How to Limit Losses Despite a Grim Market Prediction

You may have noticed that Wall Street analysts tend to be bullish, with very few sell ratings ever bubbling to the surface.

There are a few reasons for the bullish bias. The culture of Wall Street is generally bullish, almost as a rule. Nearly everyone working there is involved in selling something. Floor traders are selling their execution services alongside the representatives of high-frequency trading (HFT) firms, with both sides claiming they are more efficient than the other.

Floor traders and HFT firms can also recommend someone who can help track the trades, or complete the back-office functions. Or, you could shop for your own transfer agents or custodians. The jobs everyone does are largely irrelevant because the primary purpose for most people is selling more of their service. Almost everyone within blocks of the exchange buildings benefits from convincing other investors to use their services.

While most individual investors will never sit in offices near the New York Stock Exchange and hear the pitches of financial salespeople, many investors are familiar with the general attitude of sales reps. Just think about the real estate agents you know, or experiment by calling a random agent anywhere in the country. Ask if now is the right time to buy a house, and I am certain every agent will say yes. Either the market is bottoming in that city or the market is going to continue moving higher, but either way, buying now gets you in at a good price.

On Wall Street, almost everyone has that same attitude about buying into markets. "There's always a bull market in something," they like to say. Since buying is the primary objective of so many professionals, analysts are surrounded by bulls. This could affect their outlook, not to mention their output.

Research is not a profit center for most Wall Street firms. The firms generate revenue on commissions from traders who use the research and from firms who issue new shares of stock or bonds. Traders are always looking for something to buy and want new buy ideas from their favorite analysts.

The catch is that companies looking to issue shares or obtain funds in the bond market could be deeply upset by a "sell" rating on their company. That rating could lead to a lower stock price for the shares the company wants to sell to the public or a lower rating and higher interest costs in the bond market. 

To avoid these problems, analysts rarely issue "sell" ratings. That's why bearish calls from prominent analysts are noteworthy. And we saw quite the bearish call this month from one of the biggest names in the industry.

Goldman Sachs (NYSE: GS) equity strategist David Kostin, who was ranked as one of the most accurate forecasters by Bloomberg last year, predicted the S&P 500 index will finish December at 2,100, a little below its current level. Kostin urged institutional clients to reduce their exposure to U.S. equities for the next three months. 

He cites several reasons for concern. First is overvaluation. The S&P 500 trades at more than 18 times estimated earnings, compared with a 15.6 average for the past five years. Second is the probability of a surprise. He noted the presidential election in November and a potential interest rate increase by the Federal Reserve as risks that could trigger declines.

Until the election, I believe a pullback is likely, and it appears to already be under way. The S&P 500 is almost 3% below its early September high.

Once the uncertainty of who will be the next president is off the table, we could see sentiment improve and traders propel stocks back into an uptrend. However, investors have serious concerns about what either candidate will mean for the economy.

I know I'd personally feel a lot better with some extra protection in place, and there is a way for traders to get it that still lets them take advantage of any further upside. It's also one of my favorite income strategies -- covered calls.

How Covered Calls Work

As you likely know, 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.

Once you sell a covered call, one of two things can happen -- either the underlying stock rises in price or it falls.

If it declines in price, your shares will decrease in value, but you have the option premium to counter the loss. In other words, if the shares fall, you're better off selling covered calls than simply holding the stock. 

Meanwhile, as long as the shares stay under the strike price, the option expires worthless for the buyer. That's not necessarily a bad thing. When an option expires worthless, it means you can sell another call on the stock, capturing another income payment. That's why I only recommend selling calls on high-quality stocks that I would be happy to own for the long term.

And if the stock's price rises, that's good too. While your gains will be capped with this strategy, anything between the price at which you originally bought the shares and the option's strike price is pure profit, in addition to the cash earned when you originally sold the option.

Say you own 100 shares of a stock that is trading at $150, and you could sell a call option that expires in one month from now with a strike price of $155 for about $0.50. That would generate income of $50 for each contract sold.

If that stock is below $155 at expiration, the income from selling the call option is a gain and you are free to sell another option. Selling one call each month for around $0.50 would generate income of about 4% a year, in addition to any income from dividends.

If the stock is above $155 when the option expires, you will have to sell 100 shares at $155. Combined with the income from the option sale, the total gain would be 3.7% in a month, or about 45% a year.

You can sell covered calls on the stocks already in your portfolio to help protect against any losses. Some investors are using it to bring in up to an extra $3,000 a month, which can go a long way in offsetting a downturn in stocks.

I've put together a free webinar that can help you get started with this strategy. Access it here. 

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