Options prices are rising as the market is on edge. How to use this to your advantage
Options premiums are rising and we’ll discuss how to take advantage of that by generating income through a covered call options strategy. Specifically, we’ll look at applying that trade to Domino’s Pizza, which has delivered some tasty returns of greater than 20% so far this year. There was plenty of cause for alarm over the past several days. First the consumer price index inflation data came in hotter than expected on Wednesday. The trouble is that inflation was running hotter than the Fed’s stated target in January and February, but that was excused as companies will often adjust their prices at the beginning of the year. The expectation had been that the pace of inflation – once those year-over-year price increases were in place — would slow in March. It didn’t. Higher rates of inflation will likely postpone any hoped-for rate cuts from the Fed, which is bad news for risk assets generally. War has been ongoing in Europe and the Middle East, but investors geopolitical concerns increased again as Iran signaled its intention to launch a direct attack on Israel, which it did over the weekend. Of course, it is well known that Iran had been attacking Israel already via Islamist proxies, most notably Hezbollah, primarily from Lebanon, and Hamas and Palestinian Islamic Jihad from the Palestinian territories. A direct attack does represent a serious escalation. However, both Iran and the United States made public statements that they do not intend to engage militarily with each other. While the G-7 condemned the Iranian attack, all parties are, for now, urging restraint or suggesting they will exercise restraint. Given these events, it is unsurprising that the S & P 500 fell 1.56% for the week and the CBOE Volatility Index (VIX), often called the “Fear Index” or “Fear Gauge”, which typically moves in the opposite direction, rose 1.27 to 17.3 week over week, its highest weekly close of the year. .VIX 1Y mountain CBOE Volatility Index, 1-year Warren Buffett suggests investors should be greedy when others are fearful, but he neglected to tell us how fearful others need to be. Is 17.3 in the VIX elevated enough that we can view the S & P’s 2.5% decline from March 28th’s all-time high as a buying opportunity? VIX data is calculated using historical prices going back to January of 1990. Since then, the “average” level of the VIX Index is 19.53. Using that as a benchmark it would seem that Friday’s closing level of 17.3 is not that high. A critic of using the average might suggest that the problem is a very high reading, such as the 82.69 all-time high in March of 2020 will elevate an average more than a low reading, such as the November 2017 9.14 low will bring it down. So how does it rank? If the 100th percentile is the highest it has ever been and .01% is the lowest, where does Friday’s close rank? Viewed that way, the VIX is in about the 48th percentile. So about half of the time the VIX has been at this level or lower and the other half of the time it has been at this level or higher. Once again, 17.3 does not seem that extraordinary. So the VIX hitting the high of the year, is not at a particularly extraordinary level and therefore doesn’t yet represent the contrarian “buy” signal Buffett was referring to. This makes sense when we look at the S & P itself, a 2.5% discount to the all-time high isn’t the kind of sale that has shoppers queuing up hours before the doors open. The trade It does suggest though that option sellers are getting higher premiums than they were, which could present an opportunity for selling covered calls on stocks that may be stretched or selling cash-covered puts on stocks trading well-under all time highs that may be getting close to reasonable entry points. Domino’s Pizza (DPZ) has done very well off the October 2023 lows, up nearly 50%. Their franchise model has provided the company with steady free cash flow, and the company has grown adjusted earnings per share by about 50% from the pre-pandemic levels. DPZ 5Y mountain Domino’s Pizza, 5 years However, 34 times trailing earnings, and 31.5 times forward price-earnings ratio represent well-above average multiples. This would be fine if earnings growth was anticipated to accelerate, but analysts are now anticipating low- to mid-single digit growth in the first quarter. These kind of numbers don’t mean that holders of the shares should sell, but it does suggest that the rapid price-appreciation of the past several months could slow. Holders could therefore look to options to potentially provide some yield if they are expecting less capital appreciation. A holder of the shares could sell the May $540 strike call for example and collect $5.50 per contract, a standstill yield of more than 1% of the current stock price. That strike is 9% above Friday’s closing price of $495.31/share, so the holder will still have significant upside participation if the stock rallies over the next month or so, a possibility if the company reports earnings better than the expected later this month. You may not be able to have your cake and eat it, but you may be able to hold your shares in Domino’s while generating a little income as well. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
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