Test your stock picking mettle - without as much risk

by Wayne Ferbert on May 9th, 2013

Let’s say you have a group of stocks that you like – but these market highs have you worried that this is the wrong time to enter. You can always purchase these stocks and build a market short position against it – dollar for dollar to create a market neutral position. In this case, you don’t have to be RIGHT that these stocks are going to go up – you just have to be RIGHT that these stocks are better to own than the broad market.
Here is how you can do it. Start with the list of stocks you want to own. I will start with 9 stocks below – equally weighted. I picked the highest rated Morningstar stocks – one from each of the 9 main market sectors. The 9 selected stocks had to have a weighted average forward dividend yield of at least a 2%.  And I eliminated ADRs – preferring companies based in the US.
Why the dividend yield? I wanted to make sure that my portfolio yield would equal that of the S&P500 – which I plan to use to build the market short position.
The list by sector is:
Materials: AA – Alcoa
Consumer Cyclical: F – Ford Motors
Energy: DVN – Devon Energy
Financials: WU – Western Union
Healthcare: ITMN - Intermune
Industrials: SCHN - Schnitzer Steel Industries
Technology: AAPL – Apple
Utilities: EXC - Exelon
Consumer Defensive: TAP – Molson Coors Brewing
If you were equal weight these, the weighted average dividend would be 2.26% - or higher than the S&P 500 average of 2%. Let’s say we have $25,000 invested in each stock – or a $225,000 portfolio.
Now, we want to construct a market short position that will confidently have a fairly high delta and make $1 for every $1 the market declines. But to use options, we will need to construct a range. I like the following approach: Purchase a Bear Put spread.
Let’s say between now and August, I want a market short position equal to about $225k of notional control on the S&P500. The SPY is a good ETF for that kind of control. That is almost 1400 shares of SPY. So, I would buy 14 put spreads on the SPY. The August date is longer than 3 months so I should collect a dividend from each of these stocks along the way.
The question is: how deep ITM should the long side be in my spread and how deep OTM should the short side be? I prefer a cost neutral approach. So, I like the $173 puts – which cost $11.40 today while the SPY trades at $163.04. Basically, these have $10 of intrinsic value and $1.40 of extrinsic.
I then look for the OTM put that trades for $1.40 in August expiration. That is basically the $150 strike. So, I have $13 of downside protection in the short position and $10 of upside I give away.
In the end, my profit should be: the dividend I collect plus/minus the out-performance / under-performance of my 9 stocks compared to the S&P500. In the end, whether I am right will depend on how good of a stock picker I am with those 9 stocks. But I don’t have to worry about a market correction dragging all of them down. My puts will offset that all the way down to $150 on the SPY (ie, $1500 on S&P500)
It is a solid way to generate some income (from dividends) while testing your ability to pick stocks for the long haul. Come August when these options expire – you will ask yourself the following question: what new put strikes do you want to set based on where the market is trading? And, what stocks do you want to keep or replace based on the performance over the next 90 days.
Good luck!

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