Are You 'Back to Even?' Here's How to Stay There

SmallCapInvestor.com


If you're like most investors, you're probably looking doubtfully at this stock market. Is it worth the risk now that many of us are back to where we were before the 2008 crash?

Why not just take money off the table, put it in bonds and be done with it?

Well, there's a little-known way that anyone can KEEP their stocks AND continue to make profits even if the market makes a further turn for the worst.

The time has come for the average investor, whether wealthy or in the process of accumulating wealth, to consider using a powerful investment strategy - covered calls.

Covered calls are widely used by savvy "institutional investors"...pension funds, insurance companies, endowment funds and some mutual funds. The strategy is little known and often misunderstood by individual investors.

However, when using highly-liquid options on small-cap stocks or ETFs the combined return from potential capital appreciation and additional income you receive from covered calls can yield double digit returns, more predictably, consistently and conservatively than with small cap stocks or ETFs alone.

As I have stated numerous times in the past, most investors think of options as high-risk, speculative strategies where large losses can be incurred. While this is certainly true of some options strategies, covered calls are more conservative than investing in stocks or ETFs alone and most importantly, they can provide significant protection in a down market, and can be a key component for an investor to achieve double digit returns in a flat or slow growth market.

So I am certain that some of you are asking the question, "what is meant by the term 'covered' anyway?"

Simply stated, it means that you own shares of the underlying security, in our case a small cap stock or ETF that stand behind the options. And you are selling calls against the "covered" portion that you own.

For example, let's say that you own 1000 shares of iShares Russell 2000 Index (NYSE:IWM) and you would like to increase your income on the IWM shares that you own through the use of a covered call options strategy.

It is the third Friday in September (options expiration falls on the third Friday of each month) and you start to check into the premiums for IWM options contracts with various strike prices and expiration dates.

While you like IWM's long-term prospects, you think that the price of your 1000 shares may not be higher than $5 above its current market price of $65 at the end of the next three months.

The front month September $70 call is trading at $1 per contract. For receiving a premium of $1 per share you decide you would be willing to let go of your 1,000 shares of the IWM at $70 if the price should be greater than $70 on the expiration date (in our case September 16th).

So, from this transaction you will collect $1,000 in option income ($1 premium per share * 10 contracts * 100 shares per contract). Annualized, the premium income at the current market price of IWM will yield 19.0 percent based upon that premium and the market price of IWM. Not too shabby!

You also have the potential to realize an additional $5,000 of capital appreciation if the price of IWM exceeds $70 per share on the expiration date.

Now the downside. If IWM would go to, say, $73 before the expiration date, you would probably feel pretty bad that you had lost out on some additional capital appreciation. You would only receive $70 per share plus you roption premium of $1, or a total of $71 per share, so you would have missed out o receiving $2 per share that your shares would have been worth had you done nothing but hold them. You also have $1 per share of downside protection if IWM's price heads south.

But, it is still possible to lose money buying IWM and using covered calls if the price of IWM declines significantly. But, if you are caught in a declining market like we are experiencing today, you will ALWAYS be better off if you use covered calls on your shares compares with just owning IWM.

Why?

Because the premium income gives you the added downside protection that you would not otherwise have. If the market drops out and you aren't selling covered calls, then your shares are worth less, AND you're out the $1,000 (in our example) that you didn't collect from selling the calls.

Just remember, when using covered calls you are no longer in the business of trying to maximize capital appreciation on your shares. You are now in the business of using covered calls to provide a rate of return that will meet or exceed your objective on a consistent and predictable basis.

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