It was a very tough Thursday and Friday for investors, and I've got an index exchange-traded fund play that might help.
I'll get to the strategy down below, but first, let's assess the damage.
Inflation data sent equities in a tailwind causing the Nasdaq to drop more than 6% during the final two days of trading. The S&P 500 was not far behind. The odds of a three-quarter point hike when the Federal Reserve meets next Wednesday feels like a coin flip now and the five-year and 30-year Treasury yield inverted late in the week. Consumer sentiment is at the lowest levels ever measured, despite a 3.6% jobless rate. It is hard to blame consumers for being skittish with inflation at its highest mark since 1981 and the average consumer losing net buying power month after month.
Investors have to be feeling snake bit at this point. Outside of the energy and some other commodity driven sectors, just about every part of the market has been whacked. Bonds have offered little solace in this broad-based pullback, too. Recession within the next 12 months seems a more and more probable scenario. Those of sitting on a good deal of cash have to weigh the benefits of hunkering down and missing opportunities now that the market is full of much lower entry points than at the start of the year.
What can we do?
Simple covered call strategies really help to bridge this challenge. They provide downside protection, which are much needed in this market. They can also give one the extra dose of confidence to get off the sideline to act upon opportunities instead of waiting for an exact bottom, which few ever do successfully, and none do consistently. The spike of volatility across the market has increased option premiums, so this strategy now can deliver additional potential returns and risk mitigation than in a lower beta environment.
At the moment, I like using index exchange-traded funds more than I typically do. They eliminate company specific risk and my endless ruminations trying to project how much inflation will impact a particular firms profit margins or how they would weather a recession. Options on index ETFs are also very liquid, which means orders get executed quickly and are very easy to "roll," if markets continue to go down.
Late Friday as markets were tanking, I added some more exposure to my slowly growing holdings of iShares Russell 2000 ETF (IWM) , which tracks the small cap benchmark. I will be the first to admit this is not a particularly sexy trade, but does provide a nice discount to buy a broad swath of the market. The ETF is already down approximately 20% for the year as it is.
This is how one can execute a covered call position in IWM. Using the January $180 calls, fashion a covered call order with a net debit in the $163.30 to $163.50 range (net stock price - option premium). Options are more than liquid and the order should fill quickly. This strategy provides downside protection of nearly 10% and potential upside in the low teens over just over seven months even if the index does little. This trade is very easy to roll if markets are still performing badly late in the year as well.