In today's uncertain market, bonds are proving to be increasingly attractive to investors. While money-market funds and short-term government bonds offer a solid return of 5% or more, even the 10-year Treasury bond boasts a yield of around 4.3%.
After facing significant market events such as the Asian contagion in 1998, the bursting of the internet bubble in 2000, the global financial crisis of 2008-09, the Covid meltdown of 2020, and ongoing central bank actions to combat inflation, a reasonable risk-free return is more appealing than ever.
Although the cash return falls short of the stock market's long-term average annual return of about 9%, investors seeking to enhance their yields without significantly increasing risk can explore attractive opportunities in the equity options market.
Here's an effective strategy: Allocate 80% or 90% of your cash to bonds, and dedicate the remaining portion to an interest-bearing account that your broker allows for financing options strategies. Utilizing this setup, you can sell puts on blue-chip stocks that hold long-term value.
At present, put options command attractive premiums as buyers pay up for downside protection. By having a special brokerage account in place, you assure your ability to purchase the stock should it fall below the strike price.
Consider selling puts that are approximately 10% out-of-the-money and have a four to six-week expiration date. This approach can generate around a 1% monthly return on the cash used to secure the put.
The key takeaway is that investors can benefit from attractive fixed-income yields while capturing the rising fear-premiums associated with put options. The majority of your funds remain invested in bonds, while the money necessary to finance cash-secured put sales also sits in an account that earns attractive interest rates. The put premium serves as an additional bonus to this strategic approach.
The Risk of Selling Cash-Secured Puts
Selling cash-secured puts comes with its fair share of risks, much like buying stocks. There is always a possibility of losing money, especially if certain events unfold. Factors such as the Federal Reserve increasing rates beyond expectations, a potential crash in China's economy, or the deterioration of corporate earnings can lead to a sharp decline in the stock market.
When faced with such uncertainties, it is crucial for investors to consider their temperament and risk tolerances. Additionally, keeping a close eye on the yield of the 10-Year Treasury bond can provide valuable insights into the direction of the stock market.
History has shown us time and again that stock markets do not respond well to 10-year yields of 4% or higher. At this level, these yields disrupt commonly used valuation models that assess multiyear earnings.
The vulnerability to valuation fluctuations is particularly true for leading big technology stocks. Their equity prices are heavily influenced by the perceived value of their multiyear revenue streams. If yields continue to rise—an uncertain prospect—the result will likely be a drop in stock prices.
To navigate these uncertain waters, adopting a blended bond and options approach can be advantageous. This strategy, known as time arbitrage, positions investors more strategically.
In an unstable stock market environment, it is essential to exercise caution when selecting strike prices and expiration dates. Moreover, it is wise to refrain from selling puts on stocks that you are not prepared to own.
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