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I wish I could sit here and tell you I have a "golden handcuff" problem with my current job.
You're chained, or "cuffed" down to the job by reason of the benefits and security it provides. Your handcuffs are very shiny, expensive, and valuable--but they're still handcuffs. They restrict your movement and limit your freedom. You can cut the handcuffs off (cut ties with your employer), but then they're worthless. The gold fades. And you can't sell broken, aluminum handcuffs at the pawn shop.
So, which is better--going without the handcuff, and having complete freedom... or living with the entanglement, and getting all the perks at the cost of that freedom?
I can't answer that for you... but I can for me.
The Golden Handcuffs of Investing
I am a lover of liberty. If you ask me whether I'd take a moderately high salary and little freedom, or a normal salary and lots of autonomy, I'll take the lower salary in a second.
The only time I'd opt for the golden handcuffs is in investing.
The way I invest is much more unique than what most of you probably do. 99% of the people I interact with have their wealth invested in 401ks and other retirement accounts via mutual funds, not in individual stocks. A mutual fund is basically a huge mix of tiny fractional shares of sometimes thousands of different companies, industries, or sectors of the economy. Investing in this way, even if you buy just one mutual fund and put 100% of your money into it, supposedly diversifies risk... and I would probably agree with that.
Except that when the entirety of the financial markets is going haywire, nothing is spared. There's this little thing called "systematic risk"... which is, risk that can't be avoided, no matter what (unless you step out of the markets entirely and put 100% of your money into so-called "risk-free" investments, like US Treasury Bonds).Even during the financial crisis, investors who parked their wealth in mutual funds lost 40% of it, along with everyone else. If you hadn't diversified, you may have lost even more.
But what if you invested in the one thing which behaved in a manner opposite to the general market? What if there was a type of "stock market insurance", so to speak?
As it turns out, there is.
I wrote about it last month. Today I'll expand on this concept, and give you a few more notes about where the Village is parking its money for the next little while.
Monthly Dividends, No Matter the Market Direction
The golden handcuff of investing is a covered call option. I write about call options all the time. If you need some references, go here, and read my last 10 or so articles.
To review, the purpose of investing is to make money. If you know the methods, you can make money when the market is going up, when it's going down, or when it's going nowhere.
Lately, that last things is what the markets have been doing--going nowhere. And that bodes well for those of us who like to make safe, predictable amounts of money in excess of general market returns, which for 2015 approached zero.
When we sell a covered call option, we already own at least 100 shares of some underlying company's stock. We agree to sell those shares at some point in the future if the price of those shares is above a certain point, which we choose, and we get paid money for that agreement.
The buyer of the call option (who generally takes the opposite side of the trade we are proposing) has the right, but not the obligation, to buy a certain number of shares (100 per contract) of a company up until a certain date (the expiry date), at a price he or she agrees to in advance (called the "strike" price), as long as the price of that underlying share is above their strike price. The buyer of this option thinks the price of the underlying security is going to go up in price by the time the expiry date rolls around, so they can either sell this option for more than they bought it for, or, if the price of the shares is above the strike they have chose, they will have the option "exercised" after expiry, getting shares at a lower price than what the market currently offers.
We, as the seller of a call option, don't think the price of the underlying stock is going to continue increasing. We sell the option, which obligates us to sell 100 shares per contract, for the strike price we agreed to.
In selling the option, we're speculating that we'll never have to sell our shares... but even if we do, that's fine, because we earns the premium for the option, any dividend paid while we own the shares, and earn capital gains on the shares if we ends up having to sell them.
Why is the covered call option a Golden Handcuff?
Just like the golden handcuff in the regular world, the golden handcuff (call option) of investing has several benefits, and some drawbacks.
The benefits are the guaranteed dividend, the guaranteed option premium, and the potential for capital gains.
The drawback is simply LIMITATION OF UPSIDE. The covered call forces you to give up any gains which occur on the stock above the strike price of your option. Your gains are capped at a certain point.
Here's an example.
You buy 100 shares of Microsoft for $50, and sell a call option with a strike of $52, this option expiring on next May 20. You get paid $1 for every share you own to make this agreement.
In the next month, you will earn the quarterly dividend of 36 cents per share ($36), you get the $1 in options premium, and if the shares are above $52 on May 20, you sell them for $52 even, and pocket the $2 differnce, for a total of $1 + $2 + $.36 = $3.36, or 6.72% in one month. ONE MONTH.
If the stock price is actually $52.50 on expiry though, you give up that extra $.50. You can see that gain, but you can't get it. Much like a glass ceiling.
The handcuff of covered call options forces you to forego some potential gains. That's it. That's why we should only sell calls on shares we own, which we think aren't going to move a whole lot, so there's less risk of giving up a lot. Or better yet, if we think there's a good chance that shares prices could decrease over the next month, we sell the call, and collect free income at low risk.This happened to me several months back. I owned 100 shares of Intel Corp, and the price increased (on a fluke) by over 10% in a single month. I forfeited about $3.54 per share that I owned.
As usually happens when the market does irrational things, like sending a value stock up 10% in a matter of days, the price of that stock subsequently normalized, and is now back around the same price it was when I sold the option last year.
Why don't I care about this? Because of the fact that I'm more happy with guaranteed income, via the options premiums, than I am about "shoulda, could, woulda" gains on my investments. If I had simply owned the stock outright without the option for long-term gains, I never would have locked in a gain on that stock, even at the elevated level it was. I'd be no better off today than I was six months ago. I'm much better off selling the option.
How I am Using the Golden Handcuff Now
I initiated "golden handcuff" trades this month on two of my active positions.
The first was Silver Wheaton Corp (SLW).This is a precious metals stock I bought just a month ago. Last month, I was able to pick up 100 shares for $17.79 apiece, and sold a $18 call option on those shares for $.65. The stock was below the strike on expiry 4/18/16, so the $65 was basically free money, which I kept, and it offset the cost basis of my shares to $17.14.
I got a $5 dividend on 4/14 (whoopee!) since I still held the shares, and just sold another call option on those shares at a strike of $18.50, collecting $.79. Now, my cost basis on the shares is actually $16.35.
Selling the $18.50 option for May expiry means that if the price of SLW is above $18.50 on May 20, I'll have to sell my shares for that price, and I'll pocket the difference between that price and $16.35. It would be a $2.15 per share gain on $16.35, or 13% in two months, or 78% on an annualized basis.
If the price isn't above $18.50, I'll just continue selling the calls until the shares are called away, then watch for another opportunity.
Secondly, I hold some shares of a company called Ceour Mining (CDE). I have for a while, in fact, and I've been waiting for the price to come back to where it was feasible to collect some call option income on the position without risking having to sell my shares for less than I bought them for.
The premium I got for CDE was a bit less than SLW--just $29. But, that's on just a $715 investment. It's better than nothing, and I'm going to continue holding those shares, and selling covered calls, until those shares get called away, and I can better leverage this cash into some larger positions for better and more safe gains going forward.
The $29 gives me about a return of about 4.05% in thirty-two days. If I don't end up selling the shares, I'll make just 4%. If I do, I'll have to sell the shares for $8, a total gain of 15.6% in thirty-two days, or 177% annualized.
That sounds high, but it's not unusual for precious metals mining investors to see gains this like. Gold miners have seen a tremendous gain so far this year, up more than 30%. They were coming off a four-year low, and due for a good rise, especially considering the rout in the general market so far this year.
I sold the option because I expect a temporary rout in gold mining stocks after their meteoric rise so far in 2016.
I'm Punny
You can now see that the golden handcuff pun is a fitting way to frame this article. I'm talking about new gold stock positions, and also referencing the critical aspect investors of covered call options should understand. That is:
- Covered calls reduce risk on stocks by helping to lower cost basis. But they limit the upside on the potential investment. They handcuff potential gains to the floor. That's why it's best to only sell them if you think the underlying investment isn't going much higher, is going nowhere, or is going lower
I hope this concept makes sense. If it doesn't I'd be happy to explain more. Send me a message, and I'll find time to respond.
Thanks
Jeremiah
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