If you were spooked by the sudden correction in the market this past week, you probably realized that you haven’t thought about risk as much as you should have. That’s one of the many reasons to have a long-term diversified investment strategy, with a focus on non-correlated assets, like my stock advisory newsletter The Liberty Portfolio.
However, some investors like the idea of having a hedge to their portfolio, just in case a major correction occurs again — and sticks. You can do this by using covered calls.
By selling covered calls against securities you own, you offer yourself a bit of downside protection. You are selling the right for another investor to buy a given security from you on or before a given contract expiration date. The money you earn for selling this contract can offset any decline in that investment. Likewise, if you are forced to sell, you keep the money, and offset any possible upside you may give up. You can, of course, just buy the security back.
The Liberty Portfolio will sometimes use covered calls to simply generate additional monthly income.
Many investors own the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) as a proxy for owning the S&P 500. So, if you think the market is headed for a correction in 2018, you can sell covered calls that stretch all the way to New Year’s Eve.
If you do this, you will earn a very large premium. If you are right, as the price of SPY falls, the price of its covered calls will fall also. At some point, if you think a rally could occur after a big correction, you are allowed to buy back the covered calls at a lower price.
The SPY closed Wednesday at $267. If you sell the 31 Dec $267 calls, you should get about $19 per contract, or $1,900 in cash. This gives you about a 7.5% downside hedge. It also means that SPY can climb to $286 per share and you won’t have lost any money.
IWM closed at $150 on Wednesday. You don’t buy nearly as much of a hedge here, but if you sell the 31 Dec $150 covered calls, you can sell the contract for about $7. That’s a 4.7% downside hedge. It’s not huge, but it’s something. You also don’t lose any money until the IWM goes over $157.
More aggressive investors may own the PowerShares QQQ ETF (NYSEARCA:QQQ), which only holds the largest 100 stocks on the Nasdaq. In other words, you’ll find the FANG stocks in here along with virtually every big technology name in the market.
You’ve surely learned by now that these stocks tend to be volatile as well. That means some pretty decent premiums offering a measure of downside protection if you sell covered calls against the QQQ.
QQQ closed Wednesday at $161. Once again, looking all the way out to year-end, you could sell the 31 Dec $161 covered calls for about $11 per contract, and therefore pick up $1,100 right now. That provides a downside hedge of about 7%, giving you safety on QQQ down to $150 per share, and not lose money until QQQ exceeds $172 per share.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.