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New highs are often followed by sell-offs, but they can also be followed by yet more new highs. In time, we will know which is the case with the current market. For now, we need to develop strategies that could be profitable no matter what the future holds.
Regardless of what the broad market averages are doing, investors should generally have some exposure to the stock market. This can be difficult to accept given the history of the past 15 years.
Looking at the SPDR S&P 500 (NYSE: SPY), the only two previous times it reached the $155 level, bear markets followed. If the broad market declines, as it did in 2000 and 2007 after SPY traded above $155, the losses could be large.
There is nothing magical about $155 that requires the market to move lower now. Arguments for higher prices are easy to find and a target of $167 is possible based on estimated earnings for this year.
On the bearish side, the argument is that stock prices have moved up rapidly and are due for a pullback.
Some investors act as if they believe their opinion on this matter should be backed by a commitment of 100% of their capital. Nothing could be further from the truth. Whether you are long or short, it makes sense to hedge some of the risk that is always present in the stock market.
Hedge funds are often thought of as high-risk investments but the very first hedge fund was designed to minimize the risks of the stock market by balancing long and short positions. Now, there are a number of ways to hedge risks and one of my favorites is the covered call writing strategy.
Covered calls could be a way to reduce the anxiety of owning stocks, reduce risk and generate immediate income. To establish a covered call position, you would need to own at least 100 shares of a stock, and you would then sell one call option contract against those shares. Each call option will be for 100 shares, so the strategy has to involve multiples of 100 shares. You could sell two calls if you own 200 shares, for example.
Call buyers have the right, but not the obligation, to buy the stock at a predetermined price (strike price) for a predetermined amount of time. Call sellers have the obligation to deliver the shares during the life of the options contract. Covered call sellers already own the stock they might have to deliver so the risks are limited.
Theories behind options strategies can be confusing, so I'd like to use a real-world example. Many retailers are up more than 10% since the start of the year, and there could be more gains ahead.
One of the leaders in the sector is Walgreen (NYSE: WAG), which is up about 15% year to date. Despite the large gain in the past 11 weeks, Walgreen could have additional upside. Based on expected earnings per share (EPS) for this year, WAG is trading with a P/E ratio of about 12. This is below the expected EPS growth rate of 14, making WAG a buy using the rule that PEG ratios under 1 represent value. PEG ratios compare P/E ratios with long-term EPS growth rates, and WAG's PEG ratio is 0.93.
If you own WAG, which is trading at $44.58 at the time of this writing, as an insurance policy against a possible decline you could sell a call option expiring in April with a strike price of $46. The WAG April 46 Call is trading at about $0.36 and would allow you to earn immediate income of $36 per 100 shares.
If WAG rises above $46 by the April 19 expiration date, the call will likely be exercised, and you would have to sell WAG at $46 even though it would be trading at a higher price at that time. This limits your profit to $1.78 a share ($1.42 in stock appreciation plus $0.36 in options premium) based on the current price of WAG, or 4% in the next month.
Your maximum profit would include the options premium, which you keep no matter what happens to the stock. If WAG falls, your losses would be offset by that premium and you would be able to sell additional calls to generate income as long as you own the stock.
Walgreen offers just one example of this strategy and covered call writing could work well with other stocks or ETFs that you own. This strategy offers a way to reduce risk since premiums offset losses, and allows you to turn current holdings into current income.
Consider protecting against downside risk with covered calls on stocks or ETFs that you own.
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