Note from Managing Editor Sara Nunnally: It’s a good day when Smart Investing Daily uncovers a tool the bigwigs don’t want you to know about. And we only had to look in our own backyard to find it.
This week’s guest article comes from Zach Scheidt, editor of Taipan’s New Growth Investor. One of the biggest myths about long-term investing is that you can only go long by buying and holding stocks.
That’s just not true.
Zach explains one strategy that can boost your portfolio returns while decreasing risk of losses.
It’s part of our new”Smart Investment Strategies” edition of Smart Investing Daily. We want to link your investment questions to our investment experts. And we’re inviting you to send us your investment questions. Your topic could be featured in our weekly Smart Investment Strategies article.
Email us at [email protected], and enjoy this first edition that can really give you an edge in the markets.
More Income, Less Risk…
Looking to get a little more out of your investment portfolio? Who isn’t, right?
Today I want to tell you about a strategy many hedge funds use to make and protect profits. Using this tool (which is available to nearly every investor but very rarely used by individuals), the funds are able to create additional income from stocks they own — while at the same time, limit the amount of risk for their overall portfolio.
Sound too good to be true? This is no gimmick. It takes a little work, and just like with any tool, you have to invest a little time to learn to use it properly.
But when it’s used well, the returns can add up quickly.
Institutional investors would probably rather you didn’t spend your time learning how to create this additional income. They would prefer you look at them with reverence and believe that they have an edge that isn’t available to you as an individual investor.
But it’s not true. During my time as a hedge fund manager, I learned how to use a number of tools that can increase investment returns and manage risk more effectively. But none of these strategies are off-limits to smart investors with a personal brokerage account.
Ready to take a look at how this tool boosts income and cuts risk? Let’s jump in!
Covered Calls — A New Growth Investor Strategy
Today we’re going to look at how covered calls can be an excellent strategy for a portfolio of stocks that you already own.
Let’s say that in September 2010, you took my recommendation to buy Allied Nevada Gold Corp. (ANV:AMEX), and you picked up 200 shares at $22.64. Today, those shares trade close to $40 per share.
A 75% gain in less than a year is an impressive return. If you’re like me, when you start seeing that kind of gain, you start to think about how you can protect those profits. The”covered call” strategy is a great way of preserving those profits and capturing additional gains on this trade, even if the stock declines.
To explain how this strategy works, let me first explain how a”call option” works.
(Don’t forget to sign up for Smart Investing Daily and let regular editors Sara Nunnally and Jared Levy simplify the market for you with our easy-to-understand articles.)
Call Options — The Right to Buy
A call option is a contract between a buyer and a seller — and typically represents an agreement on 100 shares of stock. The call option gives the buyer or owner of the option the right but not the obligation to buy 100 shares of stock at an agreed-upon price.
There are three key points of information that a call option covers:
- Security — What stock is actually covered by the contract?
- Strike price — At what price is the contract actionable?
- Contract Date — When can the contract be exercised?
So if you are convinced that a $50 stock (XYZ) is going to rise sharply between now and the end of the year, you might buy a December $60 call. One call option would give you the right to buy 100 shares of XYX at $60 through the third Friday in December.
(Typically, options can be exercised through the third Friday of their contract date. This is also called the expiration date.)
If the stock rallies to $80, you are still able to buy that stock for $60. After all, that’s in the terms of the contract. If you are wrong, and the stock drops to $10, the only thing that you lose is the cost of the option.
You can see why aggressive traders like to buy call options. If your market calls are correct, you can make a lot of money in a very short amount of time. But today we’re not talking about buying call options — we’re actually talking about selling them… That’s how the covered call strategy works.
Selling Calls Against Our Stock Position
Back to my example of Allied Nevada Gold Corp… As I write, the September $40 calls are trading at about $3.
What this means is you can sell someone the right to buy ANV shares from you for $40 per share. When you sell that right, you collect an additional $3 per share. If you have 200 shares, you could sell two contracts and receive $600 for offering this right to another trader.
This is what a”covered” call means… It means that you own enough stock to be able to fulfill your contract with the options buyer. In other words, if you promised someone they could buy three bags of oranges at $3 a piece, you’d better have three bags of oranges when your buyer comes calling.
But let’s get back to ANV.
If ANV trades higher from here, you are still obligated to sell your shares at $40. But you get to keep the $3 per share you received when selling the call. That $3 is equal to an extra 13% from your original purchase price last year.
Of course, if ANV finishes below $40 on the third Friday of September, you get to keep your stock as well. In fact, at that point, you might turn around and sell December calls in much the same way, and collect more income for the same stock position.
Steady Returns Can Add Up Impressively
Covered call positions were some of our best moneymakers at the long/short fund I managed. We would typically buy a few thousand shares of different stocks that we believed had a good chance of trading higher (or at least not trading lower), and then we would sell covered calls against that stock.
Over a period of two months, a typical call option will give you only a modest percentage return. For instance, if you were to buy ANV today at $40, and sell the $40 calls at $3, you would be locking in a 7.5% return over the next 60 days. That sounds a bit boring, right?
But what if you could generate 7.5% during every 60-day period over the course of a year? The compound annual returns would add up to 54%! And this is in a stock portfolio that actually holds less risk than a typical account that doesn’t use covered calls.
The covered call strategy is just one of the hedge fund tools that I am teaching subscribers to my New Growth Investor to use. These hedge fund tools offer plenty of ways for investors to cut back on their risk, add to returns, and create a stockpile of wealth — even in a turbulent market!
Wall Street institutions may think that they’ve got a lock on the smart investing market. But my goal is to make sure that individual investors are able to trade on a level playing field and understand how to use all of the tools available to protect and grow wealth.
Publisher’s Note: Zach’s track record through the first half of the year is incredible… an average closed position worth 86.5%. To see what other tricks our former hedge fund boss has up his sleeve, follow the link.
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