I just saw a graphic on TV that said the Dow Jones Industrial Average has posted triple-digit moves in 18 of the last 23 sessions. Turning to the CBOE's volatility indices, I see the Volatility Index (VIX) was up a couple of points to 36 and the Nasdaq-100 Volatility Index (VXN) was up above 34 this morning.
Given the wide range of potential problems and outcomes I mentioned in Thursday's column, I do not think volatility is going to compress anytime soon. It is a great market for traders, according to my wild-eyed compatriots who think long term means the 4 p.m. market close, but it is a bit more frustrating for long-term investors. It can be difficult to watch the value of your holdings gyrate wildly based on events in Europe or China, or the decisions of black-box traders that dominate the market.
As markets develop and change, old dogs have to learn new tricks. Most of the old-school value investors eschew options for the most part. Sure, they may sell a few covered calls from time to time, but options generally are not in their toolboxes. That is a mistake.
When volatility is high, you can create opportunities by selling puts on stocks that are cheap on an asset basis. Selling puts allows you to make the manic-depressive fits of the market work for you. When you sell a put, one of two things will happen. You will collect and keep the premium, or you will buy a stock you like at a lower price and still keep the premium.
Consider electronics and IT distributor Ingram Micro (IM). Its shares are cheap, trading at 85% of tangible book value. More than half the share price is in cash on the balance sheet. It also trades at a small discount to net current assets, and has traded below book value for several months.
If you recently bought the stock, it is not doing much for you right now. But if we sell the December $17.50 strike put options with the stock at $17.58, we collect a 6.8% premium of $1.20. If the stock remains above $17.50, we keep that. If the shares move below the strike price, we will have to buy the stock at $17.50, but we still keep the premium. Our net cost for the stock becomes $16.30.
Selling puts can also work well for groups having difficulty finding the bottom. I believe that buying regional and community banks is going to be the trade of the decade, but those stocks keep getting cheaper. The selling in bank stocks has been as relentless as the weak economy. Declining interest rate spreads and new regulations pressure both the top and bottom line. Thus, selling puts can be a way to scale into a position.
TCF Financial (TCB) is one of my favorite small regional banks. The balance sheet is improving and they are taking steps to replace fee income eliminated by new regulations. With shares trading at a slight discount to tangible book value, I can either wait for the stock to decline further or sell some options to hopefully back into the stock. Right now, with the stock around $9.50, it looks like you could sell the $9 October puts for $.50. That's 5.6% for a little over a month. If shares of TCF close blew $9, I will buy stock at a net cost of $8.50. That is 85% of tangible book value, which is a level where I am very comfortable buying the stock.
Selling puts to back into stocks is a valuable tool that allows you to make volatility an ally instead of an enemy. The key to maintaining a margin of safety when selling put options is to make sure you have done the work and are not just willing but excited to buy the stock at the strike price. Post the full purchase price, not the exchange-minimum margin. Sell only as many puts as you are willing and able to buy in stock.
It may sound obvious, but remember that the key to success as a long-term investor is to survive for the long term. Learn and adapt as new tools become available, and you will increase your chances of both survival and success.