This Boring Trade Could Yield Double-Digit Returns

Joseph Hogue's picture

Tuesday, January 13, 2015 - 7:30am

by Joseph Hogue

The markets had investors on edge last year as they waited for the other shoe to drop in the form of a correction so many were predicting. After all, the S&P 500 had been up for five straight years including a blockbuster 2013. My own estimate for 2014 was for a gain of just 7% to 1,970 by the end of the year. 

I, along with many others, underestimated the market, and the index of large-cap stocks returned another double-digit year. 

As everyone asks whether the market can do it for a sixth year, it seems pretty doubtful. Beyond the age of the bull market, oil has plunged with no bottom yet in sight, and we will face the effects of the end to an unprecedented quantitative easing program in the United States and rising interest rates.

One ominous sign is that the typically market-leading Russell 2000 index of small-cap companies underperformed last year with a return of just 3.5% versus 11.4% for the S&P 500.

But against all this, the writing is on the wall for positive returns. In fact, the catalysts are so strong that I am going to do something that I rarely do...

I'm going to bet on the general market.

 

I do not tend to make bullish trades on the overall market. I might sell the market short as a hedge against my stock holdings, but betting on an increase in the overall market just seems, well, boring. 

But this year, when a lot of individual names are looking a little expensive, we've got some of the most compelling evidence in years that the market will remain positive. The return may not be as high as it has been over the past several years, but we can use an options strategy to collect a great cash return every month. 

[Note: In 2014, one of my colleagues recommended 78 trades using this same strategy -- and every single trade made money. That's not the kind of track record you see every day! If you want to learn more about how she's doing it and get in on her next trade, click here.]

Before I get into the specifics of the strategy I'll be using, let's go over a few of the things I think virtually guarantee a positive year for the market in 2015.

First, remember that bull markets don't die simply of old age. Stock values drop when the outlook for corporate profits fails to meet inflated expectations. At a valuation of 19.4 times trailing earnings for the S&P 500, expectations do not seem particularly lofty, especially when you compare them to historical data. 

The average price-to-earnings (P/E) ratio over the 10 years to 2008 was 25, and the ratio maxed out at 34 times and 26.8 times before the previous bubbles burst in 1999 and 2008.

International stocks are even cheaper with European equities trading for an average of 17 times trailing earnings and Russian stocks scraping the bottom of the barrel at just 7 times earnings.

Beyond a modest valuation, three catalysts have emerged that make the case for positive returns this year.

2015 Catalysts: The Old and the New

Even as the Federal Reserve puts on the breaks this year, monetary stimulus will still be the name of the game in 2015. The European Central Bank (ECB) is moving closer to large-scale purchases as it approaches a Jan. 22 meeting, and even the conservative German Bundesbank is backing further stimulus. Japan is not even close to easing up on its own stimulus and surprised the markets in October when it increased its bond-buying program to $726 billion per year.

Deflation, rather than inflation, is the worry in developed markets, and that is giving a lot of wiggle room to central bank doves who want to keep rates lower for longer. Even in the relatively economically healthy United States, consumer prices rose just 1.3% in the 12 months ended Nov. 30. That's well below the Fed's 2% target and why I think Yellen and company will surprise the market by waiting to hike rates. 

Plummeting oil is the big story lately, but this could actually be the strongest aid to the markets this year. The U.S. Energy Information Administration estimates that 134.5 billion gallons of gasoline are consumed annually. With prices down nearly $1.14 per gallon from a year ago, that translates to $153 billion in savings in the U.S. alone. 

Estimates for the global impact are for a 0.2% increase in GDP for every $10 drop in the price of a barrel of oil. The $40 plunge in oil prices over the past quarter could mean global economic growth surprises this year.

Beat the Market Even if it Doesn't Zoom Higher

Taken together, this does not sound like an environment of uncertain corporate profits. However, I am not ready to bet that we will see a repeat of 2013 or 2014 in terms of market returns. 

Fortunately, utilizing a put selling strategy means the market doesn't have to surge higher to book a strong return.

With the SPDR S&P 500 ETF Trust (NYSE: SPY) closing Friday at $204.25, we can sell the SPY Feb 206 Puts for a limit price of $5 per share ($500 per contract).

If SPY closes below the $206 strike price at expiration on Feb. 20, we will be assigned shares at that price. Since we received $5 in options premium, our actual cost is $201 per share, a 2% discount to the current price.

We want to make sure we have enough money in our account to cover the purchase. This means setting aside $20,125 for every contract plus the $475 we collected from selling the puts.

If SPY closes above $206 on expiration, we keep the premium for a gain of 2.5% in just 40 days. If we were able to make a similar trade every 40 days, we would generate a 23% annual rate of return on a diversified index with strong upside support.

While the upside is not as high as some trades I've made, the annualized return would still beat all but two of the past five years' returns. If we get assigned the shares, we can sell covered calls against the position to continue the cash flow strategy.

And remember, if you're interested in learning how my colleague, Amber Hestla, has used this strategy to earn 43% average annualized gains on her way to a perfect 78 for 78 track record, you can follow this link.

 

This article originally appeared on ProfitableTrading.com The Most Boring Trade I'll Make All Year Could Yield Double-Digit Returns​

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.