As you saw yesterday, Fed Chair Janet Yellen helped drive the markets down by announcing that there’s no fixed timetable for raising interest rates.
But with rates under 1% since since 2008, and with three FOMC voting members opposing the decision to hold rates steady for now, I see the next Fed rate hike happening by December 31st.
Now there are two different strategies you can use that offer the best protection for your portfolio…
The first helps you lock in steady income every month.
The second offers you unlimited profit potential – with limited risk.
And the best part is, it doesn’t matter if this is your first time trading or you’ve been trading for years – they’re both extremely easy to use.
So let’s get started.
Using Covered Calls and Married Puts to Generate Monthly Income When The Fed Raises Rates
Of all the various trading strategies out there that you could employ, there are two in particular that offer (the best) protection against a Fed rate hike.
And we’ve talked about both of them before…
- Covered Calls
A covered call strategy is used when you already own the stock, and you’re selling the right to buy your stock at a specific price on or before a specific expiration date. That means you sell-to-open a call option against the shared you own. Remember, one contract equals 100 shares, so you would need to own at least 100 shares in order to sell (or write) one option contract.
You make money by selling the call option, but you’re also giving the markets the right to buy (or call awa) your stock at the option’s strike price any time up to – and including – expiration.
So when the Fed raises rates (or if the market drops), you get to keep the money from the option premiums you sold. And you’ll likely get to keep your stoc, too.
Let’s look at scenario using Microsoft Corporation (NASDAQ: MSFT)…
In this example, you already own at least 100 shares of MSFT and sold-to-open the October 21, 2016 MSFT $59 call. This is also known as “writing a covered call.” This means the market has the right to buy the 100 shares of MSFT from you at any time up to – and including – expiration.
So if the Fed raises rates and the markets drop (specifically MSFT drops), you get to keep the $1.01 ($101) from the sale of the MSFT $59 call. And if MSFT is under that $59 strike price at the close of the trade’s expiration, then you also get to keep the stock.
Now if the Fed DOESN’T end up raising rates and the markets surge, you do face the risk of having your stock getting called away (bought) from you. In that event, you’re left without any stock but still get to keep the premium you made from selling the MSFT $59 call.
- Married Puts
A married put strategy is where you buy a stock and an at-the-money put (the strike price is the same as the stock’s market price) or an out-the-money put (the put’s strike price is lower than the stock’s market price) to protect yourself against the risk of the markets falling. So you’re selling the right to put to the markets (sell) at least 100 shares of the stock the stock you own at the strike price of the put option you bought.
When using this strategy, you don’t have any contractual obligations to sell the stock at any price. You have spent money to protect or insure your shares by buying-to-open the put option.
This is an example of a married put trade using MSFT, again, as an example…
In this scenario, you own the stock at $58.03 and bought the put option at $1.45.
So if the markets run higher, you’ve only lost that premium. Now you could also sell-to-close the put you bought in order to scrounge up a little bit of that premium. But either way, the total cost of your trade is $59.48. So gains made over that amount are yours to keep.
And say the markets drop…
You still own the stock you bought, which now has the potential to increase in value – even high enough to offset any losses from the stock’s drop in price.
Now both of these strategies are great to use in a rising interest rate environment. But the number one question I’ve been asked by my students over the years is, which one is better?
And honestly, I’d have to lean slightly to the married put because I don’t like to risk giving up my stock over a significant price increase. I also don’t like to risk leaving any money on the table should my stock get called at a lower price, which could happen when using the covered call strategy.
The married put strategy, though, lets you keep your upside open on the stock, with only the cost of the put piercing your overall profit potential. And with the opportunity to make money on the put when the price falls – while still keeping the stock – you have the option to buy more stock at a reduced price using the money you made from the put you sold. So you essentially get to cost average down the price of the stock you like while still cashing in on the markets.
Here’s Your Trading Lesson Summary:
- Both covered calls and married puts are a great way to protect yourself and earn income when the Fed raises interest rates.
- With covered calls, you already own the stock and are selling the right to buy the stock at a specific price on or before a specific expiration date.
- With married puts, you buy the stock and an at-the-money or out-the-money put option.