LEAPS for the Leap Year: 3 Covered Calls for 2016

Hedge your holdings and brace for a rough year

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There are plenty of pundits prognosticating the probable performance of the major market indices for this leap year. I generally consider this a fruitless task, although it is mostly because I have long suggested that the best defense against a bad market is to have a broadly diversified long-term portfolio.

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Predicting the actual performance in any year, or leap year, of the indices is a shot in the dark. Predicting the direction for leap year — up or down — is a 50/50 proposition, however. That’s why there can be some value in assessing the overall picture. Although the long-term diversified portfolio is the best move, I personally always allocate about 10% of my holdings to trades and options.

I think 2016 is going to be bad for stocks. I don’t see the overall market just going down, but going down by more than 7%. Individual stocks could do well, depending on your selections.

Here are three covered calls to consider for the broad market that push into next year. Because we’re looking that far in advance, we’re looking at Long-Term Equity Anticipation Securities, or LEAPS.

Covered Calls on the SPDR S&P 500 ETF (SPY)

Because I think the market will struggle, one possible way to hedge your portfolio using covered calls is to sell them against entire indices. That way, you collect a premium by initiating the sale. If the stock ends up higher than the strike price you sold the covered calls at, the stock gets called away. If it ends up lower, as I believe it will, then you keep the premium. That premium should offset at least some, if not all, of the downside the underlying stock experiences.

If you hold a broad market ETF — like the SPDR S&P 500 ETF (SPY) — as you should, then selling covered calls against the SPY stock is a good idea.

Covered Calls on the SPDR S&P 500 ETF (SPY)

The SPY currently is trading under the $200 mark. I would sell the Jan 2017 $199 covered calls for $15.14, giving you a 7.6% hedge.

Covered Calls on the iShares Select Dividend ETF (DVY)

Another way to hedge the market is to focus on some large-cap dividend stocks. These have always been popular stocks with retired and income investors, and have become more popular because bonds have been paying next to nothing.

Consequently, I think a lot of these stocks have risen beyond their inherent fair value. Still, many people hold these large cap dividend stocks.

You may want to hedge that bet if you own the iShares Select Dividend ETF (DVY) — which holds numerous large-cap dividend stocks. Or you may want to buy DVY stock eventually, or swap out some of your individual stocks for this ETF (assuming no large tax liability as the result of the sale).

DVY ETF stock

DVY trades around $74.30. Here, there actually are no LEAPS available for the DVY, but we can sell out to June. So we’ll sell the June $74 covered calls for $2.70. This gives you about a 3.7% hedge, and you can roll the trade over in June and sell the December or January calls.

Covered Calls on the iShares Russell 2000 Index (ETF) (IWM)

Let’s say you want even broader coverage for the year, and want it for the whole year. Then have a look at the iShares Russell 2000 ETF (IWM) — which holds the stocks in the Russell 2000 index of small caps, and which should be a pretty popular holding for those with diversified portfolios anyway.

If you don’t own it, you may again want to dispose of some stocks that are hovering around breakeven and replace it with IWM, then sell covered calls against it.

IWM ETF

IWM stock is at $109, so the move would be to sell the Jan 2017 $109 covered calls for $9, giving you almost a 9% hedge.

Remember two things with IWM, and the other trades:

First, if the market ends up more than what you received in premium, you’ll have underperformed. This seems unlikely to me for the coming year, but it’s certainly possible. Second, you may want to consider buying back the calls if a Republican is going to be elected president, as that is likely to help the market.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.

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