The Best Strategy for Dealing With the Stock Market Sell-Off
Stock-Markets / Stock Markets 2014 Oct 15, 2014 - 05:20 PM GMTBy: Investment_U
Marc Lichtenfeld writes:Investors have it tough today.
The market has been ugly the past few weeks, instilling fear in some investors that the bull market is over and they missed their chance at making money.
Additionally, interest rates are still so low, it's tough to generate any income from your nest egg.
However, the recent market slide is a perfect opportunity for investors who know how to pick up extra cash with a conservative strategy.
This method can easily generate a year or more worth of dividend income in just four to eight weeks. And the recent market volatility means we can actually make more today than we could have a few weeks ago on the same trades.
Let me repeat that because it's important.
The market sell-off means we can now generate more income than we could have just a few short weeks ago.
The strategy is selling covered calls.
Fear Not
Now, before you run away screaming because you've heard options are scary or complicated, understand that selling covered calls is more conservative than owning a stock outright. And it takes only one more simple step than simply owning a stock.
I'll walk you through the process right now.
Let's say you want to own shares of a blue chip dividend payer like <strong>Merck</strong> (NYSE: MRK). As I write this, to buy 100 shares, it would cost you $5,740. Shareholders receive an annual dividend of $1.76, or $0.44 per quarter. That comes out to a 3.1% annual yield. Not bad in today's low interest rate environment.
It's not bad, but 3.1% isn't a whole lot of income either. So an investor who wants to generate more income from his Merck shares can sell a covered call on the stock.
It's considered covered because the investor owns the stock already. If the investor sold the call without owning the stock, that would be a naked call. That's risky. Covered calls are not. I'll explain why in a moment.
The investor could sell a Merck December $60 call for $1.15. That means that he will collect $1.15 per share for 100 shares. Options are traded in 100-share blocks. So on 100 shares, the investor collects $115 cash immediately after selling the call.
Remember, we're <em>selling</em> calls, not buying them. The buyer of the call has the right, but not the obligation, to buy the Merck stock from the investor at $60. If at options expiration, which is typically the third Friday of the month, the stock is below $60, the call will expire worthless and the investor keeps the $115.
If the stock is above $60, the buyer will likely exercise the call, meaning he will buy the stock for $60. In that case, the investor must sell the stock for $60, no matter where it's trading. But because he bought it at $57.40, he'll still make a $2.60 per share profit or $260.
Additionally, he keeps the $115 he received for selling the call. And he also gets the $0.44 dividend if he owns the stock on the ex-dividend date.
So on a stock that yields 3.1% per year, the investor who sells a covered call earned 7.3% in two months. He earned more than twice the income in one-sixth the amount of time.
Even if the stock price falls below where the investor bought it, he still collects the $0.44 per share dividend like normal and keeps the $115 option premium he received for selling the call.
Because of that $115 or $1.15 per share, the breakeven point is now $56.25 instead of the original price of $57.40. The option acts as a buffer against falling prices and is the reason covered calls are more conservative than owning a stock outright. When things go bad, you lose less.
Be the House
When you go to a casino, you know you may get lucky, but the house usually wins. When you sell a covered call, you are the house. You're selling a call to speculators who are betting on the stock price going up. More than 80% of options expire worthless, which is fine with us because we sold it already; we didn't buy the call and own it. We own only the stock.
Right now is a great time to sell covered calls because market volatility has increased significantly. There are several components that go into how options are priced. I won't bore you with the details here (if you want more information, click here, but when markets get more volatile, option prices get more expensive.
So with the current market environment rather volatile, those options have become more expensive, which is good news for option sellers. They get more money for the options they're selling than they would have a few weeks ago.
You can see that selling covered calls makes a lot of sense in the current market - especially with all of this volatility. Low interest rates and yields combined with higher volatility means that covered call sellers can make more money with less risk than they could by just owning a stock.
Good investing,
Marc
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