This year has been a sobering reminder of how volatile the stock market can be without much to show for it.[ad#Google Adsense 336×280-IA]But we often hear that we should ignore short-term volatility because, in the long run, stocks have always delivered great returns.
Historically, this is true — but how do we know we can expect the same in the future?
One highly respected firm is cautious about the long term.
The seven-year forecast for asset classes published by GMO, the $117 billion hedge fund founded by noted value investor Jeremy Grantham, is far from comforting.
These are forecasts for real returns, which are returns after inflation. Assuming GMO’s forecast is correct, if inflation averages 2% a year, we are likely to see below-average returns in U.S. stocks for the next few years. Even if returns are better than GMO expects, we are unlikely to see them near their long-term historical return of 6.5%.
This is consistent with work by Nobel Prize winning economist Robert Shiller, who is also calling for lower-than-average stock returns in the next few years.
Now, this doesn’t mean investors should throw in the towel or avoid U.S. stocks altogether. GMO forecasts high-quality U.S. stocks will outperform, so selection will be key. And traders willing to take just one extra step can multiply their returns many times over.
The technique is actually pretty simple, but requires some investors leave their comfort zone. You see, it involves options — one of the most misunderstood corners of the financial world.
Many investors steer clear of options because they have a reputation for being risky. But options aren’t always risky; in fact, the strategy I’ll show you today can actually be more conservative than buy-and-hold investing.
Let’s say you own shares of a high-quality stock trading for $100.
You think it’s a good, solid company — the kind GMO’s forecast looks promising for. Based on your analysis, its share price may go up 10% in value over the next few months, but you don’t expect it to skyrocket in the near future.
Your friend, however, thinks the stock is about to take off. He believes that over the next few months it’s going to run all the way to $200.
So he comes to you with a proposal.
He’ll pay you $500 today… as long as you agree to sell him your shares if the price reaches $120 in the next two months.
Let me repeat that…
He’ll pay you $500 today, if you’ll sell him your shares once the price — which is now at $100 — reaches $120.
This sounds like a pretty good deal to you. After all, you want $500 today. And if the stock goes up to $120 and you have to sell your shares to him, that would give you a 20% capital gain. So you agree to his offer and he hands you $500.
Over the next two months, the share price begins to rise. Before the two months is up, it hits $120. That means you have to sell your shares.
So you and your friend meet, and you fulfill your end of the bargain by selling him your shares for $120. With the sale, you get a 20% return on your investment — in addition to the $500 your friend already gave you.
That, in a nutshell, is how my strategy — selling covered calls — works.
The buyer believes the stock will skyrocket over the next couple months… and he believes this so strongly, he’s willing to pay you — the seller — a cash premium upfront to make this bet.
You both agree that if the share price hits a certain price — what’s known as the “strike price” — by a certain date — called the “expiration date” — you will sell him your shares. But you get to keep your cash premium no matter what.
If the stock 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 do happen to fall, you’re better off selling covered calls than simply holding the stock.
Whether shares rise or fall, as long as they stay under the strike price, the option expires worthless. That’s not necessarily a bad thing though. When an option expires worthless, it means you keep the shares and can sell another call on them, capturing another income payment.
This is why I only recommend selling calls on high-quality stocks that I would be happy to own for the long term. I’ve used this strategy with stocks like Apple (NASDAQ: AAPL), MasterCard (NYSE: MA), Tyson Foods (NYSE: TSN), Morgan Stanley (NYSE: MS) and dozens of others.
In an environment where some of the greatest investment minds are forecasting below-average stock returns, using covered calls is a no-brainer. Traders can boost their returns on high-quality stocks while lowering their risk compared to buy-and-hold investors.
— Amber Hestia[ad#sa-trader]
Source: Profitable Trading