Last week, we saw a massive broader market sell-off that, in part, appeared to be a reaction to stronger economic activity. This included 4% GDP growth in the second quarter and strong labor market data. These reports added to concerns that the Federal Reserve will allow interest rates to rise sooner than expected.
As economic activity picks up, the danger of inflation also rises -- and the Fed's primary weapon against inflation is higher interest rates. After a period of near-zero rates, an uptick in Treasury yields could cause a significant shock to the system and trigger a flight out of equities and into higher-yielding fixed-income products.
Of course, there is a tremendous amount of uncertainty in the market right now as the Fed's future path is in question and the economic recovery is anything but certain. Several Fed officials have indicated that any rate hike will probably not occur until late 2015, but it's always a good idea to be prepared.
The big question for us is how the new environment will affect our ability to generate income selling puts. And the answer may be a lot more exciting than you anticipate.
Key Factors for Options Pricing
Our income strategy is centered around selling put options on stocks that we would generally like to own. Buy selling a put contract, we are accepting the obligation to buy a stock at a particular price, known as the strike price (usually below the current market price for our purposes), within a defined time period. We are compensated for taking on this obligation, and the premium we receive from selling the option contract is what generates income in our account.
It stands to reason that the higher the option premiums, the more income we can expect to generate in our account. So what are the catalysts that drive options prices higher, and what kind of pricing can we expect over the next year or so?
Options are very statistical vehicles, meaning they derive their value from key statistical qualities of the underlying stocks that they represent. Specifically, options pricing is heavily affected by two key issues:
1. Volatility, specifically the expected volatility of the underlying stock or security.
2. Interest Rates, specifically the risk-free rate, which is usually equated with the yield on Treasury bills.
There are a few other considerations taken into the pricing models. But these two issues account for the majority of option pricing dynamics.
Don't worry, we're not going to get into a deep statistical discussion here. But I do want to explain why higher interest rates will actually kick off a healthy environment for selling put contracts.
The Volatility Factor
Uncertainty in the broader market applies directly to option prices, which tend to rise when risk (or uncertainty) is elevated. Higher option prices, of course, add to the profitability of our put selling strategy.
As we draw closer to a rate hike, traders will move capital into areas that are expected to do well in a rising interest rate environment and out of areas that are higher risk.
Considering the fact that interest rates have been very low for a long period of time, this capital rotation will represent a major shift. Traders have been conditioned to expect low interest rates for years, so they have had plenty of time to optimize their portfolios for a low-yield environment.
As a huge amount of capital shifts back toward a more "normal" rate and economic environment, volatility will naturally increase.
So our strategy of selling puts on stocks that we want to own becomes even more lucrative because we are receiving more compensation for the puts we are selling.
Equities are likely to be falling as rates increase, which means that we will be able to sell puts with lower strike prices -- giving us even more attractive buy points if we are actually obligated to purchase shares of stock.
The Interest Rate Factor
Higher interest rates also add to the premium level of option contracts. The rationale is a bit more statistically involved, but the basic idea is that with higher interest rates, traders have more opportunity costs for income strategies. This is because they can own Treasuries that pay a higher interest rate, so traders should demand even more income for strategies that require taking on more risk.
So simply as a function of higher interest rates, we can expect option prices to trade higher, giving us more income for our put selling strategy.
Despite the uncertainty surrounding the Fed's actions right now, I am very excited about our put selling strategy and continuing to generate a healthy rate of return by collecting premiums -- and potentially buying quality stocks at very attractive prices.
She recently closed her 63rd straight winning trade. If you're interested in guided put selling recommendations, my colleague Amber Hestla has a stellar track record. Check out her books and get prepared for a rising interest rate environment now by clicking here.