This Trade Could Deliver a Potential Annualized Return of Over 20%

After nearly three years of extremely weak economic growth, the European Central Bank is finally delivering on Mario Draghi’s pledge to do “whatever it takes” to get the region back on track.

The central bank is set to pump $64 billion into the economy through monthly bond purchases through September 2016. The quantitative easing program, alluded to in September, formally announced in January and started on March 9, may already be having an effect on the economy in terms of sentiment.

Q4 GDP growth of 0.3% beat expectations, and manufacturing data showed signs of life in March. Exports to the United States could get a big boost this year on a massive depreciation in the euro versus the U.S. dollar.

[ad#Google Adsense 336×280-IA]All things considered, I would say it could be a very good year for European stocks, and possibly most of 2016 as well.

There is one fly in the ointment.

Greece is back in the headlines as officials were said to have informally approached the IMF to delay repayment on the country’s debt but were denied.

Thanos Vamvakidis, head of European G10 FX strategy at BofA Merrill Lynch Global Research, said the country may run out of money if a reprieve is not granted at the meeting of eurozone finance ministers on April 24.

How do we act on what could be a great opportunity in European stocks without running the risk that a “Grexit” wipes out returns?

Taking a Position Without Paying Anything Yet

My favorite way to take a position in a stock or fund while getting downside protection and a discount to boot is by selling put options.

If you’re not familiar with the strategy, please don’t stop reading here. Many people think options are too risky, but when done properly, put selling is a conservative, high-income strategy.

By selling put options, I agree to buy the shares if they are below a certain price (the option’s strike price) at a certain date in the future. For taking on this risk, the option buyer pays me a premium and I have a net credit on the trade. If the shares close above the strike price when the option expires, I do nothing and keep the premium.

Depending on the volatility of the underlying stock, the premium I receive can be significant. The premium lowers my cost basis in the shares, so even if I have to buy them, it will be at a price that is below the point where I was contemplating a position anyway.

Each option contract represents 100 shares of the underlying stock or ETF. In addition to only selling put options on stocks I want to own, I also only sell as many contracts as I can cover. This is called a cash-secured put, and it means I have enough in my account to cover the strike price minus the premium, multiplied by the number of shares I’m obligated to buy.

Basically, selling puts gives me immediate income, which offers downside protection, and I may book a return without even having to buy the shares.

Why a Grexit May Ultimately be Much Ado About Nothing

I still like European stocks and think an escalation of Greek debt problems may not be as bad as the market fears.

More than three-quarters of the 323 billion euros ($348 billion) in Greek debt is held by government and international creditors. While a major restructuring would be a loss to some banks, most of its creditors don’t really have to worry about their balance sheets.

It seems the market isn’t worried much about a “Grexit” either. While the yield on the 10-year Greek bond has jumped more than 4 percentage points to 12.5% since the end of 2014, yields on debt across the eurozone have fallen over the past few months. If investors were worried about the ability of other countries to pay their debt after a Grexit, you would not expect the yield on the Spanish 10-year bond to have fallen nearly 0.75 points to 1.4% in the first three months of the year.

So how would the markets and international institutions react to a Greek default or exit of the eurozone? The knee-jerk reaction could be a big sell-off in European stocks. Fear can rule the markets and bears have been looking for an excuse to book some profits.

Since fears of a 2010 Greek exit, the region set up an $800 billion bailout fund for emergency loans and rules were established on how countries can access the funds. Member countries would access some of these funds but, as the chart above shows, there is not much private money at risk. The new monetary program will continue to pump $64 billion into the regional economy each month and could provide all the support it needs.

Downside Protection and Double-Digit Annualized Returns

The Vanguard FTSE Europe ETF (NYSE: VGK) offers broad exposure to Europe through shares of 540 companies with a median market capitalization of $47.9 billion. The fund holds just 0.1% exposure to Greece, so even a total loss on the country’s assets would not be significant. But I still want some downside protection in the event things get worse before they get better.

With shares of VGK trading at $55.64 at the time of this writing, we can sell the VGK June 56 Puts for a limit price of $1.85 per share ($185 per contract). If VGK closes below the $56 strike price at expiration on June 19, we will be assigned shares at that price. Since we received $1.85 in options premium, our actual cost basis is $54.15 per share, a 2.7% discount to the current price.

As I mentioned above, we want to make sure we have enough money in our account to cover the purchase. This means setting aside $5,415 for every put contract we sell, plus the $185 we collected from selling the puts.

If VGK closes above $56 on expiration, we keep the premium for a gain of 3.4% in just two months. That works out to an annualized return of more than 20%. That’s pretty good considering the fund’s low volatility and diversification, and the fact we wouldn’t even have to take a position in the shares.

— Joseph Hogue

[ad#sa-trader]

Source: Profitable Trading