Once again investors are faced with the fact that the politicians in Washington D.C. cannot get anything done. With the president’s State of the Union address tonight, the focus turns again to the politics of the sequester, where spending is drastically reduced on March 1. UBS A.G. (NYSE: UBS) U.S. Chief Economist Maury Harris expects the cuts to trim 0.4% from 2013 gross domestic product in its current form. Headline risk from Washington is expected to continue through the spring, as funding and debt ceiling deadlines loom. Given the large move up in the stock market, is there a way for investors to take profits, but still be involved if the sell-off is broad but quick?
Replacing stocks that you own with call options on the same names is the strategy from the derivative analysts at UBS. Investors are literally given a limited risk/ unlimited reward solution. Now it is important to note that this is a strategy for experienced investors as options have the potential to expire worthless. However, they would only be worthless if the stock you sold at a profit goes down.
Twice in the last two years investors have experienced sharp market sell offs when political lines are drawn in the sand. There is a chance that can happen again soon given the time deadlines. With low current volatility in the market, options prices are cheap. The UBS team searched their Key Call list for stocks with low implied volatility. They in turn recommended stock replacement trades on four top names.
Ross Stores Inc. (NASDAQ: ROST). The Wall Street consensus price target for this popular retailer is $67.50
Tesoro Corp. (NYSE: TSO). In the red hot refining sector the Thomson/First call estimate is $53.50
Time Warner Inc. (NYSE: TWX). The consensus Wall Street estimate for this premiere media and entertainment company is $56.50
U.S. Bancorp (NYSE: USB). The Thomson/First call estimate on this leading financial services firm is $37.
With the exception of Ross Stores all of the names on the UBS list are trading at or near the Wall St. price targets. By taking profits near the consensus targets and replacing the stock position with an option, investors can put capital back into their accounts and still have a position.
If an investor sold 1000 share of Ross Stores today and replaced it with the equivalent of ten 60 strike call options (each call option represents 100 shares of stock) that expire in August, the difference in capital staying in the investor account in cash is approximately $55,000. The maximum the investor could lose would be the price of the call options which would be $4600.
The stock market sold off dramatically after the election, and again in to the end of the year as investors feared large changes in the tax code. Should politicians again find a way to send the markets down 5 to 10% or more, the UBS option strategy may help preserve some big investor profits.