By Greg Jensen
CEO and Founder, OptionsANIMAL
The problems in Europe are more than just economic in nature, they are social. It has never been more evident than now as yields in sovereign debt continue to climb in Greece, Spain, Italy, Ireland, and a host of other European Union members and threaten default.
At the same time unemployment levels are near 40% in some of these countries and the people are angry, very angry. As an average U.S. investor, it may seem easy to look at this problem and shrug off the events by saying. “This problem is over in Europe. Why do I care if someone in Greece ends up stealing money from someone in Germany? Let them work it out!” The problem with the idea of shrugging off the problems in Europe is the interconnectivity of the world economy. No longer can problems in one country stay completely isolated. This is due to growing international companies such as IBM and Caterpillar (CAT), but also to the complex web of financial integration from huge banks such as J.P Morgan (JPM) and Deutsche Bank.
So why can’t the European Central Bank (ECB) just bail out the Euro by printing more money like the Federal Reserve does for the United States? The problem comes down to politics. There is not a clear political reason or motivation for the European Union to do so, as there is in the U.S.. Germany, France, Italy, etc. are led by their own individual governing bodies. This is at its core the reason the ECB does not have the authority to simply print more money. The United States will never run out of money, they will just continue to print more, with the ultimate outcome being inflation and a tax burden on the country's future citizens. With the EU being made of many countries that have no tie, other than their currency, there is not political incentive to tax the future for the benefit of today as the U.S. is doing.
As Cullen Roche from the Pragmatic Capitalist wrote, “A fiscal union in Europe would achieve the same things it has achieved in the U.S. The biggest advantage would be stability. The U.S. doesn’t suffer state insolvency crises once every few decades because they have the power of the U.S. government backing them. The Federal government is ALWAYS spending money on the states. On average, about 20% of state budgets are aided by federal spending. This is a huge persistent “bailout” if you want to think about it like that, but it avoids constant imbalances and creates stability. California is never going bankrupt. The Federal government would never allow it to happen. Greece doesn’t have this backing. The U.S. has lots of weak states or members who don’t pull their weight. But we don’t kick them out because we’re politically unified. Europe doesn’t have that unity.” So, what does this spell? Eventually, it means default somewhere from someone in Europe. The only question that remains is who defaults, and how big the contagion becomes.
So what’s the trade? For the average investor, the best trade may be to just sit on the sideline and wait for this to play out. Many times investors feel like they have to stay invested at all costs. The mantra of “money never sleeps” causes the average investor to take unnecessary risks while not having the proper tools to trade what feels like a rigged game to many. This game is not rigged. It just is not as simple as going long the S&P and expecting that you are not going to have to stomach some ups and downs. As for the active trader, the trades are limitless.
Long US dollar? Short Euro? Short S&P? Much of this will depend on an individual's risk tolerance and knowledge. For me, the trade is the collar trade on whatever issue has the most solid fundamentals. Without a doubt to me the best fundamentals in the world continue to reside at Apple Inc. (AAPL). The growth continues to be stellar, yet the market, because of its uncertainty, has not allowed the stock to truly run.
A dynamic collar trade is a trade where the risk can be limited, but still allowing for an upside if the stock decides to run. The trade is accomplished by buying the stock along with a long put option. This strategy alone (the married put) is a great trade, but can be very costly when Implied Volatility is high. The dynamic collar can offset some of this IV risk. It is a collar when you then sell a call 60-90 days further out in time than the long put, which lets someone else pay for your downside insurance. This unique approach protects the trade as much as a standard collar trade, but it also lets you take part in bullish underlying moves and offers potential returns of 25-30 percent — roughly four times as large as a standard collar (6-8 percent).
When you sell the call for a dynamic collar, try to: 1) collect enough premium to pay for the long put, and 2) ensure its strike price is above the underlying stock’s price. If the short call is assigned, forcing you to sell stock at the strike, you want to sell the shares to the call’s holder at a profit.
Regardless of the outcome in Europe, AAPL is going to stay in business and continue to innovate and bring us products to enhance our lives and engage us. This does not mean that good companies cannot go down in a bad market, so the trade for me in this European mess… Buy Apple (AAPL) with a collar.