Ask Doc Today, I'm turning our Friday issue over to you again...
If you've been following along this week, my team and I have been celebrating closing our 140th winning position in a row in my Retirement Trader newsletter. We shared issues about how I've done this using my favorite way to generate steady income... options.
I know, even for some of the most seasoned investors, that word strikes fear. So today, I'm going to answer some of the questions you've asked me this week about using this strategy in a bear market, how to use it month after month, and more...
To celebrate the winning streak, I've struck a special arrangement with my publisher... something we've never done before. And it will help you get started earning potentially thousands of dollars in income each month.
Now, let's get into your options questions... Keep sending your comments, questions, and topic suggestions to [email protected]. We read every e-mail.
Q: Does your Retirement Trader strategy change during bear markets? – C.C.
A: The simplest environment for Retirement Trader is a rising market. When the markets rise, our holdings tend to rise... and we get to collect our option income without drama.
Bear markets can be tough for any trader, but Retirement Trader has some advantages...
First, we start with high-quality, blue-chip stocks. They tend to hold their value better than risky stocks in bear markets.
Second, our option income means we effectively buy stocks at lower prices. This gives us a cushion for stocks to fall before we take losses.
Third, because of the way options are priced, we can earn higher payments when there's fear in the markets.
Lastly, we sometimes "roll" a struggling position, which means we collect more income from the same stock while giving shares more time to recover.
We do sometimes alter our strategy in severe downturns as well. But most of the time, these factors are enough to keep us consistently profitable in any market.
Q: Are there any reasons [why] we shouldn't trade options month after month on blue chips? – S.M.
A: The short answer is that for any stock you love and are willing to own – stocks that grow revenues every year, increase dividend payments, and have economic moats – you can make a lot of money by just selling options on them over and over again.
You can easily make 15% to 25% a year doing this. And there's little downside...
Think about the worst possible outcome when you sell an option... The stock moves lower, and you'll either still own shares if you're a covered-call trader or buy shares if you sold a put.
That doesn't sound too bad – especially if you want to own that stock. For companies that you would love to own, selling options on them month after month is a terrific source of income.
The biggest pitfall is that you give up some upside potential by selling options. If a stock shoots up 20% in a month, you'll still only earn what you sold from selling the option: usually a profit of about 2% to 5%. Your upside is capped. And if the stock shoots up, you'll no longer own it.
So if you're thinking about selling options on a specific stock over and over again, it's best to do it on stocks that don't have many wild price swings – stocks with a low "beta." These include some of our longtime favorite blue-chip stocks like Coca-Cola (KO), CVS Health (CVS), and Walmart (WMT).
Also, remember what you've agreed to when you sell a contract. You've agreed to sell shares if you've sold a call, and you've agreed to buy shares if you've sold a put. And each option contract you sell involves 100 shares of that stock. Make sure you have the shares or the cash available to meet that potential obligation.
Q: I am new to options trading. Is there anything I need to do at expiration? – T.D.
A: It's simple... You don't need to do anything.
There are two outcomes when you sell covered calls.
If the stock is trading below your strike price at expiration, your calls will expire worthless. You'll be left holding shares with no options the following Monday. This happens automatically, so you won't have to do anything.
Alternatively, the stock could be trading above your strike price at expiration. In this scenario, your calls would be exercised, forcing you to sell your shares. Your broker takes care of this for you automatically. You'll have the cash from the sale sitting in your account the following week.
Q: If I'm trading in my IRA account, do I still need to use stops? – B.T.
A: You should always use trailing stops on your positions – whether you have an individual retirement account ("IRA") account or a regular trading account. This minimizes the risk to your portfolio and forces you to be disciplined when you're wrong.
Do what I do and keep a "mental stop" on your positions. Write the position's entry price on a piece of paper. Calculate your maximum loss as a percentage of your capital at risk – we normally use 25%. With a position size of 4% of your portfolio, the maximum loss to your overall portfolio on any position would be just 1%.
Once your stop price is hit, stick to your selling discipline and close out your position the next day. This is one of the hardest things to do, but I promise it will save you thousands of dollars and untold grief.
By the way, I prefer to use closing prices as my data point instead of using intraday prices because option prices can swing dramatically within a particular day. Just remember to factor in the full cost of closing the trade, including buying back the option you sold.
What We're Reading...
- The Fed continues its fight against inflation with another big rate hike.
- Something different: Stopping ransomware attacks on the health care system.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
November 4, 2022