By: Costas Bocelli — August 28, 2019
It was just a month ago that stocks were hitting record highs and market breadth was strong.
But that soon changed after President Trump announced new tariffs on the remainder of Chinese imports would be starting September 1st.
Some of those tariffs have been delayed until December.
Nevertheless, starting next week, import duties are set to go into effect on billions of dollars of goods entering into the U.S.
Trump proclaims himself to be “tariff man”, as he often reminds his millions of Twitter followers.
“We’re taking in billions of dollars in tariffs at China’s expense”, he proclaims.
While some may argue that Trump’s escalation in the trade dispute is a negotiating tactic to pressure China into making a deal, the reality is that it’s been a drag on risk assets, including U.S. Equities.
In early-August, the NYSE bullish percent chart, the granddaddy of stock market indicators, had reversed to a column of O’s.
When this happens, the proverbial “traffic light” of risk turns from green to yellow.
(Click any image to enlarge)
In other words, it’s a signal to investors that it’s time to focus more on wealth preservation than wealth accumulation.
Three weeks ago, we shared one easy hedging technique that can help protect an entire portfolio of stocks from a market selloff.
Since the late-July highs, the S&P 500, the primary U.S. stock market benchmark, has fallen more than 6% during the month of August.
As we advocated, purchasing put options and put spreads in an exchange traded fund such as the SPDR S&P 500 ETF (SPY) can be an effective measure investors can take to mitigate risk.
The hedges have gained in value, which has likely offset a significant portion of the losses in the stocks held in the portfolio.
But portfolio hedging might not be everyone’s cup of tea.
And we get that.
The good news is there are other measures individual investors can take to reduce risk.
One of those happens to be an income generating strategy that uses existing stocks that you happen to own.
And it can work even if you hold just one stock position.
While Trump is “taking in billions and billions on Chinese tariffs”, you too can get in on the trade war action by taking in hundreds, if not thousands of dollars in easy cash.
In other words, you’ll be charging your own “special tariff” on other investors that have interest in owning the same stock as you.
I’m referring to a Covered Call strategy where you sell Call options against a long stock position that you own.
By selling Covered Calls, it instantly generates cash and provides a limited form of downside protection from the premium collected by selling the option.
And let me tell you that right now market conditions are ripe for selling covered calls against stocks that you own.
For one thing, while the stock market is still long-term bullish, the major stock averages have been stuck in a trading range over the short to intermediate-term.
Have a look at the S&P 500…
Throughout most of August, the index has been trading in a range between the 50-day moving average (blue line) and the 200-day moving average (red line).
And with so much uncertainty weighing on the markets, we will likely continue to see more of the same type of action as we move into September and October, two calendar months that have a tendency to be relatively volatile.
Speaking of volatility, have a look at the CBOE Market Volatility Index (VIX), also known as the “fear gauge”.
The VIX is trading around 20, which is a relatively high reading.
And when the VIX is elevated it tells us that the implied volatility of options is high too.
This means that option premiums are also relatively expensive.
And that’s great news for option sellers, because we’ll get to collect even more on that “special tariff” we get to charge option buyers.
With that in mind, let’s run through a timely example to see how it works…
Let’s say we own 500 shares of Texas Instruments (TXN).
In this example, TXN is trading around $123 per share.
Stock holders could look to sell the October 130 strike Call option for $2.15 credit which means you’ll get to instantly collect $215 for each contract sold.
Since each Call option obligates you to potentially deliver 100 shares of stock in the case of an assignment, you’ll want to sell no more than five contracts which will ensure the position is completely covered.
Choosing the proper option to sell is an important consideration.
In this example, we chose an out-of-the-money Call option that has a strike price above the current price of the stock.
This will allow upside appreciation should the stock get called away.
If we must deliver the stock, it would be at $130 per share, which marks the previous all-time high.
Considering the kind of market landscape we’re in right now, picking up an additional $7 capital gain or 6% of upside from here wouldn’t be such a bad result, right?
The $215 per contract we collected is immediately deposited in our brokerage account.
Since we sold five contracts, that means we just took in $1,075 on our “special tariff” we slapped on the Call option buyer.
It’s ours to keep and we can do anything we like with it.
Since the Call option obligates us until its October expiration, or 50 days from now, the return on investment is more than a 12% annualized return, not including any of the capital appreciation should the stock get called away at $130 per share.
And if TXN should remain below $130 at October expiration, the Call option would most likely expire worthless, freeing you of the obligation.
That means we can sell another round of covered calls and collect another “special tariff” on our stock holding.
Each time you do this, it effectively acts as a limited hedge because the premium collected lowers the cost basis of the stock.
Selling Covered Calls in this type of market environment can be a good strategy to boost returns and generate some serious cash on stocks that you own.
Want to learn more about the Covered Call strategy? In Options Soup to Nuts, our options educational program, we show investors exactly how to generate income on stocks that you own (and even on stocks that you don’t own). To learn more about Options Soup to Nuts, click here now.
Until next time,