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MAKING CENTS OUT OF THE NEWS
Blog #02
(January 14th, 2010)
SEE MORE SCENERY AND ENHANCE PORTFOLIO INCOME , TOO!
By Tom McAllister, CFP®
Whoever coined that wry saying “Unless you're the lead dog, the scenery never changes” might have been referring to stock investing.
As I suggested in my last quarterly newsletter, stock market leadership going forward is changing from small capitalization stocks to large capitalization, multi-national stocks. The need to broaden our investing vista relates to this “lead dog” concept, because foreign corporate earnings seem to be on track for a faster recovery versus similar U.S. prospects. In fact, here at home, the wave of dividend reductions - and outright dividend eliminations - have contributed to the paltry 2% investor return on Standard and Poor’s 500 stocks. What’s an investor to do for income?
Going back to my “roots”, I recall my days as Indiana manager for Robert W. Baird & Company. At that New York Stock Exchange Member firm, beginning in 1973, our office developed a strategy for “writing” covered call options. These options were tradable at specific prices for specific time spans on the then-new Chicago Board Options Exchange.
The very limited number of stocks that had options available is in stark contrast to today, when nearly every large-cap stock has options for trading on an exchange. I suggest my readers look to the multinational stocks in their portfolio and consider selling covered call options against these positions.
Not only do investors incur no extra risk by using a covered call strategy, stock owners actually “lay off” risk to third parties who willingly assume the additional risk in exchange for the opportunity to multiply short term trading profits.
Interestingly, the speculative side of options trading is currently being promoted by a certain well-known, highly excitable commentator on a cable TV finance channel. But in order for speculators to participate in these activities, other investors must offer the “safe side” of the transaction, and that’s where the opportunity for enhanced portfolio income arises. In other words, speculators are willing to pay a “premium” or fee to a person or an entity for creating (called “writing”) the option they want to buy. Each option represents the speculator’s right to purchase that particular stock at a particular, preset, “strike price” at any time during the next three, six, or twelve-month period. You, the “writer”, receive the premium money, less modest transaction costs. The effect is that your risk for holding that stock is now lower by the amount of the premium.
Example: You own 100 shares of ACB stock, now trading at $50 per share.
Speculator pays you a premium (say $10) for the right to buy ACB from you
at $55 per share any time within the next six months. (Speculator expects
price to go to $65 or higher.)
Effects for you: a) You’ve increased income from your stocks. b) You’ve
decreased your risk. Since you have the premium money, if the stock price goes
down rather than up, so long as it doesn’t fall more than the premium amount,
you haven’t lost money!
From a tax planning standpoint, the premium dollars you receive represent taxable income, but so were the dividends and interest you’re trying to enhance! The whole objective is to develop additional income out of your stock holdings. Premiums are naturally higher for longer-term options, with three-month options having perhaps half the premium of nine-month ones. Option writers take the risk of generating capital gains tax when their stock is “called”. (Not to worry – options are only rarely called.) In addition, it’s possible to “buy back” options prior to a call. In fact, writers usually buy back their options as the underlying stock nears its “strike price”, probably selling another option at an even higher strike price and with a later maturity. This “lays off” even more risk and generated even more income from the portfolio!
A well-run options strategy can add six to eight percent income annually to a stock portfolio. In fact, at McAllister Financial, our portfolio managers are expert in utilizing and monitoring option positions. Call or email me for additional information (1-800-663-3419) or tom@tommcallister.com.
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