The Perfect Way To Protect Your Portfolio In This Market
The market has certainly taken us on a wild path since the beginning of the year. When the coronavirus pandemic took hold, a lot of investors were caught off guard. Some days seemed like pure chaos as the market tried to make sense of whether this is a “new normal” or a “temporary normal” — and what that means for the economy and individual stocks.
We’ll save that discussion for another day. In any case, with a sense of stability now set in the market, it’s easy to see that stocks may move sideways for a while. Now, that doesn’t mean listless drifting each day. Quite the opposite — I expect this heightened volatility to continue. But in the ongoing tug-of-war between bulls and bears, it’s possible that neither side maintains the upper-hand too long… At least until we get more certainty about how long this is going to last, how much of a threat coronavirus will be in the fall, and how quickly the broader economy will recover.
Meanwhile, trading has been orderly recently. Borrowing costs are still low, inflation is subdued, and S&P companies may have a low bar to jump in terms of expectations.
So, while stocks might have a ceiling, they might also have a floor. If that’s the case, we could be facing a range-bound market. And I have the perfect strategy in mind for this kind of market — one that not only protects your portfolio, but also earns extra income in the process…
Get Paid To Protect Your Portfolio
Let me explain, using a widely-held stock such as Pfizer (NYSE: PFE). As I write this, the stock is currently trading around $37 and offers a respectable yield of nearly 4%. Suppose I own the drugmaker and like its long-term prospects. But I also think it could be in for a bumpy ride over the next few months.
One way to mitigate risk — and generate extra income at the same time — is by selling a covered call option.
If you’re new to options, don’t be scared by the terminology. It’s really quite simple.
Call options convey the right (but not the obligation) for one investor to purchase stock from another at a pre-designated price. In this case, there is a call option on PFE expiring June 26, with a strike price of $40. The cost (or premium) is $0.46 per share. Since each contract involves 100 shares, this one would cost $46. (Keep in mind, prices can and do change frequently. This example is for illustrative purposes only.)
As the seller, I would collect that cash from the buyer up front. In turn, they have the right to buy 100 shares of PFE from me at $40 per share.
Given the ongoing uncertainty in the market, there’s a decent chance that PFE fails to reach $40 between now and June 26. The stock might slide a bit, stay flat, or possibly post a slight gain. Under any of those scenarios, the option would expire, and I would keep my shares. Nobody will voluntarily exercise their right to pay $40 for a stock that can be bought on the open market for less.
So, I would happily pocket an extra $46 profit for my trouble and move on.
That might not sound like much. But by itself, $0.46 on a $37 stock represents an income stream of 1.3%. And that’s just for a 6-week holding period. After the contract expires at the end of June, I could immediately sell a second call option for another time period, and then possibly another.
The longer PFE stays below $40, the more income I can harvest.
Repeating this strategy just four times over the next year would bring in $1.84 per share in premium income, or 4.9%. Of course, I would also still collect the regular dividend yield of 4% along the way.
Why This Works So Well
Dividend investing is a waiting game anyway. We buy with the intent of getting a paycheck every quarter and hopefully selling the stock in the future at a higher price. If the stock reaches that target price quickly, great. If not, writing call options offers a way to collect more income while you wait.
In this case, you could more than double the payout on PFE to 8.9% over the next 12 months. Now that’s making your money work harder.
Remember, the goal of this strategy is to earn supplemental income during periods when the market (or an individual stock) isn’t going anywhere fast. We all have slow movers. Utilizing options is a bit like “renting” them out for a while to make a few extra bucks.
And contrary to popular belief, these call options aren’t risky. Actually, they reduce your downside exposure. If I can collect $1.84 per share in premium income on Pfizer, then my breakeven price drops from $37 to $35.16.
I know what you’re thinking. What happens if PFE moves sharply higher and reaches above the $40 strike price? Well, let’s just say that I wouldn’t complain about that scenario either. After all, that would represent an 9.4% gain from my purchase price, based on my lower cost basis.
What’s the catch? Well, I would have to sell my PFE shares at the agreed-upon price of $40 and forgo any additional upside beyond that. So, if PFE streaks to $55, then the rest of the gain would accrue to the option buyer. But that might be a fair tradeoff, depending on your goals and the state of the overall market.
How To Put Covered Calls To Work For You
There are really only four scenarios once we buy a stock: it can decline; stay flat; rise a little; or rise a lot. Obviously, we prefer option four. But in any of the other three, covered calls can boost returns.
In the meantime, for more information about covered calls, I recommend checking out my colleague Amber Hestla’s work over at Maximum Income. If using individual options to enhance your income sounds like a smart idea to you, then she’s got you covered. You can learn more about her strategy right here.