This article is from Mike Scanlin, CEO of Born To Sell, a site providing insight and trading ideas on selling covered call options.
This month marks the second birthday of the current bull market. Can this last another, or will a mixed economy and difficult international challenges send us into the jaws of bears? Options trading investors would be wise to consider some background:
We know that three of the last 10 bull markets since 1949 have stopped short of their third-year birthday. Put another way that means 7 of the 10 made it into the third year. These kinds of statistics always involve a small sample size and invariably have special circumstances the prior markets did not, for example we are now looking at the disastrous events in Japan, QE2 soon coming to an end, uprisings in multiple Middle East countries, and so on.
Most professionals expect the bull market to continue, albeit at a slower rate of gain than we have seen the last two years. Considering that these first two years saw the S&P 500 rise by 95%, it is reasonable to assume a flattening of growth going forward. In fact, the S&P 500 has had an average return of 3% during the third year of a bull market.
The biggest risk to the stock market is rising interest rates. With QE2 slated to end in June, who will step in to purchase the $110 billion/month in treasuries that the Fed has been buying — (that’s $75B/month in new purchases and $35B/month in reinvestment purchases) — at today’s prices? And if the answer is ‘no one’ then prices will drop until buyers are found. Lower prices for treasuries translate into higher interest rates.
So, what should you do during the third year of a bull market when you expect increased inflation? Here are five ideas: 1. Buy the ProShares UltraShort 20+ Year Treasury (NYSE: TBT) and sell calls against it. TBT is an inverse bond ETF that will go up as interest rates go up. Because it is leveraged two-times you’ll want to do more in-the-money than you normally do. Sell the near-month option each month, rather than a multi-month option. Medium-term (next six to 12 months) the odds of TBT dropping much is small unless we get a surprise and experience deflation instead of inflation.
2. Sell your bonds, or at least some of them. Unless you A) plan to hold them to maturity, B) are happy with the interest rate you are getting until then, and C) are not worried about default, then why hold something that is for sure going to fall in value as interest rates rise? If you have money in bonds that you will need before the bonds mature then selling them now will probably be a better outcome than selling them in a year or two when rates are higher.
3. Buy SPDR Gold Trust (NYSE: GLD) and write calls against it. Normally gold rises during periods of inflation. Everyone should have at least a little gold exposure.
4. Buy commodity-based stocks and ETFs, and then write calls against them. Traditional inflation hedge, commodity-based companies tend to see increased profits as inflation rises.
Many of them have good premiums for writing covered calls. Here are some stocks to consider:
Exxon Mobil (NYSE: XOM), Potash Corp. (NYSE: POT), Freeport-McMoRan Copper & Gold (NYSE: FCX).
Here are some exchange-traded funds: PowerShares DB Commodity Index Tracking Fund (NYSE: DBC), and SPDR S&P Metals and Mining (NYSE: XME).
5. Don’t hoard cash if rates begin to rise. Inflation reduces the real-world buying power of cash. Rather than hold cash, buy some broad-based ETFs and sell in-the-money calls against them. You will get some downside protection because of the intrinsic value of the in-the-money options you’re selling and you should be able to earn significantly more yield than what interest on cash pays.
Mike Scanlin operates Born To Sell, a web site dedicated to helping people earn monthly income from selling call options.
