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Banyan Hill
Pure Income

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Trade Alert: Survival Tips Ahead of the Fed

At 2 p.m. today, the finance world will get the highly anticipated answer to its question: Will the Federal Reserve raise interest rates?

That means the market is poised to react, so we’re going to take some precautions in our portfolio today.

I’ll be reading the statement and following Fed Chair Janet Yellen’s press conference, but there are only two ways this can end — either low rates for longer than anyone expects, or a market crash far worse than 2008. Considering no one wants a market crash, it doesn’t seem likely that the Fed will raise rates, and if it does, it won’t be by much.

If the Fed begins an aggressive rate-hike cycle, it will surely send the U.S. back into a recession, or even a depression. Corporate earnings have already entered a recession; oil and many energy-related stocks have been steadily declining; and a strong rate hike will surely put the rest of the U.S. in a downturn.

About the only things doing well are tied to the Fed’s easy-money policies — housing, price-to-earnings multiples and other credit-related bubbles. Otherwise, the economy is barely sputtering along, with our third-quarter GDP growth just over 2%.

A rate hike will surely slow our sluggish growth, sending those strong sectors crashing back to reality.

That leaves the Fed with only one logical option: to keep rates low for longer than anyone expects.

Seeing as we know how this will all end — with rates kept extremely low for the foreseeable future — we’re in a great position. The income opportunities in our portfolio are going to be exactly the ones investors need to survive in the coming market environment.

With that said, the Fed’s decision this week will likely stir up the markets no matter what. So, of the four options expiring this Friday — two protective puts and two short put options — I want to roll out the two protective puts to maintain protection.

Let’s start with those, and then I’ll update you on the other expiring positions…

Protective Put Options

BP (NYSE: BP) December 2015 $31 protective put option: Shares in our oil and gas giant have yet to recover from the oil plunge that started last year. We had a brief rally in October, but it has given up those gains yet again. However, now is not the time to bail on energy or oil, as I wrote about last week.

Since BP is just below $31, our protective put option is at about a 70% loss. Just remember, this protective put was there as a worst-case scenario. So a loss is actually good news because it means our shares weren’t pummeled too much.

I want to continue protecting us from volatility in the oil sphere — especially ahead of this afternoon’s Fed meeting — so we’re going to roll out that protective put option. That means we’ll be closing our current position and buying a new protective put for the same price, just a later expiration date.

Please note, these trades are only for those of us who own BP.

Action to take: Sell to close the BP December 2015 $31 put option (BP151218P00031000) at the market. It closed yesterday at $0.60.

Action to take: Buy to open the BP April 2016 $31 put option (BP160415P00031000) at the market. It closed yesterday at $2.48.

By adding this protective put, we’re basically rolling out our protection for another four months at a cost of $3.88 per share. We’ll end up losing about $1.40 on the protective put we’re closing, which is perfectly fine. As you may recall, our September $41 protective put was closed out for a gain of nearly 250%, which more than offset our cost for this April put. In fact, this option may actually add to our position instead of expiring worthless. Either way, we will continue to pick up BP’s solid 5% dividend yield and benefit from any rise in share price over the next four months.

Omega Healthcare (NYSE: OHI) December 2015 $35 protective put option: For our health care REIT, I plan to do the same thing we did with BP: roll out our protective put option.

Recently, investors have put REITs under pressure in anticipation of a rate-hike announcement this afternoon. But we know low rates are here to stay. Even if the Fed goes forward with an ill-advised rate hike, it will be an infinitesimal amount, and there won’t be a series of hikes afterward. Rather, it will be just one. Then, after further review and economic data, maybe we’ll see one more down the road — but it will also be a marginal hike.

That’s why I don’t want to sell our REIT, which will flourish in a low-rate environment, just yet. Instead, I want to limit our downside risk and allow for capital gains in case the Fed fails to raise rates at the end of the day.

Please note, these trades are only for those of us who own OHI.

Action to take: Sell to close the OHI December 2015 $35 put option (OHI151218P00035000) at the market. It closed yesterday at $1.42.

Action to take: Buy to open the OHI March 2016 $35 put option (OHI160318P00035000) at the market. It closed yesterday at $2.50.

We are closing out our protective put option for a slight loss. But, just as we did with BP, we’re going to roll this option into the March puts, which will hedge our risk to the downside over the next three months.

For REITs in particular, this is going to be an interesting time. We’ll know in just a few hours if the Fed decided to lift rates from the zero bound for the first time in nearly a decade, and we’ll see how interest-rate-sensitive stocks, such as REITs, will react.

If rates rise, my gut tells me REITs will take a hit at first, depending on the language the Fed uses to justify a rate hike. But once it’s clear that low rates are here to stay, investors who fled to traditional income generators — bonds, CDs or other savings accounts — will come flooding back to the market, sending share prices higher. That’s why we own Omega Healthcare. We just have to be patient while that plays out. And our protective put buys us the time with limited downside risk.

Short Put Options

As for our expiring short put options — the Spectra Energy Partners (NYSE: SEP) December 2015 $45 short put option and the Senior Housing Properties (NYSE: SNH) December 2015 $15 short put option — here’s what we can expect:

At this point, depending on how the markets react to the Fed’s action (or its lack thereof), it looks like these will both be put to us on Friday’s close. And that’s perfectly fine. Both Spectra Energy and Senior Housing are down through no fault of their own. Both stocks were hit by interest-hike expectations, which are (as we know) largely overblown.

Investors will realize that soon enough. Then we’ll see investors flock back to these very stocks in search of some sort of yield. At the moment, Spectra Energy is yielding 6.5% and Senior Housing Properties is yielding a nice 11%. Those positions will start with open losses of roughly 9% and 5%, respectively. But we will soon begin collecting those substantial dividend yields, and I will look to sell covered calls to collect even more income.


Chad Shoop
Editor, Pure Income