks making up the list of 52-week lows on the U.S. exchanges.

Readers of my columns know I'm not losing any sleep over what happens comes Dec. 31. The Adam Smith in me says let's go over the cliff if that leads to attractive equity valuations. Ultimately, we will get an agreement because voters will only allow their elected officials to grandstand for so long. My investment criteria come down to valuation, or what I am paying for the underlying assets and cash flows.

Indeed the market is behaving as if the politicians will ultimately come to an agreement by year-end. So if they don't, perhaps the shock factor will lead to a rapid multi-day or multi-week selloff. After all, the markets biggest movements occur when the unexpected happens. Perhaps one way to insure against such an occurrence to sell covered call options, or call options against securities held in your portfolio. With many equity prices stretching for higher and higher valuations, selling covered calls provide you with a little incremental income if prices decided to go on a temporary decline. And if prices continue to rise, you have locked in a sale price above today's current prices.

Housing related stocks have been on a tear this year but it's still not clear if we are on a permanent path to a recovery in housing. PulteGroup (PHM) had moved up over 200% in the past year and now trades at $17. Perhaps owners of the stock might find it attractive to sell the January 2013 $17 calls for $1. If the stock is called, you effectively netted $18 from the sale price and call premium, or a 6% return in about one month's time. Of course, if housing sentiment turns sour, you will keep the call premium but that would offer little comfort if the shares plunged back to say $12 a share or so.

Instead of citing more examples of stocks that may or may not be in your portfolio, the idea behind selling covered calls as way to contain any effects from the fiscal cliff is subject to a few simple factors. First, sell short-term covered calls -- perhaps out to January or February. You don't want to lock yourself down to deliver shares at a certain price for long periods of time because over time, one hopes that companies grow and increase in value. Second, sell covered calls against positions that you feel are nearing or are close to a peak valuation. I wouldn't sell calls against a name like Deere (DE) or Apple (AAPL). In an ideal world, a favorably valued stock that is trading in tight range is the perfect candidate. Finally, be completely aware and comfortable with the contract you are getting into. If you are going to get upset about selling a covered call on a stock that continues to climb higher and regret missing the additional upside, then I would hesitate from doing so.

Ultimately, investors are better served paying more attention to the condition and operating performance of their portfolio companies than spending anytime trying to handicap the behavior of politicians.

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