The Market Gets Amnesia

Remember all the fuss the market made about inflation?

I’m only asking because it’s almost like the market has already forgotten about last week’s tumult.

Indeed, investors were girding for more volatility this week in advance of key releases of various inflation data. But the market’s reaction was more like, “Oh well, whatever, never mind.”

On Wednesday, the Bureau of Labor Statistics announced the latest numbers for the widely watched consumer price index (CPI).

Given recent momentum, the CPI rose faster than economists expected. Prices rose 0.5% month over month versus predictions of 0.3%. Core inflation, which excludes food and energy, also ticked higher.

On a year-over-year basis, however, the rate of inflation remained unchanged, at 2.1%. That’s right around the level that some economists see as neutral for the overall economy.

Then on Thursday, the producer price index (PPI) came out.

While the monthly rise was in line with expectations, at 0.4%, the core PPI, which excludes food and energy, rose about twice as fast as predicted, at 0.4%.

On a year-over-year basis, producer prices were up 2.7% overall.

Personally, I don’t get overly concerned about monthly economic data. Rather, I prefer to look at the medium- to longer-term trend, say over the trailing year or perhaps even the past three years.

On both counts, there has been a pick-up in inflation, but nothing that looks all that remarkable as of yet. 

Of the six data points for which I compared the current prints to averages over the trailing one- and three-year periods, only the year-over-year change for the PPI showed truly remarkable movement.

Over the trailing three-year period, the PPI grew at an average rate of 0.7% year over year, quickened to 2.4% over the past year, culminating in the latest read of 2.7%.

One obvious factor during this period, however, was the energy crash, from which we’re still recovering. Naturally, growth in the core PPI, which strips out food and energy prices, has been less dramatic.

And nearly all of the data I looked at have actually seen equal or higher readings over the past five years. Clearly, those sudden surges of inflation were not sustained.

Meanwhile, markets can move a lot faster than prices. And the yield on the benchmark 10-year U.S. Treasury hit 2.91% this week, up an astonishing 87 basis points from the September low.

Of course, we’ve been here before, too. In 2013, the yield on the 10-year climbed just above 3.0%. It then spent the next two-and-a-half years finding a long-term bottom, at an all-time low of just 1.36%.

The difference this time, of course, is that we know a number of macro factors are changing. In addition to the stimulative effect of tax reform, the Fed is gradually normalizing monetary policy. Both should boost inflation.

Then there’s business and consumer sentiment. Both are notably positive for the first time in many years.

Since analyzing economics and markets is ultimately about predicting how various masses of people will behave in concert, these shifts in sentiment could be the most critical factors of all.

As each piece of inflationary data hit the wires this week, I groaned in anticipation of the punishment dividend stocks might suffer in response, especially after seeing how Treasuries were reacting.

Incredibly enough, just like the broad market, key sectors for dividend stocks seemed to take the latest numbers—and resulting action in the bond markets—in stride. Perhaps that’s because dividend stocks have already taken their beating, and the prospect of rising rates is now priced into these stocks at current levels.

The market is tracking toward a 4.9% gain for the week as I write this, while utilities are up 3.1%, MLPs have risen 1.8%, and REITs have gained 1.6%.

Get Paid to Buy Low and Sell High

Last week, I briefly summarized the new tactical trading strategy we’ll begin using next week.

Accordingly, I detailed the first thing you’ll need to do in order to participate, which is secure the appropriate authorization from your broker to trade options—or more specifically, to sell naked puts and covered calls.

This week, I wanted to review the strategy in further detail.

If you’re like me, you hate paying retail when buying, and you always want just a few pennies more when selling. So you use limit orders to enter and exit your positions—below market for the former and above market for the latter.

The problem is the market doesn’t always cooperate.

When I set a stingy limit for a stock I want to buy, my order might not get filled for weeks. And when I’m ready to sell, the market might not accommodate the lofty price I have in mind.

In both cases, money that could be productive is mostly sitting idle. But I realized I could use options to solve both problems while getting paid handsomely to boot.

My new strategy lets income investors win in several ways.

First, we can generate instant income without actually owning a stock.

Selling a put is just another way of setting a limit order to buy a stock we’d want to own anyway. But instead of sitting around and waiting for our order to get filled while making no money, we get paid up front.

Further, options allow us to precisely calibrate our risk by setting parameters for the price and timing of the contract.

When you sell a put, you’re entering a contract that will require you to buy 100 shares of stock at a certain price on a certain date.

You get the cash from selling the put right away—almost like an instant dividend.

Since I’m a risk-averse investor, I will only ever recommend selling puts on dividend-paying stocks that we’d be happy to own anyway.

To further mitigate risk, the put we sell will be out of the money, typically somewhere between 10% to 20% below the stock’s current market price.

That way, if the stock does get put to us, we’re not only buying a solid dividend payer, we’re also getting it at a nice discount. And if the stock doesn’t get put to us, we’ve gotten paid while avoiding the risk of stock ownership.

As an income investor, I want to get paid at least once a quarter, just like I do when owning a typical dividend stock. So we’ll generally be selling puts that expire in the next three to four months.

Let’s go through one example using current market prices.

Right now, Enterprise Products Partners LP (NYSE: EPD) trades around $26.63 per unit. EPD is not only the largest MLP, it’s also one of the most conservative players in the midstream space. With its well-covered quarterly distribution, EPD currently yields 6.4% on a forward basis.

Now, we happen to already hold EPD in the Income Millionaire Portfolio. But if you don’t already own it, you could sell a put to establish a position at a discount to where EPD trades presently.

There’s a put contract for EPD that expires in June that would let us buy 100 shares per contract of the MLP for just $23 per unit, or a 13.6% discount to the current price.

EPD last traded at that price near the bottom of the energy crash, so odds are we’ll get to collect our premium without having to buy the stock in June. But if EPD were to get put to us, at that price we’d be getting a solid MLP that yields around 7.4%.

Selling one EPD put with those terms would give us around $35 of immediate income. But if you have more money to trade, you can easily make multiples of that—selling four contracts would give you $140, while selling eight contracts would give you $280.

In this case, each option would require you to buy 100 shares of stock, so you’d want to set aside $2,300 per contract sold in case EPD gets put to you.

And if we don’t get the stock when the put expires, then we can sell another put. If the stock never gets put to us, we win by creating what amounts to regular quarterly dividends without the risk of stock ownership.

If the stock does eventually get put to us, we still win because we’ll be buying a high-yielding stock we’d want to own anyway at a nice discount to where it was trading when we sold the put.

Then, we’ll sit back and collect the dividend until the stock approaches full value. At that point, rather than setting a sell limit at a premium price, we’ll sell a call with a strike at that premium price instead.

Remember, each call is a contract that represents 100 shares of stock. So the number of calls you sell should be based on the number of shares you actually own.

If you happen to own shares in multiples of 100, then it’s easy. If not, then simply round down to the nearest hundred. For instance, if you own 343 shares of stock, you would only want to sell 3 covered calls against it.

Let’s use another solid dividend payer as an example. With a yield of 3.0%, Paychex Inc. (NSDQ: PAYX) doesn’t offer the sort of yield we’d normally seek out for Income Millionaire.

But it’s a good example of a stock with a premium valuation that even trades near what Wall Street’s overly optimistic analysts would call full value. So let’s assume we own 100 shares of the stock.

Right now, Paychex trades around $66.95 per share. There’s a call option with a June expiration that would let us sell the stock for $75 per share and get paid a premium of $67.50 per contract to do it.

That price would be a new all-time high for Paychex, so odds are the stock won’t get called away at that price. But if it does, we get to collect the upfront cash from selling the call, plus the additional 12.0% capital gain from the price appreciation that happened in the interim.

If the stock doesn’t get called away, we win by enhancing the stock’s dividend stream with additional income from selling covered calls.

If the stock does get called away, we win by selling the stock at a premium and getting paid to do it when we sold the contract that made the transaction happen.

Investing can be highly emotional. And many investors can lament trades in hindsight. But don’t let the perfect be the enemy of the good.

When you sell a naked put, you have to accept the fact that the stock you bought by selling a put may trade at an even lower price than the one at which it was put to you.

When you sell a covered call, you have to accept the fact that you could miss out on further share-price appreciation when the stock gets called away.

But perfect timing is impossible. And the fact is that, together, these tactics reduce the risk of stock ownership at all levels, while giving us the ability to generate income whenever we choose.

Stock Talk

Bruce Demko

Bruce Demko

Since Options for Income started I have been playing with this process using very similar rationals. I used to like when all of Jim’s trades had a covered call segment. I look forward to your thoughts on appropriate stocks to trade via options.

Ari Charney

Ari Charney

Hi Bruce,

I’m glad to hear you’re already plying a similar strategy. My ultimate goal for this process is to create a virtuous cycle of income.

Best regards,

Michael D

Michael D

Ari- love the strategy and ready to get cracking on it. I have been in OFI since last summer and love it but want to broaden my portfolio and have some more fun- I joined VT and PCA a couple months ago as well, and am trading some of those recommendations also..
about to be retired later this year and intending on self mgmt/investing one of my new hobbies….
when do we start with your new strategy? or is your EDP example a recommendation to start with?
thanks again, appreciate your help in educating us and helping us take some more risk in building wealth/income.

Ari Charney

Ari Charney

Hi Michael,

Sounds like you’re ready to go!

And one of my goals with this strategy–aside from generating more income–is to actually reduce the risk of stock ownership, not take on more risk.

The text pertaining to EPD was just an example, not a recommended trade, at least at that point.

I plan to publish the first three official trades via email alert by 1:30 p.m. tomorrow afternoon. They will also be posted at this website around that same time.

Best regards,

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