3 Covered Calls To Guard Against The Impending Drop

Use covered calls to hedge against a market correction, large or small

If you subscribe to the Shiller price-earnings ratio, then the associated graph should sound alarm bells. According to the graph, stocks are the most expensive in history, save right before the stock market crash of 1929 and the dot-com bubble.

If you have a long-term diversified investment strategy, like my forthcoming stock advisory newsletter The Liberty Portfolio, then the relative valuation of the market doesn’t matter very much. Stocks rise over the long term.

However, some of you may like the idea of hedging your portfolio if things are pricey overall. You can do this by using covered calls. By selling covered calls against various securities, you can provide yourself some downside protection without selling out of your position, which might trigger capital gains taxes. You give up some potential upside, although you can always buy back the security or the covered calls.

Here are some covered calls you might sell if you hold any of these popular exchange-traded funds.

Covered Calls: SPDR S&P 500 ETF (SPY)

SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is the most likely ETF that you’ll be holding, as it tracks the S&P 500. If you buy into the fact that the index and market are indeed significantly overvalued, you may want to consider selling covered calls a few months out.

Doing so gets you a larger premium. Should you be correct, as the price of SPY falls, the price of the covered calls will also fall. At some point, if you fear a snapback rally that takes the SPY to new highs, you could just buy back the covered calls at a lower price.

The SPY closed Friday at $237.03. Consider selling the 15 Sept $237 covered calls for $8.70, providing a 3.65% downside hedge. If you really think we’re headed for a big fall of, say, 20%, and the SPY could fall below $200, then sell the 15 Sept $200 for $39. You’ll hedge your position a full 20%.

Covered Calls: iShares Russell 2000 ETF (IWM)

You may hold the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), as it tracks the small-cap stocks in the market. Small caps tend to be more volatile than large caps, and they can take a harder beating in a big downdraft than large caps.

That’s because they carry a bit more risk, and so they are more likely to be dumped first in a correction or crash, and are sometimes last to be repurchased when things quiet down.

Still, IWM is a great holding for diversified small-cap exposure.

IWM closed at $138.46 on Friday. Again, you can try many things. Perhaps sell the 15 Sept $138 covered calls for $6.80, giving you a 5% hedge. If you think disaster may strike with a 20% correction, then sell the 15 Sept $110 covered calls for $29. While it removes your potential upside (unless you buy the stock above $139), it does give you complete coverage for that sizable correction.

Covered Calls: PowerShares QQQ ETF (QQQ)

Finally, you may own the PowerShares QQQ Trust, Series 1 (ETF) (NYSEARCA:QQQ), which represents the largest 100 stocks on the Nasdaq. These tend to be tech stocks for the most part, and that often means additional volatility.

These tend to be a bit different than small-caps in that they often are some of the first to sell off (except for the big blue chip name) but are often one of the earliest sectors to be repurchased.

QQQ closed Friday at $131.69. You could sell the 15 Sept $131 covered calls for $5.60. That’s not a bad hedge in that it offers 5.4% protection. Again, however, if you are concerned about that 20% correction, selling the 15 Sept $105 covered calls or $27 may be the way to go. You’ll get 20% downside protection and if it comes to pass, it will all be offset by that covered call.

Note: The author of this article is Lawrence Meyers. Lawrence is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. As of this writing, he did not hold a position in any of the aforementioned securities.

 

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