Scared of Buying Stocks Near Record Highs? This Could Be the Answer
New highs are often followed by sell-offs… but they can also be followed by yet more new highs.
In time, we will know which is the case with the current market. For now, we need to develop strategies that could be profitable no matter what the future holds.
Regardless of what the broad market averages are doing, investors should generally have some exposure to the stock market. This can be difficult to accept given the history of the past couple of decades.
If the broad market declines, as it did in 2000 and 2007, the losses could be large.
There is nothing magical about new highs, however, that require the market to move lower. Arguments for higher prices are easy to find and even higher highs are possible.
Still, it’s difficult not to feel like we’re due for a pullback.
Always Hedge Your Risk
Some investors act as if they believe their opinion on this matter should be backed by a commitment of 100% of their capital. Nothing could be further from the truth. Whether you are long or short, it makes sense to hedge some of the risk that is always present in the stock market.
Hedge funds are often thought of as high-risk investments. But the very first hedge fund was designed to minimize the risks of the stock market by balancing long and short positions.
Now, there are a number of ways to hedge risks. One of my favorites is the covered call strategy.
Covered calls can be a way to reduce the anxiety of owning stocks, reduce risk, and generate immediate income. To establish a covered call position, you need to own at least 100 shares of a stock. Then, you sell one call option contract against those shares. Each call option will be for 100 shares, so the strategy has to involve multiples of 100 shares. You could sell two calls if you own 200 shares, for example.
Call buyers have the right, but not the obligation, to buy the stock at a predetermined price (strike price) for a predetermined amount of time. Call sellers have the obligation to deliver the shares during the life of the options contract. Covered call sellers already own the stock they might have to deliver, so the risks are limited.
How It Works
Theories behind options strategies can be confusing, so I’d like to use a real-world example. So let’s look at a trade I made recently within my Maximum Income service back in November. (Note: Prices will be different today; this is not an actionable trade recommendation.)
Back in November, Telecom giant AT&T (NYSE: T) was trading around $37.75. I recommended buying 100 shares of T and then selling one T Jan-17 $36 Call for every 100 shares of T you purchased. That’s a call option on T with a strike price of $36 that expires on January 17, 2020.
The initial cost to enter the position was $3,775 ($37.75 x 100).
At the time, those Jan-17 $36 Calls were trading around $2.25 per share. ($2.25 x 100 shares = $225 premium.)
In addition to the income we received from the premium, we also received a dividend payment of $0.51 per share. ($0.51 x 100 shares = $51.) Between the premium and dividend, this would give us a cost basis of $34.99 ($37.75 purchase price – $2.25 premium – $0.51 premium).
This call would obligate you to sell T at $36 a share if the stock traded above that on January 17 (the last day these options could be traded).
Now, two scenarios can happen…
1) Assuming T traded for $36 or less on January 17, we’d keep the $276 we received from the premium and distribution on $3,775. That’s a 7.3% return in 57 days. If we can repeat a similar trade every 57 days, we’d earn a 46.8% return on our capital in 12 months.
2) If T traded above $36 by January 17, our stock would be called. In that case, we would sell the shares for $36. But we’d keep the income we received from selling the call and collecting the distribution.
In this case, we would realize a profit of $1.01 per share ($36 – $34.99 new cost basis), or $101 per 100 shares. This is a profit of 2.9% in 57 days. If we can repeat a similar trade every 57 days, we’d earn an 18.5% return on our cost basis in 12 months.
Bringing It All Together
This trade offers just one example of the covered call strategy. Covered call writing could work well with other stocks or ETFs that you own.
The point is, this strategy offers a way to reduce risk. The premiums you earn help offset losses, and also allow you to turn current holdings into current income.
Consider protecting against downside risk with covered calls on stocks or ETFs that you own.
You could also consider my colleague Jim Fink’s system for delivering winning trades. By using his tried-and-true methods, you don’t have to worry about a market crash, the headlines, or anything else other than the trade itself. That’s because his system generates profits in bull or bear markets, in good economic times or bad.
In fact, over the past 50 months Jim’s trades have racked up a win rate of 84.68%. That’s unheard of for just about any investor and any asset class. If you want to get the details for Jim’s next trades, simply go here right now.