Flight to Safety accelerated by Ukraine situation

Two weeks ago the concern was a bond market slide most noticeable at the long end of the curve set off by the +4% 2Q GDP report released July 30. Now worry about the deteriorating situation in Ukraine set off a “flight to safety” most noticeable once again at the long end of the Treasury bond curve.

Strategy Idea

Since geopolitical risk could overwhelm most long directional trades, perhaps it is time to add some hedges or at least consider positions such as credit spreads that are more forgiving and less reliant on getting the direction and timing right. Writing covered calls on stocks that remain in well-defined uptrends is a strategy that fits nicely since they provide some downside protection.

Covered Call Suggestion

For the past few months, we have presented some basic principles needed to master generating monthly cash flow by selling covered call options and have been presenting a series of “ideas for consideration” to further demonstrate how this strategy can improve portfolio results.

This week we highlight?Under Armour Inc?(UA) using closing data on Friday August 15, 2014.

Under Armour, in the “Apparel” industry currently ranked in the top 20th percentile of all industries has a beta (historical volatility) of 1.64. In addition to great fundamentals, the price chart since early June has been a thing of beauty.

Flight to safety in UA

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The short-term moving average (20d exponential moving average) crossing above the longer-term moving average (100-d exponential moving average) in early June, followed by a positive earnings report on July 24, reflects positive price momentum.

With the stock trading @ $68.84, the options chain shows the following bid prices and strikes:

— $67.50 (in-the-money): $2.90
— $70(out-of-the-money): $1.65

Checking the potential returns for both these strikes by feeding the information gleaned from the options chain into the “multiple tab” of the Ellman Calculator shows:

Flight to safety in UA

We have potential 1-month returns of 2.4% in both cases that annualize to 29%. The $67.50 strike gives us 1.9% protection of that 2.5% initial profit (purple field) and the $70 strike gives us 1.7% upside potential (pink field) for a possible 1-month return of 4.1% (2.4% + 1.7%).

One of the keys to successful covered call writing is to only select stocks that you would otherwise want to own in your portfolio and then select an appropriate strike price that meets your monthly goal. Once entered, positions need managing to maximize returns. For example, we always buy back the option if premium value decreases to 20% from the original sale in the first half of the contract term and 10% or less in the latter part of the term.

For example, here is an exit strategy presuming a bearish scenario.?

— UA drops in price to $65 in the 2nd week of the contract but remains near its 20-day exponential moving average
— $70 call drops to $0.25 approximating our 20% guideline
— Buy back the $70 call and wait a few days to see if stock price recovers
— Say it returns to $67 and the $70 strike option is $1.10
— Sell the same strike option in the same month for a net credit of $1.10 – $0.25 = $0.85 or $85 per contract. If you sold 4 contracts that?s an additional $340 cash in your account (less commissions)
— This gives a net options credit of $250 per contract ($165 + $85) or 3.6% for the 1-month obligation still with the possibility of another 1.7% if share price moves to the $70 strike by expiration for a potential total 1-month return of 5.3%
— Of course, the final results will be dictated by stock price @ expiration
— If by mid-contract the stock price is stagnant, roll down to the $67.50 call to generate additional cash and downside protection
— The Blue Collar Investor methodology also has exit strategies for situations when share price rises dramatically and we explain other opportunities to generate even higher returns.

Summary

US Treasury bonds, particularly at the long end of the curve, along with US Dollar strength are understandably reflecting “flight to safety” as the geopolitical tensions increase while there was continuing evidence of rotation into a select number of large capitalization stocks included in the Powershares QQQ ETF. Until the geopolitical worries de-escalate we suggest considering hedging and credit spread less dependent on getting the direction right.