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Investors Can’t Count on the Fed for Income

Investors Can’t Count on the Fed for Income

Twice a year, the Chair of the Federal Reserve testifies before Congress. This is one of the few public comments the Chair makes in the course of a year. The current chair, Janet Yellen, also holds a press conference after Fed meetings every three months and gives occasional speeches. Her predecessors spoke even less frequently.

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  • Because their comments are relatively rare, analysts spend hours analyzing every word the Fed Chair speaks. This week, that exercise began on Wednesday when Yellen began her semiannual Congressional testimony. There is broad agreement on one point – rates should stay low for an extended period of time.

    One analyst summed up the argument noting that policy is largely unchanged, “Yellen did not specifically address the pace of rate hikes to come, but said monetary policy remains “accommodative” — meaning interest rates are low enough to stimulate economic growth, rather than restrain it.”

    In her testimony, she did note that the economy’s growth would continue to warrant “gradual increases in the federal funds rate over time.”

    For investors, the message seems to be that interest rates will continue to be disappointing. Even if rates double from their current levels and short term interest rates set by the Fed reach 2%, rates on savings are not likely to rise much.

    Low interest rates create a problem for investors, especially those who had planned on their savings providing some income for retirement. Unless rates rise significantly, investors need to consider alternative investment strategies.

    Reviewing Options

    Some investors have turned to income stocks to offset the pain of low interest rates. This strategy carries a great deal of risk. If stock prices fall by 10%, which they do an average of about once a year, then investors will lose money. The loss could be equal to three years or more of income.

    While the risks of owning stocks can be high, some investors may feel trapped into buying stocks for income. These investors, and anyone else needing income, should at least consider selling put options. This can be done with low risk. Active management of the strategy can help to avoid large losses.

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  • To begin with, consider looking for options that expire relatively soon, ideally in less than 30 days. This maximizes the number of income opportunities in a year. Also, it is best to avoid stocks that will be reporting earnings before expiration since that report can lead to surprises in volatility.

    The option should have an exercise price well below the stock’s current price, ideally 10% or more below. This minimizes the risk in the trade.

    There is one other variable that can be important to consider and that is delta.

    Delta is one of the options Greeks, a group of values that describe the individual risk factors that affect the price of an options contract. The Greeks are found with complex formulas grounded in options pricing theory and are available at the web sites of options exchanges where free calculators provide the value.

    Delta measures how much an option’s price should change if the value of the underlying security changes by $1.00. The values of delta will range from 0 to 1 for calls and it will be between 0 and -1 for puts.

    Even the calculators provided by exchanges will only provide estimates for the Greeks, which change continuously as the markets trade. Options traders should never expect actual price moves to precisely follow the predictions made by any of the Greeks.

    A Floor Traders Trick

    Floor traders understood that there was a relationship between the delta and how likely an option was to be in the money when it expires. They viewed the absolute value of delta as the probability of an option expiring in the money.  At least one study has found this works well with put options.

    That means a call option with a delta of 0.30 has a 30% probability of expiring in the money. A put option with a delta of -0.30 would also have a 30% probability of expiring in the money. The lower the delta, the greater the probability of an option expiring worthless. This is a valuable insight for selling options.

    To minimize the risk of exercise, an option seller should set a desired value of delta. For example, if you want very low risk, never write a put with a delta less than -0.20. That delta indicates there is a 20% probability the option will be in the money at expiration and an 80% probability it will be worthless.

    The goal of an options seller is generally to have the option expire worthless. By focusing on delta as one of the selection factors, the seller is putting the odds on their side.

    A Specific Trade Example

    Rather than discussing the theory of options, it is better to consider a real example of a trade that is available.

    Using an options screening tool, a number of puts on Puma Biotechnology, Inc. (Nasdaq: PBYI) show up. PBYI closed at $90.95. To verify the option has safety, the options calculator is used. A current price of $80 is used in the calculator to determine how safe an option would be after a large drop in the stock.

    Before using the calculator, we also need to determine which option to sell. In this case, we will look at an option expiring July 21, just a week away. The $65 put appears to offer a significant amount of income and has sufficient liquidity which should make trading easier.

    In the chart above, open interest is a measure of liquidity, It shows how many contracts are open. When there is more liquidity, there is a higher likelihood an order in the option will be filled. Liquidity is not a requirement for a trade but it can be useful.

    The option calculator shows that there is a delta of -0.1682 in the $65 put, even if the stock price falls all the way to $80.

     

    This indicates there is a 16.82% probability the option will be in the money at expiration or a roughly 83% probability the option will be worthless. As a put seller, this means there is an 83% probability of a winning trade.

    To sell the July 21 $65 put in PBYI, a trader would enter a “sell to open” order with their broker. The broker will usually require a margin deposit equal to about 20% of the option exercise price. In this case, that is 20% of $65 times 100 since each contract covers 100 shares, or $1,300.

    The expected income from the trade is about $1.20, the midpoint of the bid and ask price of the option. The midpoint is a reasonable price for trading options and trades entered for that price are often filled fairly quickly.

    With income of $120 and a trading capital requirement of $1,300, this trade generates a return on capital of 9.2%. This is earned in just one week. That means the capital will be available for trading again in just one week, allowing for the opportunity to compound gains quickly.

    Using delta could be the key to generating income in a low interest rate world. The truth is that rates are likely to remain low for some time. As we learned this week, even the Chair of the Federal Reserve isn’t optimistic about rates anytime soon.

    In this environment, alternative income strategies need to be considered. High probability put selling could be among the safest ways to generate income until interest rates normalize, and this strategy could even be used then.

     

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