The Stock Market Could Get a Lot Worse. You Need a Better Strategy.

The end is nigh, but not everyone agrees on what exactly is ending.

Some investors are preparing for Armageddon, and others are wondering whether stock prices have fallen so far that the end of this bearish chapter might soon end.

This dramatic tension creates an opportunity for long-term investors to engage in what we have long referred to as “time arbitrage.” The strategy seeks to balance the risks of today—and there are many—with the potential rewards of tomorrow.

Doing nothing remains a legitimate decision, but many investors are increasingly intrigued by the sharp decline in the stock market and tempted by recent better-than-expected earnings reports that suggest sentiment might be too dour.

A Bank of America fund manager survey, which is a reasonable proxy for how sophisticated investors think, found that cash levels are the highest since late 2008, when the financial crisis was raging. Stocks started surging in March 2009 and didn’t stop rising until earlier this year, when the Federal Reserve began to focus on battling inflation by raising interest rates.

It would be foolish to declare that the market’s difficulties are over. Instead, it’s better to find price points that represent attractive levels to buy quality stocks.

Long-term investors could buy low in the stock market and sell high in the options market. The approach is worth considering for investors who can afford to warehouse stocks for three to five years.

How are high and low in the options and stock market determined? By comparing the Cboe Volatility Index, or VIX, against stock prices.

The VIX is up about 100% so far this year. It was recently around 31, well above its long-term average of about 19. Many stocks are down rather sharply. The juxtaposition between the VIX and stock prices essentially means that options volatility is high and stock prices are low.

Consider CDW Corp. (ticker: CDW), a company that provides technology services to governments, the education and healthcare industries, and other businesses. The stock is down more than 20% this year. It is hard to imagine that its long-term prospects aren’t brighter than today, given the resilient nature of the industries CDW serves.

With the stock at $159.47, investors could consider selling the March $150 put option for about $9. The put sale positions investors to buy the stock at an effective price of $141. During the past 52 weeks, the stock has ranged from $147.91 to $208.71 and is trading at about 22 times trailing earnings. The company reports third-quarter earnings on Nov. 2.

The $150 put is about 5% below the current stock price, but one could choose a lower strike price to create an even lower effective purchase price.

The risk to the strategy is that CDW’s stock materially weakens. Should the stock be below the put strike price at expiration, investors are obligated to buy the stock or to roll the put to avoid assignment.

To be sure, stock prices may not be as inexpensive as many want to believe, even though the market is down more than 20% this year. The S&P 500 index is trading at about 16 times earnings, which Goldman Sachs recently told clients ranks around the 66th percentile since 1980. And many investors expect that analysts will soon lower corporate earnings estimates, which would pressure stock prices lower.

The time-arbitrage strategy allows you to monetize the exquisite tension that always exists between risk and reward, given that it is hard for investors to buy stocks at the very bottom, just as it is hard to sell stocks at the very top.

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Originally Posted October 20, 2022 – The Stock Market Could Get a Lot Worse. You Need a Better Strategy.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.