After a big year, many investors are wondering whether they should lock in their gains. The SPDR S&P 500 (NYSE: SPY) exchange-traded fund (ETF) provided a total return of 32.3% in 2013.
Unfortunately, there is no way to know for sure whether there is additional upside or if a decline will begin, but using covered calls could help investors lock in gains or cushion the downside.
A covered call strategy involves selling call options on stocks or ETFs that you own. If you own SPY, for example, you can sell call options to generate income while still benefiting from the potential upside. Additionally, the income generated from selling options offsets potential losses in the stock or ETF by decreasing your dollar amount at risk.
A call option gives the buyer the right to buy 100 shares of stock for a predetermined price (the strike price) at any time prior to the expiration date. Call sellers have an obligation to sell the shares if the buyer exercises their right to buy the stock, which they will do if the stock price is above the strike price when the option expires.
SPY is currently trading around $183. Traders could buy 100 shares of SPY and immediately sell a call option expiring in April with a strike price of $190 (about 4% above the recent price) for about $1.70 per share, or $170 per contract, since each contract controls 100 shares.
The price of the option is equal to almost 1% of the price of the ETF, and the expiration date is about three months away. If SPY is below $190 in April, you will have the opportunity to sell another call option and generate additional income. This income could offset any potential losses in SPY.
If we repeated this trade every three months, four times a year, covered calls would generate 4% a year in income, more than twice the dividend yield of 1.8% that SPY offers.
If SPY is above $190 when the option expires in April, the buyer will exercise the option and you will have to sell your 100 shares at $190. Your profit on the trade will be equal to the difference in the sale price and the purchase price ($7 in this case) plus the option premium of $1.70 for a total of $8.70 per share.
That would be a return of 4.8% in about three months. Average gains of more than 1% a month would beat the long-term average return of the stock market, and gains of that size are a reasonable target for many investors.
This strategy also works well with core portfolio holdings. Most investors maintain some exposure to the stock market at all times, even during bear markets. Income of 4% a year, added to the dividend stream of a core holding, would reduce the losses of a bear market. Even in a bull market, most covered calls will expire worthless, and that income will add to the investor's wealth.
Perfectly timing the market -- moving completely to cash when you suspect a decline is near, and switching back to stocks when the decline ends -- is impossible. Many investors sold during the decline in 2008 or 2009 and ended up missing out on the rebound that followed the bottom. It will never be possible to consistently get out at the top, and buying at the bottom is also difficult. Many investors may recall that the news was grim in March 2009 when the market turned up.
Action to Take --> Using a covered call strategy instead of market timing could help preserve wealth while maintaining exposure to stocks, even in the most difficult markets. Consider covered calls on SPY or other index ETFs to maintain stock market exposure while offsetting potential losses in a bear market.
This article originally appeared at ProfitableTrading.com:
Lock In Average Gains of 1% a Month While Insuring Against a Bear Market