If there’s one thing we learned about the market this past week, it’s that just about anything can tip the cart over and cause a sell-off.
I’ve written over 1,000 articles here at InvestorPlace and hundreds elsewhere, and have been an investor for 22 years — and I have no idea what the Brexit could possibly mean for stocks.
Yet the market sold off. Then it rallied back.
This is a lesson in why using options, especially covered calls, can be a good idea.
Normally, I counsel holding exchange-traded funds across many asset classes as a core position in a long-term diversified portfolio. Sometimes I suggest selling covered calls against individual equities, but in this case, you may want to consider selling covered calls against various portions of the market as a whole.
The reason is that I don’t think we go much higher from here, and I don’t think second-quarter earnings will be stellar.
Covered Calls to Cover the Market: SPDR S&P 500 ETF (SPY)
First, let’s look at the basic SPDR S&P 500 ETF (SPY), the ETF that holds all the stocks in the S&P 500.
While we are only 3.2% off the all-time high, I think selling covered calls may make some sense. You can always buy it back if it is called away.
The ETF closed Wednesday at $206.66. I see two different ways you may want to play with covered calls here.
The first is to look just one month out. The July 29 $207 covered calls are selling for $3.43. That’s about a 1.7% return for a one-month holding period, or 20.4% annualized. The assumption here is that the market will not break above and stay above $207 by the end of July.
You could also look to the Sept 30 $207 covered calls, which sell for $6.15. This 3% return gives the market time to cool its jets if it does break above $207.
Covered Calls to Cover the Market: SPDR S&P MidCap 400 ETF (MDY)
One of the ETFs that many investors foolishly ignore is the SPDR S&P MidCap 400 ETF (MDY). Mid-cap stocks can perform quite well, and even outperform, the broad market over time. They have more room to grow since they aren’t mega-cap behemoths yet.
The MDY is about 4.5% off its all-time highs and is a bit more volatile than the SPY. You are slightly more hemmed in as far as strike prices go, though, so you have to choose which way to go.
The MDY closed at $267.45 on Wednesday. With the July 22 $267.50 covered calls selling for $2.45, you get a 0.9% return for three weeks of holding, or 16.3% annualized.
I’m not thrilled by those returns. I’m more intrigued by the Sept 16 $270 covered calls, which can be sold for $4.65. That alone is a 1.7% return, but you add $2.55 in capital gains if it gets called away, for a total return of 2.7%.
Covered Calls to Cover the Market: iShares Russell 2000 Index (ETF) (IWM)
If you want to go after a much broader slice of the market, have a look at the iShares Russell 2000 Index (ETF) (IWM), which holds the 2,000 smallest stocks in the Russell 3000 index. It is basically the benchmark for small-cap stocks. As such, it tends to have a good deal of volatility and provides investors with good premiums for options.
The July 29 $113 covered calls are selling for $2.15. Since IWM closed at $112.88 on Wednesday, the covered calls earn a return of 1.9%, with a bonus 0.2% if they get called away.
On the other hand, you may want to consider looking all the way out into September for the Sept 30 $113 covered calls, which sell for $4.06.
Now you pick up 3.6% in returns and another 0.2% if called away.
As of this writing, Lawrence Meyers does not own shares in any security mentioned.