As we head into July, the market is at a turning point. One has to wonder if this is the start of a bigger market correction. As of now the S&P 500 is exactly flat on the year, after being up more then 3%. Worries over a Greek default have caused to market to have a mini-correction, but the question is, will the market enter a full-blown correction? I have been cautious the whole year; most of my trades have been neutral butterfly trades because it has been very hard to pick a direction. The 1st half of the year is over and the market is exactly where it started the year. I think that the 2nd half will be much more volatile. With worries over a Greek default, a Chinese bubble, and a 2nd half Fed rate hike, I think the catalysts are out there to drive some volatility.
The pundits were right when they said that this would be a stock pickers market. Names in the cyber security space and technology have been the clear winners; Netflix Inc (NASDAQ:NFLX) has practically doubled this year. With the S&P 500 sitting at the 200dma, I think it is time to be extra-cautious or even bearish. I do not see the S&P 500 gaining much steam to the upside until after we get a correction. The entire year the market was stuck; there was no volume/commitment to the upside. There are no catalysts for the market to go higher. Earnings are decisively weaker, and if it were not for names like Apple Inc (NASDAQ:AAPL), the market’s fundamental picture would be worse. There are many ways to play a pullback, and ways to profit from one without much risk.
For cautious investors, I think that now is the time to start selling OTM Puts. With the VIX back near 20, premium selling is becoming more attractive. Given that the market is only down 3%, it is hard to get excited yet. By selling OTM Puts, you force yourself to buy the stock at a lower price. By selling the option, you collect a premium. If the stock does not hit the strike price you collect the full premium.
Let’s look at an example. If one wanted to buy AAPL at $120, but felt uncomfortable buying it at $125, he/she can sell the August $120 Put for $3. There are two ways this trade is profitable:
- First, if AAPL rallies (or stays above 120) you collect the full $3 on August expiration,
- Second, if AAPL falls, instead of being long at $120 you are long at $117 ($120-$3 premium). By selling this put, it makes the risk/reward profile even better.
The same trade can be done in SPY, or any stock for that matter. I usually only sell Puts in names that are not extremely volatile or subject to big moves.
I would not make the assumption that the correction in the broader market has started just because of the big sell-off today, but given the weak fundamental backdrop, and the increasingly weakening technicals, I think now is time to increase one’s bearish bets, and focus on picking your spots on individual stocks.