The Perfect Way To Protect Your Portfolio In This Market

Nathan Slaughter's picture

Friday, January 4, 2019 - 12:00am

by Nathan Slaughter

The market has certainly taken us on a circuitous path over the past 12 months. Some days we put a lot of mileage behind us; others were full of wrong turns and detours. But in the end, the market ultimately ended right back where it started.


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In any case, with the benefit of hindsight, we can see that stocks have essentially been moving sideways. I expect that trend to continue as we progress through 2019. 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.

The path to higher ground is blocked by all kinds of macro and geopolitical obstacles... record corporate debt levels, an inverted yield curve, a weakening housing market, unresolved trade disputes. Plus, most sectors were fully valued before this downturn, if not overpriced. So, it will be difficult for equities to make meaningful headway in the near-term.

But trading has been orderly, and buyers have some strong arguments as well. Borrowing costs are still low, inflation is subdued, and S&P earnings are projected to climb 12.8% next quarter (the fifth straight quarter of double-digit growth). Furthermore, business capital-expenditure (CapEx) spending remains healthy, thanks in part to corporate tax reform.

And the economy continues to expand, albeit at a slower rate. After sprinting at a 4%+ pace earlier this year, the U.S. Federal Reserve expects GDP to merely jog ahead about 2.5% in 2019. But there's a big difference between deceleration and contraction. At this point, the odds of sliding into recession appear slim. Goldman Sachs pegs them at just 30% -- meaning there is a 70% chance the economy continues to grow.

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). The stock is currently trading around $43 and offers a respectable yield of 3.3%. Suppose I own the drugmaker and like its long-term prospects but 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.

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 March 15, 2019, with a strike price of $48. The cost (or premium) is $0.50 per share. Since each contract involves 100 shares, this one would cost $50.

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 $48 per share.

Given market headwinds, there's a good chance that PFE fails to reach $48 between now and March 15. The stock might slide a bit, stay flat at $43, or possibly gain a few dollars per share. Under any of those scenarios, the option would expire, and I would keep my shares. Nobody will voluntarily exercise their right to pay $48 for a stock that can be bought on the open market for, say, $46.

So, I would happily pocket an extra $50 profit for my trouble and move on.

That might not sound like much. But by itself, $0.50 on a $43 stock represents an income stream of 1.1%. And that's just for a 3-month holding period. After the contract expires in March, I could immediately sell a second call option for another 3-month period, and then possibly another.

The longer PFE stays below $48, the more income I can harvest.

Repeating this strategy four times over the next year would bring in $2.00 per share in premium income, or 4.4%. Of course, I would also still collect the regular dividend yield of 3.3% 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 7.7% 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.


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And contrary to popular belief, these call options aren't risky. Actually, they reduce your downside exposure. If I can collect $2.00 per share in premium income on Pfizer, then my breakeven price drops from $43.80 to $41.80. So, if I end up selling in a decline at $40, the loss would be just 4.3%, versus 8.7% without the options.

I know what you're thinking. What happens if PFE moves sharply higher and reaches above the $48 strike price? Well, let's just say that I wouldn't complain about that scenario either. After all, that would represent an 11.6% gain from my purchase price -- and I'd still keep the $50 premium income as a parting gift.

What's the catch? Well, I would have to sell my PFE shares at the agreed-upon price of $48 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, particularly in a market that is showing signs of topping out.

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.

As I mentioned earlier, covered calls are a perfectly safe and legitimate strategy for investors looking to boost their income. But if you're still uncomfortable with the idea, don't worry. Tomorrow, I'm going to follow up by explaining a more "hands off" way of taking advantage of this strategy.

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, then she's got you covered. You can learn more about her strategy right 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.