[Editor’s Note: This is part IV of our series on investment income plays selling put contracts. In Part I I explained put contracts and how to sell them for income. Part II covered how to find the best income plays. And in Part III we talked about how much income you can really make.
Today, we’ll discuss how our income strategy holds up in a bear market, along with ways you can protect your wealth when stocks trade lower.]
“Never confuse a bull market for brains.”
That’s one of the many phrases my boss and mentor Bill would use when I worked at the hedge fund.
In a bull market, everyone looks like a genius. Especially the speculative (AKA risky) investors. In certain periods, the more you risk, the more money you make!
When markets are surging higher, it’s the careful investors who look like idiots. Because they typically don’t keep up with the market averages — and certainly don’t bet heavily on speculative stocks that are surging higher. Which brings up another Wall Street axiom:
“There are bold traders, and there are old traders… But there are very few old, bold traders.” ~Ed Seykota
We can debate the merits of that statement another day. The key takeaway is that you need a strategy that can survive both bull market environments and bear markets as well.
Because if you give up all of your gains — or all of your capital during a bear market, it really doesn’t matter how much you make when times are good.
That’s why I like our put-selling income strategy so much. It actually has a built-in buffer system that helps protect you from a bear market.
Today, I’m going to show you three ways this strategy can protect your wealth when stocks are trading lower.
Bear Market Advantage #1: A Discount Stock Price
In Part II of this series we talked about selling out-of-the-money put contracts. When you sell these put contracts, you’re entering an agreement to buy shares at a specific price.
And out-of-the-money put contracts have an agreement price (or a “strike price”) below where the market is trading.
Suppose you decide to use our put selling income strategy on a stock that currently trades for $55. You might decide to sell the $50 put contracts that expire in six weeks. And let’s say you receive $3.00 per share for selling this contract.
By selling the put contract, you’re agreeing to buy shares of the stock at $50. And that’s were our first advantage comes in.
If we enter a bear market and the stock could possibly trade 20% lower.
Anyone who bought the stock at $55 and held it through the 20% decline would lose $11 per share. (A 20% decline would push the stock from $55 to $44)
But selling the put contracts obligated you to buy shares at $50. So you missed the first $5.00 of the stock’s slide!
That’s a big reason why I always sell out of the money put contracts. Because this approach gives us some extra buffer even if a bear market causes our stocks to trade lower!
Advantage #2: Offsetting Income
The second advantage for our income approach is tied to the cash you receive every time you sell a put contract.
In the example above, you received $3.00 per share for selling your put contract. So even though you were required to buy shares at $50, you still had an extra $3.00 of income already in your account.
That income add even more of a buffer during bear market periods.
For this particular example, your “breakeven” stock price is actually $47. That’s because you agreed to only buy shares at $50. And you received $3 per share for your agreement.
So a 20% pullback would cause the stock to fall from $55 to $44. That means a normal “buy and hold” investor would lose $11 per share.
But since our income approach gives you a “breakeven” price near $47, you’ll only lose $3 per share with this trade.
Of course this is just a hypothetical example. And a bear market may hit some stocks harder than others.
Still, the basic concept stands. When stocks trade lower, our put-selling strategy holds up much better than a typical buy and hold approach.
Advantage #3: More Income for the NEXT Play
One final advantage kicks in as you continue to use our income strategy throughout a bear market period.
When stocks trade lower, investors naturally look for ways to protect their positions. And that means they’re willing to pay more for option contracts.
Statistically, the “premium price” of option contracts tends to increase significantly during volatile bear market periods. This simply means that an option with the same metrics will be more expensive during a bear market than a similar contract during a more peaceful market period.
Since our approach sells option contracts, higher option prices actually give us more income.
You’ll notice that during a bear market, you’ll get more income for most of the put contracts you sell. And this gives you more of a safety buffer. And of course it’s great to have more income flowing into your account as well.
Now this doesn’t mean that our strategy doesn’t carry risk. You saw in our example that a stock pullback can still lead to losses with your income play.
But with three distinct bear market advantages, this income approach can help insulate your investment account, allow you to keep more of your wealth, and even accelerate your profits thanks to higher income payments.
It all sounds pretty good right?
In the next installment, we’ll talk about the “catch” — or what you’re giving up when you use this income strategy. Stay tuned and I’ll explain exactly what that’s about!