By most accounts, especially my own, the market is 25% to 30% overvalued. I personally believe that if you’re going to invest in the market, you need to be invested for the very-long term. That being said, some investors may be feeling a little jittery right now.
Perhaps the market will go higher in the next few months, but it has also had a pretty incredible run.
Some investors may be wondering how to hedge their current market position without going through the trouble and expense of purchasing downside insurance on the market using options known as puts.
One of the ways that you can hedge your long-term position is by selling covered calls. You can do this with just about any stock, but you can also do it on many of the exchange-traded funds that represent large sectors of the market.
Selling covered calls is a options trade in which you agree for another investor to buy a given stock or ETF from you that you own at a particular strike price on or before the contract expiration date. Usually the stock is not sold — also known as called away — unless the closing price of the stock or ETF is above the contract strike price on the contract expiration date. In certain circumstances, if the stock rallies significantly, the stock could get called away before.
Here are three ways to sell covered calls to protect your position or pad your wallet.
Covered Calls to Hedge the Market: SPDR S&P 500 ETF (SPDR)
So why not start with the most popular ETF that represents the S&P 500? That would be the SPDR S&P 500 ETF (NYSEARCA:SPY). The extent to which you hedge your position depends on how far out your contract expiration date is going to be. The closer it is to today, the less of a premium you will get and therefore the less of a hedge. Of course it also means a shorter time period in which you are actually protecting your position. Not only that, you aren’t protecting it very much.
The ETF closed Wednesday at $263.17. To give you an example of the difference between a short-term and long-term hedge, let’s suppose you sell the 4 Jun $264 covered calls. You only protect yourself for one month and get paid $4.60 per contract, or $460 per 100 shares that you own. That’s enough to cover a 1.8% drop in the S&P 500.
If you sell the 21 Dec $264 covered calls, you get $12.50 per share, giving you about 5% downside coverage.
And if the SPY rises and gets called away, or looks like it will, you can always just buy more of it.
Covered Calls to Hedge the Market: iShares Russell 2000 ETF (IWM)
Suppose you want to expand the coverage for your hedge. You can use one of the indices that covers more and different stocks. Take the iShares Russell 2000 Index ETF (NYSEARCA:IWM), which owns the smallest 2,000 stocks in the Russell 3000 index.
Small-cap stocks can sometimes suffer more in a big selloff just because investors see them as more speculative. So, using the example of short term vs long term hedges again, the IWM closed at $154.65 on Wednesday, so if you sell the 8 Jun $155 covered calls, you only get $2.65 per contract. Again, that gives you 1.6% downside coverage.
If you sell the 21 Dec $155, you get closed to 5.5% downside hedge with a selling price of $8.50. That means you get paid $850 right now. That also means if IWM goes to $163.50, you can buy it back and not have lost anything.
Covered Calls to Hedge the Market: SPDR S&P Midcap 400 ETF (MDY)
You can split the difference in the market by going after midcap stocks, if you happen to own the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY). Mid-cap stocks can also be somewhat more volatile in a selloff, but don’t have the volatility that small-caps usually do. Nor are they as stable as the large cap legends.
The MDY closed at $341 on Wednesday. With the 15 Jun $342.50 covered calls, you first get $4.60, or $460 per contract. That’s only giving you protection of 1.6% to the downside, although you have a tiny bit of buffer on the upside before it gets called away.
The 21 Dec $345 covered calls are selling for around $12.50. You are getting 3.7% coverage on the downside and also a 1.3% buffer on the upside.
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.