A strange thing is happening in the stock and options markets.
As stock prices keep racing to records, investors are increasingly using bullish call options in anticipation of higher highs. Normally, sky-high stock prices prompt investors to buy bearish put options to hedge gains.
While we have advised investors since late last year that institutions were hedging the Democratic primaries, guarding against a strong showing by Bernie Sanders and other ultraliberal candidates, the hedging is now largely episodic.
Since President Donald Trump has emerged unbowed and largely unscathed from his impeachment trial, investors are aggressively positioning for the market to trade even higher. This has created historically unusual conditions in the options market.
The demand for call buying is so intense that the greed premiums of many stocks exceed the fear premium. This will seem like a very dull statement to anyone who isn’t schooled in the inner workings of markets and trading, but those who understand such things will realize that the conditions are the equivalent of a barking cat: unusual and odd.
Usually, bearish put options are more expensive than bullish calls, a relationship that reflects a persistent demand for hedging stock. Apple (ticker: AAPL) has often been persistently “skewed up” with calls that are more expensive than puts, but now the condition is widespread.
Consider Microsoft (MSFT). The demand for bullish calls on the stock has reached a multiyear high over the past two weeks. About 1.5 calls are trading for every put, and open interest is tilted in about the same way.
So far this year, shares of Microsoft are up about 18%, compared with a 5% gain for the S&P 500 index.
During the past 52 weeks, the stock has ranged from $106.29 to $190.70. The stock is up 72% over that period.
In such situations of extraordinary outperformance, investors tend to consider ways to reduce the risk that a hot stock may stall. But Quigg has suggested that his clients consider a clever approach that lets them participate in additional gains while creating an opportunity to sell at a sharply higher price.
When the stock was at $184.44, Quigg told clients to buy Microsoft’s December $210 call and sell two December $230 calls for a 55-cent credit. The strategy—a ratio spread, or 1×2 call spread—lets investors participate in any gains up to $250, which also marks a sale point. The bank’s December target price is $200.
The risk to this trade is the same as the risk that defines this incredibly hot stock: If it falls sharply, investors will lose money because it isn’t hedged in any meaningful way by this bullish strategy.
Yet if you believe that Microsoft’s stock is headed even higher—and will keep setting record prices—J.P. Morgan’s strategy is worth considering. If the stock is at $230 at expiration, investors will realize a maximum profit of $20.55—that’s the difference between the call strike prices plus the credit received for doing the trade. If the stock is at $250 at expiration, investors will be obligated to sell Microsoft stock at $250, or to cover the short call.
This strategy essentially enhances long stock positions. How? The calls will increase in value if the stock surges, adding to the gains. The drawback to the strategy is that selling two upside calls creates an obligation to sell stock.
To be sure, the trade has more moving parts than many investors are probably accustomed to considering. But these are unusual times, and Quigg’s approach offers a creative solution to the problem of managing hot stocks when many investors are focused on making as much money as possible for as long as this historic market keeps advancing.
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