Investors face many risks right now. Chief among them: the escalating U.S.-China trade war could wreck the global economy; the aging U.S. recovery is overdue for a downturn; talk of impeachment against President Trump is paralyzing the political process; and the Federal Reserve’s “pause” on hiking interest rates could only be temporary.
Where can yield-hungry investors go for safe and steady income? The conventional sources of income — bonds and dividend-paying equities — all face uncertainty this year.
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.
The Federal Reserve has adopted a dovish stance toward interest rates — for now. But investors aren’t completely convinced. Wall Street expects the Fed to cut rates by the end of the year, according to the CME Group’s FedWatch tool. The likely culprit: a tightening labor market.
The Labor Department reported this month that employers added 263,000 jobs in April, exceeding analyst projections. The unemployment rate fell to 3.6%, a 50-year low. In the U.S., the Bureau of Economic Analysis released an advanced estimate of gross domestic product growth in the first quarter, pegging growth at a surprisingly robust 3.2%.
Inflation appears muted, but don’t get complacent. As employers scramble to hire suitable workers, wage growth could pick up and prompt the Fed to resume rate hikes, sooner than you think.
As higher rates become available in other asset classes, dividend-paying stocks lose their appeal from a risk-to-reward standpoint.
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. To be sure, the utility sector has been on a tear this year. 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 as these risks multiply, 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.
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 remain excessive, despite recent sell-offs. Now’s the time for a safety net.
The above chart depicts the cyclically adjusted price-to-earnings ratio (CAPE).
The influential Professor Robert Shiller of Yale University invented the CAPE ratio (also known as the Shiller P/E) to provide a deeper context for market valuation.
The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. The ratio now stands at 30.26, which is 92.49% higher than the historical mean of 15.72.
Global markets are frothy. A credit spread puts a limit to an otherwise unlimited loss potential, which is crucial in these volatile times.
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 2019. And it’s fear that pushes up the volatility index, which in turn boosts the options premium. Indeed, the CBOE Volatility Index (VIX), aka the “fear gauge,” has been spiking higher this week as trade tensions worsen.
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: email@example.com
John Persinos is managing editor of Investing Daily.