Tuesday, April 8, 2008
Alright, I lied.
A few weeks ago, in a self-generated Q&A session, I wrote, "The single best income-producing strategy ever created is selling covered calls against low-risk value stocks." But that's not true.
Don't get me wrong... Covered call writing is a terrific strategy. What you do when you write covered calls is buy a cheap stock with little downside, then sell someone the right to buy it from you at a higher price (you can read more about how it works, here).
We're using that strategy quite successfully in the Advanced Income portfolio... We've locked in gains of 7% and 8% in two months, 17% in three months, 13% in six months, and in a couple of weeks we'll close out another trade and record a 23% gain in seven months.
One strategy, however, works even better – and it works a little like this...
Imagine you're walking through your favorite clothing store. As you rummage through the discount racks, looking for a bargain, you notice a beautiful cashmere sweater. It's the same sweater you thought about buying a few months ago for $100. Today, it's on sale for just $40.
The sweater is a terrific buy at that price. But you'd be even more willing to buy it for $35.
So, you approach the cashier and inform her if the sweater drops to $35 within the next couple of months, then you'd be willing to purchase it. She nods her head in agreement, opens the cash register, and gives you $2.
You stuff the $2 into your pocket and exit the store, knowing that you may get to buy the sweater at an exceptional price within the next two months. And if the price never drops, then you at least made a couple of bucks for your patience.
Wouldn't it be great if you could really get paid to go shopping?
Basically, you found a bargain, agreed to buy it at an even better price, and got paid a couple of bucks for your willingness to do so.
Of course, we know you can't buy sweaters this way. But you can use this technique to buy stocks.
That's right. You can actually get paid to simply agree to buy already beaten-down value stocks if they get even more beaten down.
The strategy I'm talking about is known as "shorting naked puts." Like covered call writing, shorting puts is a fabulous income strategy, especially during bear markets. Unfortunately, however, just like covered call writing, this strategy is misused by many investors and misunderstood by almost everyone.
Let's be clear... Selling puts is a strategy where you get paid for agreeing to buy a stock at a specified price at some point in the future. If the stock declines, then you'll buy it at the bargain-basement price. If the stock doesn't decline to the agreed-upon price, then you keep the option premium as a profit.
It's as simple as that. Unfortunately, like most good ideas, people have made this strategy more complicated by trying to extract the highest possible return...
One way to increase your risk is to sell puts on richly priced stocks, just because they offer the largest premiums. Another way to overleverage is to take a much bigger position than normal. (For example, if you typically buy 100 shares of stock, only sell one put. Selling 10 puts will obligate you to buy 1,000 shares.)
So people will tell you that selling naked puts is a risky, high-leveraged endeavor. But if you do it right, it's a simple, low-risk strategy that can generate steady, safe income in a bear market.
Best regards and good trading,
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