One of the best trading strategies for today’s market

From Dr. David Eifrig, Editor, Retirement Trader:

At Goldman Sachs, I worked with Fischer Black, one of the pioneers in the world of options.

Black had a PhD in applied mathematics from Harvard. He went on to work for the RAND Corporation and teach at the University of Chicago and MIT.

When I met him, he was a newly minted partner at Goldman Sachs. Black was one of the first academics to be lured to Wall Street. He loved the intellectual challenge – not the money. He liked to point out that of all the partners, he owned the fewest shares of the firm.

Black wasn’t just smart. Everyone at Goldman was smart. He stood well above the rest. Rather than reading graphs or charts, he preferred to study pure tables of numbers. He refused to use a computer mouse… He considered it clutter. Instead, he coded custom keyboard commands to use on his computer.

Years earlier, Black, along with Robert Merton and Myron Scholes, published a paper that established the Black-Scholes formula for pricing options. Merton and Scholes later received the Nobel Prize for the work. (Black had already passed away, and they don’t award the Nobel Prize posthumously.)

As a fixed-income trader, I didn’t really need to work with Black, a partner and researcher. But once I struck up a rapport, I’d visit him as often as I could. We’d create and price options contracts and make deals that brought the firm millions of dollars.

At the start, Black’s intelligence intimidated me. Here was a brilliant guy who had published profound, valuable, and original ideas. But before long, I noticed that although it took amazing intellect to invent these ideas, nearly anyone could understand them.

What was once revolutionary became routine.

Ever since Black showed me that options are a tool that anyone can learn, I’ve been teaching others that they can use this genius-level strategy to improve their own investment returns and actually reduce their risk.

To understand the benefits of trading options – and understand how you can use them to generate income and earn steady returns in your portfolio – I want you to explore how options work. That way, you can see how this investment fits into your financial picture and how it can give you smoother and potentially higher returns.

To start, let’s make one thing clear: Options, when used correctly, reduce your risk.

This is the opposite of what most people think… maybe even you.

Unfortunately, too many investors start using options without reading the instruction manual. They do it the exact wrong way and lose money rather than earn more of it.

The true tragedy… it’s no harder to use options correctly. In fact, it’s easier to use options the right way.

In addition to limiting risk, options can also improve your returns when used in the right market conditions. That’s a powerful combination – less risk and greater returns. You can achieve it with a strategy known as “selling covered calls.”

A “call option” is an agreement to buy or sell shares of stock at a specific price in the future. The buyer of the call-option contract gets the right to buy shares. The seller of the contract must sell the shares if the buyer wants to purchase them. At the start of the agreement, the buyer pays the seller some money up front to secure that contract.

Here’s an example…

This week, tech giant Microsoft (MSFT) trades for about $75.

You own shares of Microsoft, but let’s say someone else (an option buyer) thinks that shares are going to surge quickly. He offers to pay you $1.70 per share today for the right to buy Microsoft for $77.50 a share in December.

Let’s say you agree to that deal, and you sell him a call option. You collect that $1.70 per share.

If Microsoft trades for less than $77.50 a share come December, you’ll get to keep your shares and the money he paid you. If it trades for more, you keep the $1.70 a share he paid… plus you sell him your shares for $77.50 each.

Now, this reduces your risk because it lowers the price you’ve paid for Microsoft. Assuming you bought your shares today at $75, you’ve already gotten back $1.70 per share.

So your cost for Microsoft shares is only $73.30, even though shares haven’t moved. You’ve got less capital at risk. Microsoft can drop from $75 to $73.30 and you’ll still remain profitable.

(Black’s Nobel-worthy insight was the math that determines why this option is worth $1.70 and not some other price.)

There’s one catch: If Microsoft shares jump up – say by December they’re at $85 a share – you won’t collect more than $77.50.

That’s all there is to selling calls. You can get as deep as you want into extra terms and the underlying math, but you don’t need anything else to understand the basics of covered calls.

By selling a covered call, you’ve reduced your risk in case shares fall and increased your return when shares rise slowly. The trade-off is that you won’t get as much upside if shares rise quickly.

That can be a really attractive proposition, especially with where markets are today.

No one knows where the market will go next. But when we put together all the evidence, we can often get a sense of whether to be bullish or bearish.

Today, we’re finding that the two sides are matched. You can make a good case for the market to go either way.

On the bullish side, markets have momentum. Momentum is a real, statistical feature of markets. When markets or individual stocks rise, they tend to keep going in that direction. When markets set new highs, it’s more likely that they’ll set another, newer high than decline.

It turns out that if you buy the market when it hits new highs and hold for a month, you have a 91% chance of seeing it go up from there.

If you hold for three months, the chance of a new high rises to 97%. If you buy at market highs, your typical one-year return would be a healthy 7.9%. (All these numbers are based on the S&P 500 from 1928 to 2015.)

But we can find good reason to be bearish as well…

The market looks complacent. By complacent, we mean investors seem to be buying up stocks with little thought of downside. As the market has ticked up and up, the CBOE Volatility Index (“VIX”) has reached and maintained historic lows. Without getting into the minutia of how it works… just know that the VIX tracks options prices to measure whether investors think stocks are likely to fall. It’s often called the “fear index.” And a low number means investors aren’t nervous.

Typically, when investors feel too safe (like they do now), the market will drop and remind everyone that it can move in two directions, not just one.

It’s also strange to see such calmness when the political and social situations, both at home and abroad, seem to be less predictable than usual.

Even looking at valuation alone, you can tell two different stories about the market. If you look at a simple price-to-earnings ratio, the market looks more expensive than average… But if you consider low interest rates and low inflation, it looks cheap.

If you use the last 10 years of the cyclically adjusted price-to-earnings (“CAPE”) ratio, stocks look very expensive. But if you adjust that for accounting changes that took place over the last 10 years, they look more affordable.

The market could truly go either way from here.

Understand, we’re not trying to be wishy-washy here…

We’ve been ardent bulls since 2009. When the market turned down at the start of 2016, we said, “Right now, you don’t need to worry. Yes, the market is down about 5% this year. But the U.S. economy is strong.” When the Greek debt crisis caused markets to decline in August of 2015, we wrote, “There’s simply no reason to run scared based on all the evidence out there… And add to your investments when the market dips.”

We used those and all the other dips over the last several years as buying opportunities. We’ve called it the whole way.

Today, the evidence in our view is very balanced. To us, that means staying invested – as the general trend for stocks has always been up – but keeping a closer eye on our risk.

That’s where covered calls can serve us well.

Here’s to our health, wealth, and a great retirement,

Dr. David Eifrig Jr., MD, MBA

Crux note: If this feels like one of the most uncertain periods in stock market history, you aren’t alone. That’s why Doc just went on the record and made what could be the second-biggest call of his publishing career. See what he’s saying – and how he has amassed one of the most impressive track records in the history of our industry – right here. (This video comes down at midnight TONIGHT)

× Subscribe to Crux
Want more posts like these?
Like us on Facebook?
Crux Contributors