A Sure-Fire Income Strategy You Probably Don’t Use
Where can yield-hungry investors go for safe and steady income? The conventional sources of income — bonds and dividend-paying equities — all face uncertainty in 2018.
But income investors needn’t worry. Here, I reveal an investment strategy that can generate robust streams of income. It works in bull, bear and flat markets. Multiple dangers lurking in the new year make this method all the more compelling.
Goldman Sachs (NYSE: GS) recently forecast that dividend growth in 2018 would slow. A key factor is the Federal Reserve’s tightening. The Fed plans to hike interest rates three more times in 2018. As higher rates become available in other asset classes, dividend-paying stocks lose their appeal from a risk-to-reward standpoint.
Traditional sources of dividend income are risky places for your money right now. Rate-sensitive investments such as utility stocks get hammered during periods of rising rates. Utilities must borrow large sums of money for capital expenditures. As rates rise, their increasing cost of capital weighs on share prices.
Of course, not all utilities get hit. The highest-quality utilities can weather rising rates. But you’re still shouldering risk.
And what about bonds? They’re supposed to serve as the ballast in your portfolio, steadying the ship during the sort of market storms we’re about to witness. But in a rising interest rate environment, these fixed-income investments can rock the boat. Existing bonds continue to pay the rate stated when they were issued, so when interest rates rise, prices of existing bonds go down.
But even in these dicey conditions, a source of consistent and safe income exists, if you know where to look. And the place to look is options.
The Power of Credit Spreads
Now, don’t get spooked. Options trading is a lot easier than it seems. I’m talking about a specific strategy that’s too often ignored: credit spreads. With this simple yet powerful options strategy, you can bolster your income portfolio to secure the retirement of your dreams.
With 2018 right around the corner, we face many questions. Will corporate tax cuts stimulate beneficial growth or overheat the economy? Will corporations use the extra cash to create jobs or simply boost their bottom lines? Will the recovery lapse into recession? Will the Trump-Russia scandal tank the markets?
Now is an opportune time to consider this options strategy for generating income while simultaneously hedging your portfolio.
You may have heard that trading options is risky. And that’s true… if you’re an options buyer. But if you want dependable income with limited downside, that’s not the best way to trade options. You should sell them. Most option buyers are speculators who place high-risk trades, hoping for a big payout. And that’s why they strike out most of the time.
But when you sell options, the odds of winning tilt in your favor. Because every time the buyers strike out, you keep the money. With credit spreads, you get the opportunity to cash in not only whether the overall market is up or down, but even when individual stocks show a consistent downturn.
Credit spreads are a low-risk options strategy for generating monthly income even in down markets — all without you having to continually monitor your brokerage account.
You’re probably familiar with a “put,” which is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date.
A put is a bet that the price of the underlying stock will depreciate relative to the strike price. This is the opposite of a call option, which gives the holder the right to buy shares.
But I’m suggesting a strategy that’s far better: Instead of only selling a put contract, you trade a credit spread instead.
Credit spreads refer to options spreads that you actually receive cash (net credit) for executing them. This credit to your options trading account is why such options spreads are called “credit spreads.”
With a credit spread, you sell one put contract… and you buy another one at a lower price. You pocket the difference between the two contracts. And that money is deposited into your account immediately.
Explained another way: When you write an option, you are putting on a short options position but when you buy a cheaper option on the same underlying stock using the premium received from the sale of the short options position, a credit spread is created.
A Safety Net That Limits Losses
The beauty of a credit spread is that the two options form a “safety net” that limits any loss. The trade-off is that your gains are lower than if you only sold the puts. But there is a much tinier chance of anything going wrong.
As the chart shows, stock valuations are excessive. Now’s the time for a safety net:
A credit spread puts a limit to an otherwise unlimited loss potential, which is crucial in these times. Global markets are frothy. Next year, they’ll probably subject investors to roller coaster rides.
When you trade a credit spread, you’re swapping a limited amount of profit potential for the opportunity to limit risk. Uncovered options, on the other hand, can pose significant or unlimited risk.
This strategy is particularly effective in volatile conditions. Why? Well, as I’ve just explained, a credit spread is a type of options trade that creates income by selling options.
Investor fear will probably rise in 2018. And it’s fear that pushes up the volatility index, which in turn boosts the options premium. Higher options premiums mean that options traders who sell options can generate more income on a monthly basis. So, if you’re looking for a steady source of income with limited downside in a volatile environment, you should sell credit spreads.
Want more details about credit spreads? I’d be happy to answer your questions. Drop me a line: firstname.lastname@example.org
John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.