A Stock Replacement Strategy For Emerging Markets

| January 14, 2019 | 0 Comments

optionsThe benefits of options are numerous, as anyone who has traded them can readily tell you. We often talk about the leverage, flexibility, and definable risk characteristics of options as clear benefits to using them. Options strategies can be wonderful tools for risk management as well as speculation.

What’s more, options can serve as an excellent vehicle for stock replacement strategies. That is, investors can completely replace buying (or shorting) stocks with options in many cases. There are multiple benefits to using options instead of stocks.

Clearly, the leverage of options means investors can take positions in stocks without needing nearly the same level of capital outlay. Less capital also generally means less risk. And, options can be a far safer vehicle than stocks if the market becomes extremely volatile. There’s a reason why pension funds have gravitated towards using options for stock replacement strategies – the volatility at the end of 2018 is a perfect example.

Let’s look at an actual stock replacement trade using cash secured puts in iShares MSCI Emerging Markets ETF (NYSE: EEM). EEM is easily the largest and most popular emerging markets ETF. It’s also one of the most heavily traded funds in the world.

A very large trader recently placed a massive cash secured put trade in EEM expiring in March. More specifically, the trader sold 140,000 (yes, that many) EEM March 15th 36 puts for 41 cents, with EEM just under $40 per share. This enormous trade collects over $5.7 million in premium, which the trader keeps all of if EEM is over $36 at March expiration.

iShares MSCI Emerging Markets ETF

On the other hand, max loss can occur all the way down to zero if EEM collapses. However, EEM is not a fast-moving ETF, and even during the height of the 2018 selloff, the price only got as low as $37 (as you can see in the chart). Moreover, whoever is placing these cash secured puts may be more than wiling to get long EEM at $36 (technically $35.59 when you include the premium collected).

In the meantime, the 41 cents in premium represents a 1% yield on the trade, or about 6% annually. In order to generate this (seemingly very safe) income, the trader is giving up any significant appreciation in the price of EEM. It’s likely the trader doesn’t believe EEM has much upside (or they’d get long the stock or use a covered call instead).

Is 6% in annual income enough to justify capping the upside potential of EEM shares? It totally depends on what your goals are, your trading horizon, and your aversion to risk. This is certainly a safe 1% yield (for the duration of this trade). Despite the potential for more volatility, EEM probably doesn’t have much, if any downside potential below $36.

I like the idea of using cash secured puts on EEM if you don’t believe emerging markets have much upside. I also like March as far as time horizon. However, I believe for those of us trading much smaller size, we can move up our strike a bit and collect more premium.

For instance, the March 37.50 puts can be sold for 61 cents, with EEM still right around $40. That’s a 1.5% yield, and closer to 9% on an annual basis. That also means if you were to get assigned on the shares (if the price plunges below $37.50), you’d be able to effectively get long at $36.89. That’s below the 52-low and would still be a very reasonable price to pay for the ETF.


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Category: Options Trading Strategy

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Jay Soloff is an options analyst with Investors Alley.

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