Continuous Profits In An Uncertain Market

Amber Hestla's picture

Thursday, March 23, 2017 - 12:00am

by Amber Hestla

There are a lot of hard problems facing Washington. Healthcare will take time, as will many other issues. Tax policy seems to offer the most immediate path to a significant accomplishment for the president and Congress.

President Donald Trump has made a number of proposals related to taxes. Among the most important would be a reduction in the highest corporate income tax rate from 35% to 15%. I am fairly certain tax reform will require negotiations and Trump won't get everything he wants. But the good news is that lower corporate and personal income taxes seem likely.

Lower corporate taxes will have an immediate impact on company earnings. Standard & Poor's estimates that every 1% reduction in the corporate tax rate could add 1% to the earnings per share (EPS) of companies in the S&P 500.

However, Trump isn't looking for a small reduction in taxes... he's targeting a 20% drop. Let's assume he settles for a rate in the middle, a 10% cut. EPS for the companies in the S&P 500 could then be about $146. A P/E ratio of 17 provides a price target of about 2,500. A P/E ratio of 20, which could easily be justified by the rapid growth that would push earnings higher, provides a price target above 2,900.

If companies obtain relief from the regulatory burden and government agencies change their policy of imposing large financial penalties on companies, then EPS could rise even more.

Changes in personal income taxes should increase consumer spending and lead to even higher EPS. A target of 3,000 on the S&P 500 is realistic, assuming Washington delivers on its promises. I believe we have until late summer to see progress. If there isn't movement toward tax reform or other significant policy changes by then, the bull market could collapse. If there is change, the bull market could rival the one from the 1990s that many of us fondly recall.

This Chip Producer Will Soar In A Low-Tax Environment
In this environment, I believe companies whose results are sensitive to economic growth may outperform. Among those companies is Advanced Micro Devices (Nasdaq: AMD).

AMD makes x86 microprocessors, the central processing unit (CPU) of many desktop and laptop computers. The company's chips are also incorporated into accelerated processing unit (APU), chipsets and discrete graphics processing units (GPUs) for the consumer, commercial and professional graphics markets. These chips are also used in servers.

These are large markets, so there is room for multiple companies to generate significant revenue. AMD believes gaming represents a $15 billion market opportunity. Data centers are a potential $18 billion market and immersive platforms (virtual reality) is on its way to a $20 billion market opportunity.

On the gaming side of its business, Microsoft and Sony have each refreshed their respective consoles to enable next-generation graphic capabilities like 4K video quality and virtual reality (VR) gaming. AMD is the main supplier of semi-customer system-on-a-chip (SOC) for both Microsoft's Xbox and Sony's PlayStation gaming consoles.

In data centers, this week, AMD announced a collaboration with Microsoft to incorporate the cloud delivery features of AMD's next-generation "Naples" processor with Microsoft's Project Olympus -- Microsoft's next-generation hyperscale cloud hardware design and a new model for open source hardware development.

All that aside, it's difficult to predict exactly when Trump's administration will get around to drafting an updated tax policy that could swing the market in our favor. And even when that happens, we'll have to wait on congressional approval -- if it ever comes at all.

This means that prices could remain relatively stagnant as the market waits for signs of a change. In the meantime, I know I'd personally feel a lot better with some extra earnings coming in, and there is a way for traders to take advantage of any further upside, no matter how small. It's also one of my favorite income strategies, one that I use frequently in my premium newsletter Maximum Income -- covered calls.

How Covered Calls Work
As you likely know, a call option gives the buyer the right to purchase 100 shares of a stock at a predetermined price (the strike price) at any time before the expiration date. A covered call strategy involves selling calls on a stock you already own.

When you sell a call option, you collect a premium for accepting the obligation to sell the stock if it should rise above the option's strike price. Risk is minimized because your obligation is "covered" by the fact that you already own the shares.

Once you sell a covered call, one of two things can happen -- either the underlying stock rises in price or it falls.

If it declines in price, your shares will decrease in value, but you have the option premium to counter the loss. In other words, if the shares fall, you're better off selling covered calls than simply holding the stock.

Meanwhile, as long as the shares stay under the strike price, the option expires worthless for the buyer. That's not necessarily a bad thing. When an option expires worthless, it means you can sell another call on the stock, capturing another income payment. That's why I only recommend selling calls on high-quality stocks that I would be happy to own for the long term.

And if the stock's price rises, that's good too. While your gains will be capped with this strategy, anything between the price at which you originally bought the shares and the option's strike price is pure profit, in addition to the cash earned when you originally sold the option.

For a more specific example, let's look at the trade I'm currently recommending to my Maximum Income readers. AMD is currently trading around $13.90 per share, and you can sell a call option that expires in one month from now with a strike price of $14 for about $1.00 per share. This would generate income of $100 for each contract sold (as each contract controls 100 shares).

If that stock is below $14 at expiration, the income from selling the call option is yours and you are free to sell another option. Selling one call each month for around $100 would generate income of about 7%, for a total of about 72% over a full year, in addition to any income from dividends.

If the stock is above $14 when the option expires, you will have to sell 100 shares at that price. Combined with the income from the option sale, the total gain would be 6.1% in a month, or about 60% annualized.

So regardless of whether Trump gets around to slashing taxes any time soon or not, you can still profit from holding AMD stock and selling calls.

Covered calls will also help to protect against any losses. Some investors are using it to bring in up to an extra $3,000 a month, which can go a long way in offsetting a downturn in stocks.

I've put together a free webinar that can help you get started with this strategy. Access it here.

Amber Hestla 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.