There is a long standing saying in the Wall Street that traders should "sell in May and go away". According to the Stock Trader's Almanac, since 1950, $10,000 invested during the summer (May-October) is worth $6,724 today; $10,000 invested during November to April is worth $1.6 million dollars. The caveat of this analysis is that the outcome depends on the starting year of investment. Whether "sell in May" is a myth or not, long term oriented investors generally choose to avoid timing the overall market.
Investors can however, take advantage of covered stock options to create additional income on their holdings, may them be either stock or cash. This is perhaps especially relevant this summer, given the long overdue market correction after the bullish run since last November.
1. Sell in May and hold cash
If you sell all stock holdings and keep cash through the summer, you may well use the cash for some purpose instead of letting it stay in the money market and earn the pathetic 0.1% interest. Here is what to do:
Step 1. Pick a stock that you are familiar with and interested in, but didn't buy because you feel the valuation is too rich. But you like the company and its business, and you know that if the stock price drops to a certain lower level, you are going to buy it.
For example, General Motors (GM) is currently priced at about $25. With recovery on the way, its business is going to pick up. You are willing to buy the stock if it drops to $22.
Step 2. GM's put option with a strike price of $22 expiring September 2012 is priced at bid/ask = $1.11/$1.14. Sell to open 10 contracts at a price of $1.12. You will pocket $1,120.
Step 3. Set aside cash for 1,000 shares of GM at $22 ($22,000). This is the cash to cover the put options in case GM stock drops to below $22 before September and your put options are exercised. In that case, you will pocket the $1,120 and own 1,000 shares of GM at $22. If, however, GM stock never drops below $22 prior to September, you will pocket $1,120, together with the $22,000 cash. That's 5.1% return in five months ($1,120 / $22,000 = 5.1%), not bad for income oriented investors.
The risk is if GM stock price goes significantly below $22 -- then you will have a paper loss by owning shares purchased at $22. So choose a put option strike price that you are very comfortable to own GM shares. You won't panic even if it goes a bit lower.
2. Not sell in May and hold stocks
If you keep all stocks holdings through the summer, you can still earn some extra income by selling covered out of money calls. Here is what to do:
Step 1. You have to be fairly certain that the stock you own has a low chance of sudden price surge, since this strategy is going to cap your profits in that case.
Again, using the example of GM, say you current own 1,000 GM shares valued at $25,000.
Step 2. GM's call option with a strike price of $28 expiring September 2012 is priced at bid/ask = $1.08/$1.11. Sell to open 10 contracts at a price of $1.10. You will pocket $1,100.
Step 3. If GM stock surges above $28 before September, your call options will be exercised. In that case, you will pocket the $1,100 plus $28,000 cash from selling GM shares. If, however, GM stock never goes above $28 prior to September, you will pocket $1,100, together with the 1,000 GM shares. That's 4.4% return in five months ($1,100 / $22,000 = 4.4%).
The "risk" is if GM stock price goes significantly above $28 -- then your profit is capped at $3000 + $1100 = $4100. So choose a call option strike price that you are very comfortable selling GM stock. You won't feel miserable missing a big bullish run.