Everyone knows that bulls make the most in an up market and bears make the most in a down market.
But who does best in a flat market? Often it’s investors who write covered calls.[ad#Google Adsense 336×280-IA]Call writing is an income-producing strategy where you sell (or “write”) call options against shares you already own. In exchange for selling these calls, you collect a premium.
With that premium comes an obligation. You may have to surrender (give up) your shares at a prearranged (strike) price.
Let me run through a quick example.
Let’s say you buy 100 shares of AT&T (NYSE: T) at $39 a share. The stock currently yields 4.9%.
So if the market is flat over the next 12 months and your shares of AT&T are unchanged, your total return will be the dividend yield alone: 4.9%.
But let’s say instead that you use a call-write strategy and sell one June 16, 2017 $40 contract (for 100 shares) for $1.60. That means you would collect $160, equal to 4% of your original $3,900 purchase price for the shares.
Here if AT&T is (again) completely flat, you will earn a total return of 8.9%… or 4.9% (the dividend yield) plus 4% (the call premium).
Earning a return like that on a stock that goes nowhere is not half bad. This can be an excellent flat-market strategy.
However, I’ve outlined only one of many possible scenarios. For paying that premium, the call buyer has the right to call away your 100 shares if they are $40 or higher in June 2017.
If the stock is, say, $50 at that time, you may regret your decision to sell those calls. In fact, you may regret your decision even if the stock is as low as $41, since that is $2 higher than your purchase price and you received an option premium of only $1.60 a share.
However, history shows that most stocks are not called away. More often than not, the call seller collects the premium, doesn’t have to deliver his shares, and is free to write new calls with a different expiration date and collect another premium.
Unfortunately, I know from the many years I spent as a money manager dealing with individual investors that I have probably lost about 80% of my readers by now. Options can be complicated. Most investors never have and never will buy or sell an option.
And that’s ok… for two reasons.
The first is that I ordinarily don’t recommend selling calls anyway. Why? Because even though most of your shares will not be called away, every big winner will be. That is an unacceptable risk in most markets.
(If, for example, AT&T doubled between now and next June, you might not look back fondly on your call-writing experience when you surrender the stock at 40 bucks.)
But call writing can be a fine strategy in a flat market like we’ve experienced for the last year and a half. (And may experience again in the future.)
The second reason is that you don’t have to open an options account and fool around with call writing yourself. You can own a fund that does it for you.
A good example is the PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP).
This exchange-traded fund writes calls against the stocks that make up the S&P 500. Over the past year, the fund has delivered a total return about 6% better than the flat index.
True, the fund fell 28% in 2008, but that was eight points less than the broad market.
In other words, you can expect the fund to do better than the S&P 500 in years that the market is largely flat or down. But it will lag in big up years because – remember – the best-performing stocks within the fund will be called away.
In short, this is not a good strategy for a young or rip-roaring bull market. But in a late-stage bull market like this one, it can deliver higher returns with a lower level of risk.
And that is our Holy Grail.
Source: Investment U