An interview with Matt Weinschenk, senior analyst, Retirement Trader
Q: Stocks have marched higher for the past nine or so years. It has been a historic move, but folks on Wall Street have mixed opinions whether the bull market can continue for much longer. Where do you think we are in this bull market?
Matt Weinschenk: It’s funny you ask, actually…
In January, the S&P 500 Index peaked at 2,872.87 before falling to 2,581.00 on February 8. That’s a 10% drop. Of course, I didn’t have a crystal ball. But I knew that the market was overdue for a pullback.
A good rule of thumb is that you shouldn’t try to trade around typical market corrections of less than 20%. One, it’s hard to do. And two, you have to pay taxes on your gains. This means you have to time the correction and the rebound exactly right to make it worthwhile. Nobody can do that consistently.
Plus, it’s highly unlikely that we’ll see a 20%-plus correction without a recession happening as well. I’ve seen the numbers on this and it’s rare. Going back to 1939, the market has pulled back more than 20% without a recession just five times, or once every 15 years.
When you look at economic growth, employment, and consumer activity, it’s unlikely we’ll see a recession coming within at least a year, maybe longer.
Q: Where should the average investor be looking when things get volatile? Is there still room to profit?
Matt: In sideways markets, selling options can generate steady streams of income on stocks… even if they go nowhere. So while regular shareholders aren’t making any money, trading options allows you to make more money on the exact same stocks.
But when markets get choppy, you can use options as an opportunity to buy stocks at a discount. Higher volatility means that options prices rise, which means you can earn higher payouts. In other words, if stocks are falling and investors are getting worried, you can get paid more for your troubles.
Right now, we’re in a transitional period. We had a long stretch of low volatility, but things started to look rocky again when the market pulled back in February.
Q: So there’s even more volatility coming?
Matt: Volatility tends to “cluster.” When markets get volatile, they tend to stay volatile. After all, what makes people scared and think about selling? Other people being scared and selling.
That’s part of why we saw such a long, unprecedented period of calm in the market. Quiet markets lead people to expect quiet markets. Investors become complacent. Stocks and valuations rise. But higher valuations and complacency in the market means that when stocks begin to pullback, investors panic.
Based on history, I expect higher levels of volatility over the next couple of months.
Q: So what mistakes are investors making right now? And does trading options work when volatility is low?
Matt: Investors always want big returns. But they have it all backwards.
Their No. 1 priority should be to never lose money. By hitting singles and doubles rather than swinging for the fences on every trade, you’re able to make reasonable gains over and over again. Small wins can really add up over the course of a year or more.
When people talk about low volatility, they’re talking about the CBOE Volatility Index (or “VIX”), which measures the overall volatility of the market. That has been extremely low for a few years now.
But the VIX isn’t the only way to gauge volatility. You can still find quality companies that have higher-than-average levels of volatility. When you spot one, options can generate big returns if you know what to look for.
Q: Why do you think more people don’t trade options?
Matt: People don’t take enough control of their finances in general. And when they have to learn something new and foreign, forget about it.
At first, options trading doesn’t make sense to folks. But it doesn’t take long for everything to click, and for people to realize it’s basic math… And once you get your account set up, it’s as easy as trading stocks.
The other problem is that most people use options in the wrong way. They do it to increase their leverage to try and hit home runs in the market. It’s easy to blow your account up that way.
Used properly, options can actually reduce the risk in your portfolio. Because you’re getting paid to put these trades on, it lowers your cost basis. Instead of buying a stock for $100 and hoping for the best, you can buy a stock for $100 and get paid a few dollars to agree to sell it to someone else at a higher price down the road. You’re able to pull income out of the market and put it right into your pocket. That helps keep your win rate high and your losses small.
If everybody tried trading options this way – the right way – from the start, I bet a lot more folks would do it.
The key is to only trade options on companies you’d be happy to own… companies you’re going to want in your portfolio next month, next year, or farther down the line.
Q: That makes sense. So where should people start? What kind of options should they look for?
Matt: With our strategy – and we think it’s the best one – you’d look for trades that expire about two months down the line. That’s because the best rate of time decay (or “theta”) in options occurs between six and eight weeks before expiration.
Q: Can you walk us through a real-life example?
Matt: Sure. Back in December, I noticed a high-quality company that investors had given up on. It was railroad operator CSX. Railroad stocks perform well when the economy is humming along, because more economic activity means more “stuff” gets shipped. However, the CEO had unexpectedly passed away… and the stock tanked.
At the time, you could buy CSX for $55.66 per share. Let’s say you bought 100 shares at the time for a total of $5,566. This number is important, since one options contract requires 100 shares of stock.
So right after buying your shares, you could sell a $55 call option on your stock for $2.84. This option gives someone the right to buy your shares for $55 per share any time over the next two months. You collected $2.84 per share ($284 per contract) for selling that right. That gave us an initial outlay of $52.82 (the $55.66 stock price minus the $2.84 we received from the call premium).
By February, CSX was trading for more than $55. So you would have sold at $55 and kept the $284 you got for selling the call.
Because you sold covered calls with a strike price below the share price, you lost $0.66 per share when they were called away from you. So your net gain was $2.18 (the $2.84 premium minus $0.66 per share), or $218 with your 100 shares. That’s a safe return of 4.1% ($2.18 divided by the $52.82 cost) in less than two months.
And if CSX had been trading below $55 in February, you would have been able to do pretty much the same trade all over again since you kept your shares.
Do this “4.1% in two months” trade six times in a year and you can make 25.9%. You’d also collect CSX’s 1.5% dividend along the way. On a $25,000 stake, that would generate almost $6,500 a year.
Remember, this isn’t just a hypothetical. Real-life investors closed this exact trade.
Q: We’ve talked about the upside… But how can you protect your portfolio from market dips and volatility like we’ve seen recently?
Matt: Stop losses are essential. Between 20% and 25% is a good place to start, but it really depends on the stock and the amount of risk you’re willing to take.
How Stop Losses Work: An Example
Let’s take a look at another example… In this case, we’ll use a 25% stop loss.
Say you bought 100 shares of Company XYZ for $25 and sold the December $25 calls for $1. That means your total outlay – or what you spent to open the trade – is $24 (the $25 share price minus the $1 you received in premiums). The total cost of your trade is $2,400.
That means that if the combined value of your position falls 25%, you would sell. In this case, 25% of $2,400 is $600. So you would close the position if it fell to $1,800. This gives us a stop loss of $18 per share.
You’ll also have to buy, to close, the call if you want to close the trade, so you’ll have to factor that into your calculation. But for the sake of keeping the numbers simple, that’s how you can calculate it. The most important thing to remember is to sell when you hit your stop, and never share your stops with your broker.
Q: Why is it important not to enter your stop losses with your broker?
Matt: Entering your stop with your broker is like playing poker with your cards facing up. It lets professional, high-volume traders (or “market makers”) know exactly when you will sell. These traders can move the market and trigger your stop losses.
Instead, we recommend using price alerts – either from software like TradeStops, or from your broker – to notify you once a position has hit your stop. This is a safer way to maximize your profits and limit your losses. And it keeps you in control of your investments.
Q: One last question… Can you make these types of trades in a retirement account?
Matt: The short answer is, yes.
Almost anybody can trade covered calls in an IRA. In tax-deferred accounts, you don’t have to keep track of the trade’s gains and losses for IRS reporting. And you don’t need to worry about short- and long-term capital-gains differences, either.
You can also sell put options, but doing that in an IRA can be trickier since you can’t use margin to boost your returns.
Q: Do you have anything else to add?
Matt: We don’t have a crystal ball, and we can’t know what the market is going to do tomorrow, next month, or next year. But if you trade options the right way, you don’t have to. You can make money if stocks are going up, down, or sideways. And because you’re trading stocks you’re happy to own, you can sleep well at night. This is a strategy every investor should be using to make a little extra income, whether you’re a young investor or a retiree.
A lot of people are sitting on huge gains from this bull market and don’t want to watch them vanish. So you can sell covered calls and get paid to sell your stock to someone else at a higher price. That’s real money going right into your pockets on the stocks you already own in your portfolio.
I love teaching people about options, and I hope more folks will give it a try.
Q: Thanks for taking the time to sit down with us today, Matt.
Matt: Sure, any time.
Matt Weinschenk, CFA, is the house econometrician for American Consequences contributor Dr. David Eifrig’s Retirement Millionaire franchise. (For those who don’t know – and our editor in chief P.J. was one of them – an econometrician uses statistics and math to study, model, and predict economic outcomes.) At the risk of embarrassing Matt, we note that he has a 95% win rate in Dr. Eifrig’s Retirement Trader service.
Dr. David Eifrig and Matt Weinschenk have a single goal with Retirement Trader: To teach regular folks how to safely create income in retirement by using the same investment techniques as Wall Street banks and traders.
Learn more about what they call the “greatest investment income strategy in the world” with their book, High Income Retirement. If you’ve been nervous about trading options… or if you aren’t sure if this income-generating technique is right for you… this book will help you overcome your fears. Click here to get a copy delivered to your door for a better price than it’s selling for on Amazon.
