For most investors, 2015 will be The Year Stocks Went Nowhere. The S&P 500, the most well known large-company stock market index (symbol SPY) closed last year on December 31, 2014 at $205.54. As of this writing, December 30, 2015, SPY closed at $205.93.
That is a return of 0.19%.
What did you get in return for that 0.19%? You had to suffer through a market crash that caused stocks to fall 10%, commodity prices fell, oil prices crashed, the Chinese economy slowed down, international stocks got crushed, and the Federal Reserve finally raised interest rates. Thankfully, if you had been around to capture the 2% annual dividend, you would have been able to get about a 2.26% return. But if you diversified into mid caps, small caps, or international stocks, your returns would have been even worse, and likely negative.
Welcome to the New Normal.
I wrote at the very beginning of 2015 that given the elevated prices for the US stock market, future expected returns over the next 15 years could be around a little over 3% (and if you’re invested in anything other than index funds, you can expect those returns to be even lower since costs from higher mutual fund expense ratios, sales loads, or high management costs will eat into your returns). People conditioned by the 17% annual returns we’ve gotten from the end of 2008 to the end of 2014 probably just rolled their eyes at this prediction.
But now that it’s happening, it’s important to adjust to the new reality we’re in. Which leads us to the title of this post:
How can you make money when stocks don’t go up?
The answer: Take a less conventional path and use one of the safest tools available to generate income for your portfolio – the Covered Call.
If you haven’t heard, covered calls are one of the only approved options strategies for many retirement accounts because they are considered a safe and conservative income generating strategy. And no, you can’t do this in a 401(k), 403(b), or with mutual funds. You can only do this in IRAs or traditional brokerage accounts that hold individual stocks or ETFs.
What is a covered call? The easiest analogy I can make is to think of it like you’re renting out your stocks, specifically, a rent-to-own format. In this rent-to-own situation, you agree to rent out your stocks and sell it to the renter if the price is higher by the end of next year, and in exchange, the person renting it pays you a “rent” upfront, in this case, 6%. You keep this rent, no matter what happens in the future.
Here’s an example:
Let’s say you bought 100 shares of SPY for $205.00. You agree to “rent” out your 100 shares by selling a covered call option that expires December 2016, which as of this writing, is priced at about $12.50.
The “renter” pays you $12.50 for the right to own your shares of SPY, if at the end of December 2016 it closes above $205.00. If it closes at or below $205.00, he won’t buy it, and you end up keeping your shares. But no matter what, you get to keep the $12.50 he paid you.
$12.50 in income for a $205.00 stock is about a 6% return, and you get that upfront. Plus, over the course of the year, SPY is paying you about a 2% dividend, so by the end of the year, you could potentially have a return of 8% for your stocks in 2016.
Sounds interesting, right?
I personally find this approach very appealing in this environment. With the Federal Reserve expected to continue raising interest rates in 2016, that usually provides a head wind for stocks, and with profit margins for US companies starting to contract after a long expansionary period, I don’t see how we can have significantly higher prices for US stocks next year.
So rather than hope for an uncertain 3-5% expected return over the next decade, I like the prospect of getting 6% upfront and collecting a 2% dividend to potentially increase returns.
It’s important to note that the markets can still fall and have this strategy result in a loss. If we get a 10% drop in stocks next year, the good thing is that the covered call and dividend will cushion the fall by 8%. And if markets go sideways again, the 6% option premium and 2% dividend is yours to keep for a respectable gain. Only if markets go up more than 8% will this strategy be a “loser” (at least from an opportunity cost standpoint).
(If you had used this strategy for 2015 and sold a covered call expiring at the end of this year (at the same $205.00 price level for SPY), you could have collected about $11.50 for about a 5.6% upfront “rent” – and if you combined that with the 2% dividend, you could have potentially earned about 7.5% for your stocks.)
This strategy is only available to a narrow set of investors. As I mentioned before, this strategy can’t be implemented in your company’s 401(k)/403(b) retirement plans. Plans like that tend to just hold mutual funds, and you can’t sell covered calls on mutual funds. You can only sell covered calls on stocks and ETFs (like the SPY index fund ETF), and the easiest way to do that is to roll over your assets into a Rollover IRA. And tough luck if you’re still working at the company where all your 401(k) assets are, because you can’t roll over your funds into an IRA until you leave or retire. And if you have a plain vanilla brokerage account, tough luck again if you’re only invested in mutual funds.
If you have a 401(k) or 403(b) still sitting at your previous employer’s plan, this strategy can be made available to you via an IRA rollover. And if you already have an IRA, you’re in luck. If you are interested in implementing this covered call strategy to take advantage of the potentially higher returns it may offer in this environment, contact us today to have us implement it for your portfolio. We are experienced in executing this strategy across many client accounts, and we take advantage of heightened market volatility to generate as high a price as possible to increase the “rent” you receive for your stocks.
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Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
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