Seeking Yield And Safety

Includes: DIA, MIC
by: Brent Leonard

There is an investment strategy that, in my humble opinion, is the optimal plan for the current market and economic environment - based on thirty years experience as a Registered Option Principal and private money manager. A little known variation of a common strategy - covered call writing - can eliminate much of the risk of even the most severe correction, and avoid the common "sell at the low" point we all know.

It is simply a Deep-In-The-Money covered call strategy on solid stocks paying over 3% dividends, and with some "extrinsic" option value (premium other than the stock price surrendered). In over a hundred trades for the past three years, only a handful have turned into manageable losses: British Petroleum (NYSE:BP), Supervalu (NYSE:SVU) Not only does one have a "safety net" for the stock to vacillate above - while decaying call premium and receiving dividends- but requires minimal monitoring or option experience. Several different time analyses have delivered a similar "annualized" return of close to 10%, the historic market average over the past century. Not a get-rich-quick scheme, it can be used for CD or money market alternatives, by seniors and prudent investors such as myself for at least a portion of one's assets earning zero interest rates (the subject of my book - Zero (In)Tolerance).

There has been a tendency for both tyros and pros to be counter-intuitively skeptical of DITM calls for various heuristic reasons. However, my vast experience shows that it does work, and delivers peace of mind. In my column I point out that my smaller IRA account, the purest proxy of DITM, is currently at all-time record highs (adjusted for earlier withdrawals).

Here is an actual example:

One buys Macquarie Infrastructure (NYSE:MIC) stock at $42, which yields 5.9% dividend quarterly, just a day or two before ex-dividend date (August 9); at the same time they sell a $40 covered call with expiry 5-6 months hence (January 2013), almost guaranteeing two dividends (if the stock is called prematurely, the time compression increases the return and frees up the money for another trade). The annualized percent if called away in January is 14%. The combination of the "extrinsic" value of the call and the dividends can often exceed 20 or 30% annualized. "Annualized" just means using the same money 2 or 3 times during a 12-month period. This plan is a mid-range one between day-trading and buy-and-hold, neither of which seems to work very well in this (double)" Lost Decade," with low rates and little long term appreciation anticipated "for an extended period."

DITM (deep-in-the-money) works well in slightly up markets, flat markets, or, better yet, in slightly down markets, where one can "roll down" to the next strike, after expiry (raising the dividend yield). Only the Black Swan can cause major losses - yet they should be much less than an unhedged index portfolio, mutual fund, etc.

To get started, I recommend playing a few trades on paper, or starting with an ETF (such as the DIA), with a strike price 10% below the buy price. (Options beginners can read up here and here.)

Many happy returns!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.