At Goldman Sachs, I worked with Fischer Black, one of the pioneers in the world of options.
When I met him, he was a newly minted partner at Goldman Sachs. Black was one of the first academics to be lured to Wall Street. He loved the intellectual challenge – not the money.
You see, Black wasn’t just smart. Everyone at Goldman was smart. He stood well above the rest. Rather than reading graphs or charts, he preferred to study tables of pure numbers. He refused to use a mouse… He considered it clutter. Instead, he coded custom keyboard commands to use on his computer.
Merton and Scholes later received the Nobel Prize for the work.
(Black had already passed away, and they don’t award the Nobel Prize posthumously.)
As a fixed-income trader, I didn’t really need to work with Black, a partner and researcher.
But once I struck up a rapport, I’d visit him as often as I could.
We’d create and price options contracts and make deals that brought the firm millions of dollars.
At the start, Black’s intelligence intimidated me. Here was a brilliant guy who had published profound, valuable, and original ideas. But before long, I noticed that although it took amazing intellect to invent these ideas, nearly anyone could understand them.
What was once revolutionary became routine.
Ever since Black showed me that options are a tool that anyone can learn about, I’ve been teaching others that they can use this genius-level strategy to improve their own investment returns… and actually reduce their risk.
To understand this, I want you to explore how options work. That way, you can see how this investment fits into your financial picture at this point in the markets… and how it can give you smoother, and potentially higher, returns.
Let’s get started…
First, let’s make one thing clear: Options, when used correctly, reduce your risk.
This is the opposite of what most people think… maybe even you.
Unfortunately, too many investors start using options without reading the “instruction manual.” They do it the exact wrong way and lose money rather than earn more of it.
The true tragedy? It’s no harder to use options correctly. In fact, it’s easier to use options the right way.
In addition to limiting risk, options can also improve your returns when used in the right market conditions. That’s a powerful combination – less risk and greater returns. You can achieve it with a strategy known as “selling covered calls.”
A “call option” is an agreement to buy or sell shares of a stock at a specific price in the future. The buyer of the call-option contract gets the right to buy shares. The seller of the contract must sell the shares if the buyer wants to purchase them. At the start of the agreement, the buyer pays the seller some money up front to secure that contract.
Here’s an example…
This week, tech giant Microsoft (MSFT) trades for about $110.
You own shares of Microsoft, but let’s say someone else (an option buyer) thinks that shares are going to surge quickly. He offers to pay you $4.50 per share today for the right to buy Microsoft for $110 a share in January 2019. He thinks that by then, $110 could be a major deal.
Let’s say you agree to that deal, and you sell him a call option. You collect that $4.50 per share up front.
If Microsoft trades for less than $110 a share come January, you’ll get to keep your shares and the $4.50 he paid you. Plus you’ll be able to keep receiving Microsoft’s $0.46 per share quarterly dividend. If it trades for more, you keep the $4.50 a share he paid… plus you sell him your shares for $110 each. That’s an easy 4% gain in about two months.
Now, this also reduces your risk because it lowers the price you’ve paid for Microsoft. Assuming you bought your shares today at $110, you’ve already gotten back $4.50 per share.
So your cost for Microsoft shares is only $105.50, even though shares haven’t moved. You’ve got less capital at risk. Microsoft can drop from $110, and as long as it stays above $105.50, you’ll still remain profitable.
(Black’s Nobel-worthy insight was the math that determines why this option is worth $4.50 and not some other price.)
There’s one catch: If Microsoft shares jump up – say by January they’re at $125 a share – you won’t collect more than $110 for your shares. But that’s fine… We don’t mind giving up some upside because of the downside protection we get. Besides, earning 4% in two months is better than some mutual funds will do in an entire year.
You can do this month after month after month. If you put on this Microsoft trade every two months, you can easily make more than 20% in the course of a year.
That’s all there is to selling calls. You can get as deep as you want into extra terms and the underlying math, but you don’t need anything else to understand the basics of covered calls.
By selling a covered call, you’ve reduced your risk in case shares fall and increased your return when shares rise slowly. The trade-off is simply that you won’t get as much upside if shares rise quickly.
That can be an attractive proposition, especially with where markets are today.
No one knows where the market will go next. October was one of the worst months in terms of stock performance over the past decade. For now though, prices are charging back from last month’s lows.
In the near term, I agree with my colleague Steve Sjuggerud’s “Melt Up” thesis that the market likely has a final leg upward. Markets do tend to end in blow-off tops that post very generous returns in their final months.
And as Steve has said, a bit of extra volatility is normal during a Melt Up in stocks. We could see more corrections like we saw in October on our way to the top.
Importantly, with volatility on the rise, we can earn larger premiums on our options. People pay more for options when they think things are uncertain or that stocks will be in for a bumpy ride. So options prices rise when volatility spikes higher.
And when the boom does ultimately turn to bust, you’ll be glad to have this tool in your arsenal.
Today, the evidence in our view points to staying invested, but keeping a closer eye on our risk.
That’s where covered calls can serve us well.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig
Source: Daily Wealth