Today the Federal Reserve lowered the federal funds rate by 50 basis points. This was more aggressive than many economists prognosticated. Under the hood, the economy seems to be weakening quite a bit, and the Federal Reserve felt that they were behind the curve on cutting rates. The last two times that the Fed’s first-rate cut was 50 bps, or more were not very favorable for equity markets. On January 3, 2001, the Fed but by 50 bps, and the S&P 500 fell by 39% over the next 448 days. On September 18th, 2007, the Fed but by 50 bps, and the S&P dropped by 54% over the next 372 days. That is only two instances, so it certainly doesn’t mean the same will happen this time, but I do believe the general market is in a bubble, so I wouldn’t be overly aggressive. If we don’t go into a recession, the other big risk would be a return of high inflation, similar to what we saw in the 1970’s. Neither scenario is too favorable, but fortunately at TTCM, we have tools that 99% of advisors simply don’t use to help deal with potential volatility.
On February 19th, I wrote of an exciting options investment that we were executing for clients. Here was what I wrote:
“The stock was trading around $12 per share. It is a highly profitable business with high teens return on equity and a double-digit dividend yield that has been paid for many years. Below is one of the trades that we did:
Sell 10 $5 January 2024 puts for $.85.
In this trade, there are two things that can happen assuming we hold the option until expiration, which was 344 days from the day we set the trade. I refer to it as being like the flip of a coin:
Heads- If the stock is above $5, our options expire and we make $850 on a maximum risk of $4,150, which equates to a 20.5% return, or 21.8% annualized.
Tails- If the stock expires below $5, you will end up owning 1,000 shares at a breakeven of $4.15 per share. This means that the stock would have to drop by more than 65% for you to lose money! “
While I didn’t reveal the name of the stock at the time, it was Arbor Realty (ABR). Fast forward to today, and the stock of ABR trades at $15.03. The January cash-secured put option at $5 that we sold for $.85 now trades for $.12, still with 121 days to go. This means that we have made $.63 of our $.85 target profit in 223 days. $63 on our maximum risk of $415 is a 15.18% return, or 24.8% annualized. While that return is fantastic, the most important consideration is how much lower our risk profile was than buying the stock outright. ABR stock would have had to drop by 65% for you to lose money, and even then, you’d have all the upside or downside of owning the stock from those bargain levels, so you might end up still making money over the long-term. Think of a whole diversified portfolio of these types of risk/reward optimized strategies and how that helps you in various market conditions.
It is these types of dynamic strategies that both provide protection in market downturns, along with attractive returns in most scenarios. This type of investment holds up very favorably when you compare it to alternatives such as most fixed income opportunities or mutual funds. Building a portfolio that uses these strategies as a tool, gives us a major head up on our competition, and the advantage shines brightest in challenging or flat markets. As usual, I like to leave a disclaimer. The full benefit of options is best seen at options expiration. At that point, volatility and time value go to zero and the only thing that matters is where the stock price is at relative to the options. However, on trades like this example, we have the opportunity to close out the trade profitably, free up the cash, and use it for another investment.
I hope that you found this example of a real options investment helpful, and we will certainly do more of these moving forward.