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You are here: Home / Recent / Allocating Money in the Market at Higher Rates of Return

Allocating Money in the Market at Higher Rates of Return

August 17, 2009 by Richard Miller

Today’s economic climate doesn’t offer many growth vehicles for your money – say that lump sum that you took at retirement. You may have a million dollars, but a low-risk CD is only going to pay you $30,000 to $40,000 annually, and you won’t really feel like a millionaire. That’s the boat that many Americans find themselves in. They have a hearty lump sum, but they don’t know where to put it to earn a decent return. My goal is to deploy money in quality stocks such that I earn 15 to 20 percent annual gains with minimal risk. Granted, I’ll still be exposed to the extreme whims of the market. Here, I want to demonstrate a technique that utilizes the sell off following an earnings report, something we’re seeing frequently these days.

HMSY Chart

In an earlier article, “Intraday Trading High-Quality Stocks,” I presented a setup (CCI(35) less than -150 and RSI(2) less than 10 on 2-minute charts) and trigger (close above its10-period moving average) that defined an oversold market condition ripe for trading intraday the downtrend reversal. I want to use them again here. After an earnings report, these quality stocks usually sell off because they’ve had a profitable run and institutions take some money off the table and put it to work somewhere else. Invariably though, they’re waiting around at significant support levels (50-, 200-day moving averages and standard Fibonacci levels) to step in again and start buying. Remember, in this approach, my goal is to deploy money at a fair rate of return.

HMSY is a quality stock. Fundamentals are good with a Zacks rank of 2, earnings growth of 27, 44, 73 and 75% over the past four quarters, and value remaining in its current price with two year PEG ratios of 1.09 and 0.99. It reported earnings before the open on 7/31/09 and then delivered the intraday chart shown above (with its daily chart inserted). It’s a typical sell off, bottoming in the first half hour of trading, followed by a recovery into the close.

The daily chart shows the day gaped down big time at the open, proceeded to fall further then finished the day recovering to form a “hammer” candle. Bearing in mind that I want to deploy cash in this quality stock and at the same time provide some downside protection, I like two approaches. First, wait for the intraday setup (CCI(35) and RSI(2) criteria) and trigger (close above 10-period moving average). Then, either buy shares, wait for the run higher and sell in-the-money Calls or sell out-of-the-money Puts as soon as the trade triggers. Consider the risk/reward scenarios for each of those plays.

The first strategy buys shares at $36.75, lets price run higher as the oversold condition reverts (like a stretched rubber band becoming taught), then sell the $35 Aug Call for its $3.80 premium. With 1,000 shares and 10 contracts, we invest $32,950 over the next 19 days and earn $2,050 ($38,800 – $36,750) or 6.2% (119.5% annualized) if HMSY were to remain above $35 or somewhat less – but still profitable – if it were to fall from there to $32.95 ($36.75 – $3.80). In fact, price could fall to $33.44 over the next 19 days, and we would still earn 1.5% (28.8% annualized).

The second strategy (selling Puts as soon as the trigger is hit) would sell the $35 Put for its $0.85 premium. If price were to remain above $35, we would invest $34,150 to earn $850 (2.5%) over the next 19 days. Since price was then at $36.75, we had 7.1% downside protection. In this instance, price could fall to $34.49 over the next 19 days, and we would still earn 1.5%.

Obviously the Call strategy returned more and risked less, but the Put approach would have become profitable faster as price made its $3 run higher and offered an immediate profit by closing the position with 50 to 80% of the gain. Let’s look at a second example.

STEC Chart

If HMSY is a stock with good fundamentals, STEC is a great one with a Zacks rank of 1, earnings growth of 100, -29, 71 and 486 % over the past four quarters, and value remaining in its current price with two year PEG ratios of 0.10 and 0.38. Further, this year’s earnings estimate has increased 196% over the past 90 days. It reported earnings before the open on 8/04/09 and then delivered the intraday chart shown the next day (again with daily chart inserted).

The Call strategy buys shares at $33.01, lets price run $2 higher as the oversold condition again reverts, then sell the $30 Aug Call for its $4.80 premium. With 1,000 shares and 10 contracts, we invest $28,210 over the next 16 days and earn $1,790 ($34,800 – $33,010) or 6.3% (144.8% annualized) if STEC were to remain above $30 or somewhat less – but still profitable – if it were to fall from there to $28.21 ($33.01 – $4.80). In fact, price could fall to $28.63 over the next 16 days, and we would still earn 1.5% (28.8% annualized).

The second strategy (again, selling Puts as soon as the trigger is hit) would sell the $30 Put for $1.00 premium. If price remains above $30, we invest $29,000 to earn $1,000 (3.4%) over the next 16 days. Since price was then at $33.01, we had 12.1% downside protection. In this instance, price could fall to $29.56 over the next 16 days, and we would still earn 1.5%.

The Call strategy again returns more and risks less, but the Put strategy became profitable faster as price made its $2 run higher and offered an immediate profit by closing the position with 50 to 80% of the gain.

During the earnings season, sell offs of quality stocks offer high return opportunities to deploy cash.

Richard Miller, Ph.D. – Statistics Professional, is the president of TripleScreenMethod.com and PensacolaProcessOptimizaton.com .

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