One of the Best Sources of Income in a Declining Market

If you’re like most investors, you’re probably looking doubtfully at this stock market. Is it worth the risk now that many of us are back to where we were before the 2008 crash?

Why not just take money off the table, put it in bonds and be done with it?

[ad#Google Adsense 336×280-IA]Well, there’s a little-known way that anyone can keep their stocks and continue to make profits even if the market takes a further turn for the worst.

The time has come for the average investor – whether wealthy or in the process of accumulating wealth – to consider using a powerful investment strategy: covered calls.

Covered calls are widely used by savvy “institutional investors” – pension funds, insurance companies, endowment funds and some mutual funds.

Yet the strategy is often misunderstood by individual investors.

However, when using highly liquid options on dividend-paying stocks or ETFs, the combined return from potential capital appreciation, dividends and additional income you receive from covered calls can yield double-digit returns that are more predictable, consistent and conservative than with dividend-paying stocks or ETFs alone.

As I have often stated in this space, most investors think of options as high-risk, speculative strategies that can result in large losses. While this is certainly true of some option strategies, covered calls are more conservative than investing in stocks or ETFs alone. More importantly, they can provide significant protection in a down market and can be a key component for an investor looking to achieve double-digit returns in a flat or slow-growth market.

By now, I’m sure some of you are asking what I mean by the term “covered.”

Simply stated, it means that you sell call options on shares of the underlying security – in our case a dividend-paying stock or ETF – which you already own. The liability of selling those calls means that you are obligated to sell the shares at a predetermined price (the “strike price”) should the buyer of the calls wish to exercise the option. But your obligation is “covered” because you own the shares.

Let’s look at an example of a dividend-paying stock that holds the potential for a covered-call strategy – Diamond Offshore Drilling (NYSE: DO). The stock closed Friday at $16.91 and pays a healthy 3% dividend. Let’s assume we own 100 DO shares.

While we could sell covered calls in February, I think the best bang for our buck would be to go out to March and sell premium at the 20 strike for roughly $0.75. We would sell one call contract to account for our 100 shares of the underlying stock.

For receiving a premium of $0.75 per share (or $75 per call contract), we are willing to let go of our 100 DO shares should the stock price exceed $20 on the expiration date – in our case March 18.

So from this transaction, you will collect $75 in option income. Annualized, the premium income at the current market price of Diamond Offshore will yield roughly 26%. Not too shabby!

Add that to the current 3% dividend and you have more than 29% of income coming in on an annual basis.

You also have the potential to realize an additional $309 of capital appreciation if the price of Diamond Offshore exceeds $20 per share on the expiration date.

Now the downside. If Diamond Offshore goes to, say, $25 before the expiration date, you would lose out on the capital appreciation above $20. You would receive only $20 per share no matter how high the market price reaches.

Of course, you would retain the option premium of $0.75 for a total of $20.75 per share. If the stock hits $25 by expiration, you would miss out on receiving the added $4.25 had you done nothing but hold the stock.

But don’t forget, you also have $0.75 per share of downside protection if Diamond Offshore’s price heads south. In this case, your break-even point for the position is a stock price of $16.16 (the current price minus the premium received).

It is important to realize that it is still possible to lose money buying Diamond Offshore shares and using covered calls if the price of the stock declines significantly.

However, if you are caught in a declining market, you will ALWAYS be better off using covered calls on your shares compared to just owning them. That’s because the premium income gives you the added downside protection that you would not otherwise have.

Just remember, using covered calls means you are no longer in the business of trying to maximize capital appreciation on your shares. You are now in the business of using covered calls to provide a rate of return that will meet or exceed your objectives on a consistent and predictable basis.

— Andy Crowder

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Source: Wyatt Investment Research