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Weekly Option Windfall: How to Play the Outperforming Insurance Sector

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This year’s market action has been fast and furious as stocks continue to build on their new bull market. Better-than-expected corporate earnings, decelerating inflation, and a lower interest rate outlook are all contributing to this recent surge. Sector rotation has been on full display as other areas of the market are passed the baton.

Insurance stocks are beginning to outperform and have displayed relatively little volatility. These stocks are often overlooked due to their stable nature. But as history has shown, they can generate above-average returns as buying pressure increases in these stocks.

The shift into defensive pockets has coincided with many individual insurance stocks now reflecting positive earnings estimate revisions, which our research has shown to be the most powerful force impacting stock prices.

One such company is Assurant (AIZ - Free Report) , a Zacks Rank #1 (Strong Buy) stock. AIZ shares are outperforming the market and recently broke out to an all-time high. As we’ll see, the company’s traits make it a good candidate for a call option purchase.

The Zacks Rundown

Assurant is part of the Zacks Insurance – Multi Line industry group, which ranks in the top 25% out of more than 250 Zacks Ranked Industries. Because it is ranked in the top half of all Zacks Ranked Industries, we expect this group to outperform the market over the next 3 to 6 months.

Stocks in this industry are also showing favorable valuation and earnings metrics as we can see below:

Zacks Investment Research
Image Source: Zacks Investment Research

Historical research studies suggest that approximately half of a stock’s price appreciation is due to its industry grouping. In fact, the top 50% of Zacks Ranked Industries outperforms the bottom 50% by a factor of more than 2 to 1.

While there are many ways to take advantage of a potentially bullish move in Assurant stock, options provide us with flexibility, enabling us to tailor our strategy to the current market environment.

Option Essentials

Before we analyze today’s trade, let’s review some option fundamentals as a refresher. There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it is to work over the long run.

Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price, which is known as the strike price. A call option gives the buyer the right to buy a particular security, while a put option gives the buyer the right to sell the same. The investor who purchases an option, whether a put or call, is the option buyer, while the investor who sells a put or call is the seller or writer.

These contracts are valid for a specific period of time which ends on expiration day. There are weekly options, monthly options, and even LEAPS options which are longer-term options that have an expiration date of greater than one year.

Options consist of time value and intrinsic value. In-the-money options consist of both components; at-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value.

Below we’re going to explore a call option purchase strategy.

Multiply Your Insurance Returns

Assurant stock is in a price uptrend and displaying low volatility, making it a good candidate for a call option purchase:

StockCharts
Image Source: StockCharts

When done correctly, trading options provides huge profit opportunities with limited risk.

In today’s trade, we’re going to target the October 18th expiration date and the 150-strike price. Purchasing this option gives us the right, but not the obligation, to buy 100 shares of AIZ stock at $150 on or before October 18th, which is a bit less than 2 months from now.

The table below displays the risk/reward profile for this trade. Assurant stock is currently trading at $190/share (orange box). We are purchasing 1 October 18 150-strike call at 40.8 points, which is the option premium. Since options account for 100 shares of the underlying stock, the total cost for this call option trade is $4,080 as we can see in the yellow highlighted box.

Zacks Investment Research
Image Source: Zacks Investment Research

The top (blue) row shows the performance of Assurant stock based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our call option trade. We can see that if Assurant remains flat, this trade would encounter a minor loss of 2%. If Assurant moves up 5%, this trade will realize a 21.3% profit. If AIZ stock advances 15%, we would realize a 67.9% profit.

This illustration shows the inherent leverage that options provide. A stock investor who bought 100 shares of AIZ would have to contribute $19,000, which is a much bigger investment. A 15% increase in the stock price would yield a $2,850 profit.

On the other hand, in this example the option trader only needs to contribute $4,080 to control the same amount of underlying AIZ shares. A 15% move in AIZ stock would net a $2,770 option profit – a nearly identical profit amount with only about one-fifth of the investment!

Also note that this option contains relatively little time value. The 0.8 points worth of time value (red box) equate to just 0.4% of the underlying stock price. A good way to manage risk when buying call options is to minimize time value and maximize intrinsic value, as time value decays rapidly in the days leading up to option expiration.

Bottom Line

With insurance stocks coming back to the forefront amid ongoing sector rotation, the industry stands to benefit from increased buying pressure. These stocks are often overlooked due to their inherently stable nature.

A great way to take advantage of this move is via low-risk call options. Assurant is a good candidate for a call option purchase, as the company boasts strong fundamental and technical indicators. This allows us to leverage Assurant stock returns with the power of options.


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