I planned to discuss Ford Motor Company (F) based on yesterday’s copy. Unfortunately, the trade happened before I could type the letters into TD Ameritrade. We witnessed a 5% drop in F stock on Tuesday.
Our manufacturing numbers are looking worse. Consumer sentiment is terrible. Now, 81% of Americans are worried about a recession in the year ahead. That’s according to a March CNBC + Acorns Invest in You survey.
History shows that when people are worried about a recession, they start to consume like we are in one. So the Fed is projecting a solid economy and stating that we should continue with our usual programming. Meanwhile, this economy’s soft underbelly can slow down quickly.
I don’t mean to bring you bad news. But semiconductors, manufacturing, high-tech, rail, and consumer cyclical/retail look like trouble. Momentum is now turning YELLOW on Tuesday and several sectors showing weakness. Now is the time to have your finger on the hedge button.
Buying Insurance: On Ford For Example
One of the things that investors do when they worry about any significant downturn is the purchase of insurance. We know these insurance contracts as put options.
A put gives you the right to sell a stock at a specific price on or before a particular date (known as the expiration date). So, if you currently own 100 shares of Ford Motor Company (F) at $15.85 per share.
If you’re worried that the stock might fall quickly in the next two months, you might purchase the May 20, 2022 put option for $0.75.
This means that you have the right – but not the obligation – to sell the stock for $15 if the stock falls under that level by the expiration date. However, it’s worth noting that because you have purchased this contract, there are other numbers that you need to understand.
First, that insurance is based on today’s prices. So, as volatility goes up or the stock falls (or both), the value of that $15 call can go higher. That would make insurance around that strike price more expensive.
Second, if you are buying this contract, you’re going to have a breakeven price of $14.25 if you move to that expiration date. So if the stock is trading at $14.50 on May 20, you can execute the contract and still sell the stock for $15 per share.
However, you will have lost about $0.25 on each share because you were truly aiming to protect your interest at the total cost of the strike price minus the value of the put. The contract is valuable to you if the stock moves to a much lower price.
If the stock hits $14.00, these contracts will allow you to protect the difference between the $14.25 and the price under that level. If Ford falls to $12.00, that would be a significant amount of money you were able to protect by owning this insurance.
It Gets Competitive
One of the challenges is that there will be price competition for these contracts in this environment. Therefore, there must be a seller of this contract for every buyer of this protection. In that case, someone SELLS another person the right but not the obligation to sell that stock at a specific price on or before the expiration date.
So, you will see what people are willing to pay for that insurance at the BID price and what people are ready to sell it for at the ASK price. This is important because there may be fewer sellers in times of higher volatility and lighter liquidity, and there may be fewer sellers.
And those sellers will set the price. I remind everyone that a market’s entire purpose is for people TO SELL. That is why the focus on the ASK price is so important. Many speculators will purchase the same contract without owning any of the underlying stock. I planned to be one of them today…
That strategy would allow me to sell that same contract for a higher value to someone who needs and wants that protection if Ford stock – or any other stock linked to a specific put option – continues to decline.
The Window is Small
But I missed the trade, and now I must move on. There was quite a volume around that Ford $15 call today for May 20, 2022.
That’s a sign that people are worried that shares could drop at least another 10% or more from today’s levels. I’ll circle back with a recap of the Fed’s minutes tomorrow.
If you too worry about volatility or a selloff, remember that there are inverse ETFs. They are cheap and can provide protection similar to buying puts on the SPY (SPDR S&P 500 ETF). You can do this with either straight purchases or options contracts. Later this week, I’ll explain the Triple Inverse S&P 500 ETF – the SPXU.