Tech Stocks May Be Getting Ready for a Serious Pullback. What Investors Should Do.

Weakness is provocative.

The stock market’s sharp decline on Wednesday should be viewed as a welcome development by every long-term investor who has been sitting on the sidelines watching equities rally ever higher. Many blue-chip stocks, including those in the hot technology sector, are now suddenly a bit more reasonably priced.

The Cboe Volatility Index, or VIX, closed Wednesday at just under 33, which is far above the fear gauge’s long-term average of 19.

When the VIX is above 30, it means that options on stocks in the S&P 500 index are generally inflated with a fear premium. When fear is high—and it is starting to rise on signs the coronavirus may not be so easy to contain—many investors like to sell cash-secured put options to buy blue-chip stocks. The strategy enables investors to profit from the fear of others. (Puts give holders the right to sell a stock at a set price and time.)

We have long advocated this conservative put-selling strategy, and we do so again on fears that a resurgence of the Covid-19 virus may drive stock prices lower—and even change some of the trading patterns and pricing dynamics in the options market.

In recent weeks, investors have started to hedge the tech sector. The shift is notable because many investors generally just buy bullish calls, or sell bearish puts, to profit off the sector and many of the hot stocks.

Christopher Murphy, Susquehanna’s co-head of derivatives strategy, has advised clients of some big bearish options-trading volumes in the Technology Select Sector SPDR exchange-traded fund (XLK), Invesco QQQ Trust Series (QQQ), and even Direxion Daily Semiconductor Bear 3X Shares (SOXS), a leveraged ETF.

The rise in hedging suggests a sharper decline may be in the future for hot tech stocks, including the fabled FAANGs, which include Facebook (FB), Alphabet (GOOGL), Amazon.com (AMZN), Apple (AAPL), and Netflix (NFLX).

The narrative in the tech sector is mixed. Some investors fret that the stocks have run too far, too fast. Tech now comprises about 27% of the S&P 500, the highest since the dot-com bubble. The weighting suggests that institutional investors may begin to rotate away from the sector. Should that happen, real opportunities will emerge for cash-secured put sellers.

It is difficult, of course, to time the market. It’s easier to identify blue-chip stocks to buy on weakness.

Consider Apple. Everywhere one looks, someone is holding an iPhone, wearing an Apple watch, or using AirPods.

Apple’s stock price reflects the company’s ubiquity. Shares are up some 23% this year. The stock is up 80% over the past year. Many people fear they have missed out on the chance to buy shares. At the same time, they find it hard to buy the stock as it is dancing around an all-time high price.

With Apple stock at $360.06, Apple’s August $350 puts could be sold for about $16. If the stock is above the strike price at expiration, investors can keep the put premium. If the stock is at $350 at expiration, investors get to buy the stock at an effective price of $334. During the past 52 weeks, the stock has ranged from $192.58 to $372.38.

The August expiration should capture Apple’s third-quarter earnings report, which was released in late July last year.

We mention the Apple trade as an example of how investors can structure trades should the tech sector really tumble.

The approach will strike most people as counterintuitive. When stock prices tank, many people lose their nerve and reduce their exposure to equities. When that occurs, put premiums often inflate with fear, creating opportunities for long-term investors to monetize the fear of the market mob. Get ready.

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Originally Posted on June 25, 2020 – Tech Stocks May Be Getting Ready for a Serious Pullback. What Investors Should Do.