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Japanese stocks have been one of the hottest markets in the world during the first few months of 2013. Stocks in Japan peaked in 1989, but recent political changes have pushed them up by almost 30% in the past 10 months, and nearly 15% since the beginning of the year.
Investors seem to be excited that Japan's central bank is promising inflation of about 2% a year within two years. The money supply is expected to double during that time, which should lead to a weaker currency. A cheaper yen could boost exports for Japanese companies, and that seems to have been one of the forces behind the country's stock market surge.
One way investors can participate in the next bull market in Japan is with iShares MSCI Japan Index Fund (NYSE: EWJ). This ETF is now extremely overbought and it could be time for a pullback.
On the other hand, it is also possible for an overbought market to become even more overbought. There is no way to know whether prices will go up or down in this situation, but there is a strategy that will allow us to benefit from either type of price move.
By selling put options, we can set a buy price we are comfortable with and enter the market on a pullback. If prices continue higher, selling the put generates immediate income and allows us to earn a return on our investment capital even if we don't buy in right now.
There are options available on EWJ, but they are low-priced and not the best choice for a put selling strategy. An alternative to consider is Toyota Motor (NYSE: TM), which is the largest individual holding in EWJ and is highly correlated with that ETF. The chart below shows that TM and EWJ generally move in the same direction.
Selling a put on TM could offer investors a way to gain exposure to Japan at a lower price and generate income now if the pullback never comes.
Toyota made a new 52-week high today at $112.83, a price that is about 18 times estimated earnings for fiscal 2013, ended in March. Analysts expect earnings growth of about 24% for 2014, and then an acceleration of growth to an average of about 40% a year in the next five years. That growth rate justifies a higher price for the stock, but the risk of a pullback seems high after gaining about 50% in the past six months.
A put option with a strike price of $97.50 that expires in July is trading for about $1.03. Selling this option would allow you to immediately earn $103 since each options contract covers 100 shares of stock. If TM is trading below $97.50 when the option expires in three months, you will have to buy 100 shares of the stock at $97.50. The cost basis of your position would actually be $96.47 a share since the options premium received would offset the purchase price.
If TM is trading above $97.50 when the option expires, your gain will be limited to the income received from the option. You will have to post a deposit known as a margin requirement to sell the option to assure your broker that you have the funds available to buy TM if required to do so. Assuming you pledge 100% of the purchase amount ($9,750 in this case), your gain on the trade would be 1.1% for three months, or 4.4% annualized.
Most brokers only require a deposit of 20% of the amount required for the purchase ($1,950 in this case), boosting the gain to 5.3% in three months or more than 21% a year if a similar trade is repeated every three months.
Whether Japanese stocks and TM move up or down, this trade offers a chance to profit.
Recommended Trade Setup:
-- Sell TM July 97.50 Puts between $0.90 and $1.20
-- If TM is above $97.50 when the option expires, the profit is the amount received when selling the put
-- If TM is below $97.50 when the option expires, you will own TM at a 14% discount to recent prices
If you are interested in generating income with options, this is the kind of trade I recommend each week in my Income Trader service. Currently, we're on track to generate almost 20% income a year -- and we haven't bought a single stock yet! Click here to learn more.
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