Forget Trading -- Let These Investments Do The Work For You

Nathan Slaughter's picture

Thursday, May 5, 2016 - 10:30am

by Nathan Slaughter

On April 13, 2015, the S&P 500 closed at 2,081. On April 13, 2016, it closed at 2,082.

Of course, there have been innumerable up and down gyrations since then. But in the end, the benchmark index is right back where it started. In essence, we've gone nowhere over the past year.

There are more than a few pros, including top strategists at Goldman Sachs, who think the most likely trend for future stock prices isn't up or down, but sideways. Given the macroeconomic cross-currents, you can understand why the market has no clear direction.

There are several compelling reasons to sell stocks... crumbling commodity prices, ongoing terrorist threats, rising interest rates, excessive valuations, stalling global economic growth. Yet, there are just as many strong arguments in favor of buying... robust job creation, strong consumer spending, cheap and available capital, heated M&A activity.

You can see why the bulls and bears are in a tug-of-war right now.

It's quite possible that neither will gain the upper hand, leaving the broader market drifting. There will certainly be volatile day-to-day price swings, but the larger trend could be sideways -- what technical analysts call a "range-bound" market.

That's not necessarily the worst thing. Even if the wind goes out of the market's sails, dividend income can still put cash in your pocket each month and propel your portfolio. But there's one strategy in particular that's well-suited to deliver outsized gains in this type of environment.

I'm talking about covered call option writing, which is a great way to generate extra income on stocks you own -- on top of any regular dividends. Some people believe that stock options are inherently risky and speculative, and indeed they can be. But this particular tactic actually reduces risk and is even suitable inside IRA retirement accounts.

Let me explain.

Covered Calls 101
By selling a call option, you are granting somebody else the right (but not the obligation) to purchase a stock from you at a pre-determined price (the strike price) before a specified maturity date. In return, you receive an upfront cash payment called a premium.

I'll use an example from the portfolio of my premium newsletter, High-Yield Investing.

As I write this, CME Group (NYSE: CME) is currently trading at $93 per share. There is a call option with a strike price of $100 maturing in September priced at a premium of $1.55. Each contract involves 100 shares, so selling one of these calls would net me $155 in immediate income ($1.55 x 100).

I get to keep that money regardless of what happens to the stock. Now, if the shares fail to reach $100 before the maturity date, then the contract expires and I simply pocket an extra $155 -- adding it to the dividends I will collect over the period.

What's the catch? Well, in exchange for the income, I would have to forgo any upside above and beyond the strike price. Suppose the shares rally sharply to $105. Then the call option would be exercised and I would have to sell my shares to the buyer at $100, giving up any further appreciation.

Still, there are worse things than watching a stock you own climb from $93 to $100. That's a gain of $7 per share (or $700 total), which added to the premium income, would give me a total gain of $855.

What if the shares drop in value between now and September? Well, I still get $155 to help cushion the decline (versus zero for just holding the stock without any option writing).

You can see how this technique would be especially useful in a flat or declining market. With little impetus to push the stock into triple-digit territory, there is a good chance that the option will expire -- and I will have earned $155. And since I still get to keep my shares, I can always sell another option and earn another second premium. And so on...

Using these calls, I get paid to wait for CME to reach my target while the market is stuck in the doldrums.

Now here's why I recently brought this up to my High-Yield Investing readers... While we don't dabble in options in my premium newsletter, we have the chance to own many dividend-oriented funds that employ this same strategy -- but on a larger scale, multiplied by thousands or even millions of shares.

The premium income earned from this strategy can add up significantly. The proceeds supplement ordinary dividends, giving fund holders a larger income stream -- even when the market itself is stuck in neutral.

I recently highlighted a few of these funds for my High-Yield Investing readers. Out of fairness to my subscribers, I won't give away my favorite pick, but I'm happy to share some of the more notable candidates with you today...

Remember, this is just a stock screen to identify potential candidates that meet certain criteria. The funds in the table above are a good starting point for further research.

Keep in mind, options prices are a function of market volatility. Traders are willing to pay more (so sellers collect more) when there is some turbulence. And with a contentious presidential election right around the corner, I suspect we'll see plenty of that.

By its nature, covered call writing limits upside potential in exchange for additional income and downside protection. So it stands to reason that these funds (also called buy-write funds) will lag the S&P in runaway bull markets. But they shine in uncertain conditions like we find ourselves in right now and can boost income when stocks aren't going anywhere.

Regardless, this tactic is never a substitute for good old-fashioned stock picking. Before any options are written, the fund must first assemble a solid portfolio. And based on my research, a few of these funds have compiled impressive portfolios that should offer plenty of income opportunities for investors.

P.S. My research staff and I just finished digging through a 317-page document released by Congress that uncovers a tax-free retirement "loophole" that everyday Americans can use to earn more income each and every year. Frankly, every individual investor who wants a secure retirement needs to read this report. You can learn more here.

 

 

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.