If you're afraid to buy at a market high, then you might be terrified right now. But don't worry: stock can continue heading north even when the market is overbought.
If you're afraid to buy at a market high, then you might be terrified right now.
The level of bullishness among professional advisors is historically high, and that's often a sign that markets are near significant tops.
But as I often say, "Overbought doesn't mean over." Stocks can continue to head north even when the market is clearly in overbought territory. And that's exactly what we've been seeing lately.
You don't want to miss the potential upside in one of the strongest bull markets we've ever seen. Today, I'll show you a technique that will allow you to collect income and/or buy stocks at a discount, lowering your risk.
It's a strategy called selling "naked puts."
We advise against trying to time the market. Still, it's hard to feel comfortable buying when you see statistics like this:
Above is the Investors Intelligence Advisors Sentiment survey.
We've seen readings above 55% for 8 consecutive weeks and above 60% for 4 consecutive weeks. These high readings are often seen at or near bull market tops.
Limit your risk
When you sell naked puts, your profit potential is initially limited, but it's also more likely that you make a profit.
One put option contract represents 100 shares of stock. The buyer of the put has the right to sell 100 shares of stock to the seller of the put (in this case, you) for a set price called the "strike price."
Suppose you like Apple Inc. (Nasdaq: AAPL). You might buy 100 shares at the recent price of $96.41.
But if you think Apple may trade sideways for a while before heading north, you might instead sell a put option with a strike price of $96 that expires on August 22, 2014.
That means you are accepting the obligation to buy Apple at $96 per share if the owner decides to sell it to you.
At the time of this writing, the Apple Inc. $96 strike price put option is trading at $3.20-$3.35. That means someone is willing to pay $320-$335 for the right to sell 100 shares of Apple to you at $96.
If you were already considering the purchase of Apple at $96.41, then you shouldn't mind if someone first paid you $320 for the put option, and then sold you 100 shares of Apple for $96 each at a later time.
You're collecting 3.33% on the investment risk up front, which is 40% annualized, without even compounding monthly. Then…
• If Apple trades up, you keep that 3.33% in a month on the option's expiration day. The stock does not change hands.
• If Apple trades sideways, you keep that 3.33%. The owner will again likely keep the stock, but you will have made more than you would have had you bought shares at market a month earlier.
• If Apple closes below the strike price on expiration day, you keep that 3.33% and end up buying Apple at $96, $0.41 cheaper than where it is today, plus you get $3.20 per share, giving you a breakeven of $92.80.
Options premiums vary by stock. The more volatile the stock, the higher the premium.
There are many options to choose from. The best put options to sell expire in 30 to 45 days and have a "strike price" that is closest to the stock's price. It's best to call your broker and have him walk you through this strategy the first few times it's implemented.
I hope this helps you to feel more comfortable about buying at market highs.
Chris Rowe is the Oxford Club’s director of Investor Education. Read more by Chris here.
The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.