Passively Achieving Your Goals With Options Part2
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
So last blog I mentioned I was going to demonstrate how to use a passive strategy to achieve your investment goals. First of all, we have to get your investment goals out in the open. Since everyone has different goals for their market exposure, I will base my recommendations on goals of 5% and 10% returns. Know that to expect higher than this, you will have to take a bit more risk and you might have to expand your holdings past the S&P 500 standard index. For ideas on passive investments for a goal of higher than 10% return, look to value and growth specific indexes such as the iShares S&P 500 Value Index or the iShares S&P 500 Growth Index.
I will make my passive portfolio demonstrations based on the SPDR S&P 500 ETF (NYSEMKT: SPY) and the iShares Dow Jones Select Dividend ETF (NYSEMKT: DVY), and supplement that with recommendations of a more active equally weighted portfolio based on these tickers: Aflac, Inc (NYSE: AFL), KKR Financial Holdings (NYSE: KFN), PepsiCo, Inc (NYSE: PEP) , The Proctor and Gamble Company (NYSE: PG), and Petroleo Basileiro(NYSE: PBR). -- Note: I replaced Hasbro with Proctor and Gamble due to weak future growth for Hasbro (reader comments can often be enlightening).
So I am going to show you the best ways I have found to use options to secure returns, using two strategies: Covered Call Options and Short Strangle (or Short Guts? the terminology is a bit weird..). The Covered Call will be used for 5% returns and the Strangle for 10% returns.
Covered Call Options: To get a real understanding of how selling covered calls works, you can see this link: https://www.borntosell.com/covered-call-tutorial/covered-call-writing
Short Strangle: If you understand the basics of covered calls and naked puts (naked put tutorial here:http://www.swing-trading-options.com/naked-puts.html), then this strategy is simple. Buy 100x shares of the stock and sell x calls and x puts at a strike price to your liking. It's a great way to get income, especially if you're looking for increased exposure to a stock that might keep falling.
5% return requirement: Covered Calls are all that you need for this return strategy so here's the specifics on how it works.
Passive Portfolio: SPY
SPY has a dividend yield of 2.52 per share annually. Based on current prices, to get a 5% return, we need an increase of 6.25 per share in value. With a dividend of 2.52, our call options over the course of the year only need to amount to $3.73 for the year. To limit your downside, you could sell an ATM 2013 call option to capture a 9.1% return. For example, if you sold a Jan 2013 $125 Call Option for 11.51 (the average of today's bid and ask prices), you are getting a return of well over your goal. However, knowing that you only need a 5% return, this hedges your portfolio because you will always remain up by 5% unless SPY dips below $117. The strategy will be profitable as long as SPY remains above $110. There are also variations on this strategy. If you want to take a bit more risk and add a bit more upside potential to your portfolio, you could sell the Jan 2013 $140 Call option for 4.66, giving you a 5.7% return if the market stays at current market prices, and gives you a maximum annualized profit of 18.39%.
I used the iShares Dow Jones Select Dividend ETF obviously for its higher dividend yield. With a dividend of 3.41%, all we need is a gain of $0.86 per share to achieve an annual 5% return. The best way to do this is to sell a covered call. Since DVY only lets you sell call options as far out as June, we will do that, selling the June 2012 $55 call option for $1.92. Since you should only need a gain of 0.86 to get your 5% return, you have two options on what to do with your excess money. Currently, you are on track to gain around 7.5% annually (assuming you don't sell another call option in June...which I think you definetly should). So you should be in the black unless DVY goes below $50.47. If you are optimistic about the future of the US economy, then your strategy is simple, gain 7.5% if the market stays where it is and hope that the market doesn't push DVY below 50.5. However, if you are extremely conservative and worried about a much bigger (maybe over 15%) dip in the markets, you could use your excess $1.06 (1.92-.86) to buy a June 2012 $47 Put option. This would make your maximum downside 8.4% (using annual dividends, so to make this work you would have to repeat this strategy for the next 6 months of the year, selling another call option just low enough to cover the costs of a $47 put option).
Active Equally Weighted Portfolio: Goal-5% return.
My portfolio is made up of Aflac, KKR Financial Holdings, PepsiCo, Proctor and Gamble Company, and Petroleo Brasileiro. Since the portfolio is equally weighted, the average dividend yield of the portfolio is 4.556%. This means we simply need a 0.45% gain from each part of our portfolio to reach our 5% investment goals. Using the covered calls we should be able to effectively achieve the 0.45% gain and hedge the portfolio with extra gains at the same time.
Aflac: Sell the Jan. 2013 $45 call option for a 12.8% gain, and an effective 12.35% downside protection.
KKR Financial Holdings: Sell the July 2012 $9 call for a 6% gain, and 5.55% downside protection.
PepsiCo: Selling the Jan 2013 $67.5 call for a 5.7% gain nets you a 5.35% downside protection.
Proctor and Gamble Company: Sell the Jan 2013 $67.5 for a 5.2% gain, a 4.75% downside protection
Petroleo Brasileiro: Sell the Jan 2013 $25 call option for a 10.2% gain, and a 9.75% downside protection
Overall, this simple covered call strategy should allow any investor to passively achieve their investment goals, or even conservatively manage an active portfolio for investment success going into 2012. Part 3 will demonstrate the use of a strangle to achieve a 10% gain. Even so, generally the higher the reward, the higher risk you must take on. Remember that going into the new year.
Fool Blogger Nikhil Shamapant owns shares in AFL and KFN and will not buy shares in the next two trading days.