Start Protecting Your Investments From the Next Bear Market Now
Bear markets are as inevitable as bull markets. Unfortunately, neither market holds to a predictable schedule. The next bear market could start tomorrow, or a year from now, or maybe not for five years. While this might seem like it makes it impossible to prepare for a bear market, the knowledge that we will never have certainty in the market is actually all we need to prepare for the worst case now. Investors should always be ready for a bear market.
Some investors believe they should sell everything and hold cash in a bear market. This strategy would only work well if they knew when the bear would start and end. If their timing is accurate, moving to cash or even taking short positions to benefit from a decline would be the best strategy. If their timing is off, missing out on the gains of a bull market could destroy their chances of enjoying financial security in retirement.
Rather than trying to time the market, investors can use a covered call strategy to participate in bull markets and limit losses in bear markets.
A call option gives the buyer the right to purchase 100 shares of a stock at a predetermined price (the strike price) at any time before the expiration date. A covered call strategy involves selling calls on a stock you already own. When you sell a call option, you collect a premium for accepting the obligation to sell the stock if it should rise above the option’s strike price. Risk is minimized because your obligation is “covered” by the fact that you already own the shares.
Covered calls also reduce the risk of owning the stock. The income you receive from selling the call option will be yours to keep no matter what. If the stock falls, the income helps offset the loss.
Although covered calls can be useful in bull and bear markets, there is no such thing as a free lunch in investing, and there are downsides to any strategy. Gains with a covered call strategy are capped. Depending on how high the stock goes, you will only benefit from part of the gain.
Let’s walk through an example. Say you own 100 shares of a stock that is trading at $180, and you could sell a call option that expires in one month from now with a strike price of $185 for about $0.50. That would generate income of $50 for each contract sold.
If that stock is below $185 at expiration, the income from selling the call option is a gain and you are free to sell another option. Selling one each month at about that price would generate income of about 3.3% a year.
If the stock is above $185 when the option expires, you will have to sell 100 shares at $185. Combined with the income from the option sale, the total gain would be just over 3% in a month, or about 36% a year.
You could use this strategy to help you sell stocks that represent a large part of your portfolio. Selling part of large holdings could help you diversify your investments. Diversification could also help reduce losses in a bear market since balanced portfolios should fare better in market declines.
Every investor should consider selling covered calls as a way to buffer the downside of a bear market and increase gains in a bull market.
Note: In addition to protecting your portfolio from a bear market, there’s another reason you should be using a covered call strategy now. New data shows that 82% of investors near retirement age won’t have a “true” retirement. In fact, you’ll likely need as much as 18% annual returns to cover your expenses. See the proof here, and learn how a covered call strategy could pay as much as $3,410 per month.