How did your 2016 shape up? It was certainly a roller coaster of a year. Markets dived at the start of the year rather than follow their seasonal pattern of rallying to kick things off.
After recovering from that drop, markets mostly traded in a range throughout the spring, summer, and autumn. Stocks only broke out of that move following the election—surging far higher.
Despite these moves, it’s been a great year to be invested. Stocks are on track to return over 10 percent, a bit higher than their historical average of 8 percent. While that sounds great, the idea that stocks would move far higher was small comfort during the market’s panic drop back in January and February.
Likewise, the market’s annual returns only look great because of a powerful six-week rally that will eventually run out of steam. The quick gains to end the year may continue on for a few weeks into the new year, but no rally (or decline) lasts forever.
But there are some tools you can use to improve your returns, lower your risk, or take some of the pain out of a big market move.
The best tool available to investors today to lower their risk is with the use of options.
I know that sounds silly on the surface. After all, most people use options to increase their leverage, which in turn implies a higher risk. That’s not necessarily a problem, actually, since options have limited risk to whatever you put into a trade. Nevertheless, unless a trade goes your way, and quickly, you can easily lose 100 percent of the money you put into a trade, even if the underlying stock doesn’t falter.
That’s why it makes more sense to sell options on the whole rather than buy. Since all options contain a time premium, and since time premiums will gradually drop to zero, you’re putting the odds of an investment win on your side. Admittedly, it might not add up to that much each trade. You won’t be hitting grand slams, but you will be hitting singles consistently and racking up investment gains rather than taking a gamble on the other side of the trade working out quickly enough to make a profit.
That’s why, most of the time, the best thing you can do as an investor is to sell options to lower your risk. This can come with new trades and existing trades. In a new trade, I’m a fan of selling put options in lieu of buying shares right away. My goal is to either pick up shares at a lower price, or get paid for accepting the “risk” of buying shares of a company you like at a price you like. I consider that a win-win situation.
Back at the start of 2016, I had a series of trades get put to me. Three of those became winning trades as the year progressed, and one of them hasn’t been a winner, at least yet. But by taking advantage of short-term market fears to make long-term investments, I know that the lagging trade will work out over time. That’s the power of selling put options: it ensures you’re adding to your shares when things look bad.
With an existing trade, selling call options against your stake allows you to create more income out of a position. It also allows you to set a sell price for your shares while things are calm, not while the market is in one of its periodic panics. In other words, it ensures you’re taking some cash off the table when things look great.
Going into 2017, there are a few opportunities involving options that can get even more advanced.
For example, gold had an interesting run in 2016. It rallied in the first half, then lost most of those gains as the US dollar strengthened following the election. Gold mining companies saw their share price advance, and in many cases more than double. Most of those gains have been lost, and fear is back in the gold market.
Given the severity of the recent drop, an investor could use a buy-write strategy to make potential gains of over 30 percent in the next six months in some stocks. For example, as I write, Yamana Gold (AUY) trades at around $2.95. You could buy shares there, and then immediately sell the July 2017 $3.50 calls for (again, as I write) $0.38.
Those returns aren’t huge in dollar terms, but they are in percentage terms. The $0.38 option premium plus the $0.55 capital gain represents a gain of $0.93 on $2.95, or 31.5 percent. Between now and July 2017? That’s an amazing return. That sounds like a good bet. Either you’ll be taken out at a profit, or your cost basis will be lowered from $2.95 to $2.38 to account for the cash you’ve received from selling the covered call.
Gold looks particularly interesting here because of its sharp post-election selloff. But in a world where a president-elect is calling for massive tax cuts and massive increases in infrastructure and military spending, I see a world where inflation will once again be on the rise. That’s an environment that favors gold. Right now, the strengthening dollar is throwing that trend off. But in other currencies, gold has held up far better.
I don’t know how long those trends will hold out. But I do know that when you can get more than 20 percent in less than a year in a covered-call trade, something has been horribly mispriced. Maybe a year from now Yamana is trading at $5. That’s not so ridiculous; shares traded as high as $5.99 in 2016. But by selling the covered call, I’m still locking in a market-beating profit and taking risk off the table.
That’s just an example of using options to take some risk off the table but still set yourself up for great returns. How will 2017 unfold? It depends on how you manage your trades to ensure profitability.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report.
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