How to Juice Your Returns on a Stock you are Selling, and a Lesson for Bernanke

by JDH on June 12, 2010

Let’s start with my favorite quote of the week: Bernanke Puzzled by Gold Rally. Huh? This is the guy who is going to save the financial world, and he is puzzled by the rally in gold? “I don’t fully understand movements in the gold price,” Mr. Bernanke admitted.

Well, Ben, let me help you out. Get a pencil ready, and write this down.

First, and most importantly, the Federal Reserve, which you are the boss of, has printed a gazillion dollars in the last two years. Okay, I’m over-simplifying; they don’t actual print money, but they do “insert liquidity into the system” by providing low interest loans to banks, and a bunch of other techniques, all of which essentially amount to printing money. As a result, $1 dollar that I owned in 1940 is worth about 2 cents today. And the dollar I have today will be worth less tomorrow.

Here’s how it works: let’s pretend that in the economy there is only one dollar, and there is only one commodity (let’s say it’s a bottle of shampoo). That bottle of shampoo is probably worth around $1, since the sum total of all of the money could buy every commodity. Then let’s assume the government decides to print more money, so now there are ten dollars in the economy, but no-one makes any more shampoo, so there is still only one bottle of shampoo. What’s it worth? It could be worth up to $10, because again, that’s all the money there is. So, that $1 has gone from being worth one bottle of shampoo to only being worth one tenth of a bottle of shampoo. The value of money has decreased.

Expanding on the example, let’s assume that I’m the guy who owns that one dollar, and I know the government is about to print more money, which will devalue the value of that dollar I have. How can I preserve the value of that dollar? I can’t, because I don’t control the money supply. But what I can do is convert that dollar into something that won’t drop in value. I could convert it into something that can be printed easily on a printing press.

One option would be to take my dollar and immediately buy the one bottle of shampoo. Then, when the government prints more money, I have preserved my wealth. Before and after the printing I owned one bottle of shampoo. I preserved my wealth. Of course my bottle of shampoo is now worth $10, instead of $1, but it’s the same bottle, so I’m happy. If I hadn’t purchased that bottle, I’d still have my $1, but it wouldn’t be enough to buy the shampoo. I’d be screwed.

And that, Mr. Bernanke, is why investors are buying gold. They want to put their money in something that can’t be devalued. They want to put their money in something that you can’t print. They could have picked shampoo, but it’s possible that more shampoo could be produced. Plus, shampoo takes up a lot of room. Gold is much easier to manage. You can’t print it, and I can hold $100,000 worth of gold in my hand. It’s easily divisible, it won’t corrode or dry up, and it’s recognized and accepted around the world, and has been for 5,000 years.

End of lesson. You’re welcome, Ben. Any other questions, drop me a line or post on the Buy High Sell Higher Forum and we’ll do our best to help you out.

Now, on to the markets this week. The Dow closed above 10,000, the S&P 500 is still above 1,000, so all is well right? Sure, everything’s great.

Of course you could interpret this week’s bounce as a “technical bounce”, meaning there is nothing driving it fundamentally. It appears that volume was fairly light, so I don’t see the public rushing back in. We are also still experiencing massive volatility. 200 point swings on the Dow are now common. By my count (and I could be wrong), we have now had 25 consecutive sessions where the Dow has traded in more than a 100 point range. That’s pretty wild, and not indicative of a calming resumption of a bull market.

Jobless claims are also still a disaster. 456,000 was last week’s number, and looking at the four week average that number is higher than ever. Higher than during the internet bubble burst, or the aftermath of Katrina, Fannie and Freddie, or the Lehman Brothers collapse. With the Gulf oil spill causing even more unemployment, and the end of the census stimulus, numbers in the 500,000 range are sure to follow.

Doesn’t sound like a recovery to me.

So, with this negative perspective, I started to protect myself this week. I did some covered writes.

(If you are new here, a covered write is where you sell an option against a stock you already own. An option gives the owner of the option the right to purchase the stock at a set price, up to a certain date).

For example, on Tuesday I sold the June 46 call options on my G.TO – Goldcorp Inc. holdings for $1.20. Tuesday, you will recall, was the day after Monday, and Monday was a big up day for gold and gold stocks. Goldcorp was trading just shy of $47 when I covered, so I sold an option worth, say, 90 cents, for $1.20 (with the 30 cent difference being the time premium). Gold weakened, so on Thursday I was able to buy back those options for 39 cents. That’s a nice little profit for two days work. I did the same on my shares of K.TO – Kinross Gold Corp. as well; covered on Tuesday, and closed the position on Thursday.

In fact, on Tuesday I did covered writes on most of my gold and silver blue chip holdings, including:

AEM.TO – Agnico-Eagle Mines Ltd.

PAA.TO – Pan American Silver Corp.

PBG.TO – Petrobank Energy and Resources Limited (I realize this isn’t a gold stock, but with the market weakness I covered it anyway).

SLW.TO – Silver Wheaton Corp.

I also own CEF.A.TO – Central Fund of Canada, but there were no suitable options for a covered write.

I put in my “buy to close” orders on the above stocks, but they weren’t filled at my required price, so that’s fine, I will either:

  • attempt to buy them back next week on further weakness, or
  • let them expire worthless after the close next Friday when they expire; or
  • if the stocks increase, I’ll let my stocks be called.

If I’m going to buy back an option that I’ve sold, I want to at least double my money. So, in the Goldcorp example, I sold the options for $1.20, so I would not buy them back for anything more than 60 cents (ignoring commissions). Since I bought them back for 39 cents, I was satisfied. Since I couldn’t get a similar deal on most of the other options, I haven’t bought them back, yet.

If gold goes on a tear this week and I lose my stocks, so be it. The summer is a traditionally weak time for gold, so since I sold options at strike prices above market value at the time I sold them, and since I also got a premium, I’ll be satisfied with that result. My goal over the next month is to increase my cash position, so this is a way to do that.

Let me repeat: there are two ways to sell a stock.

First, you can just sell it.

Second, you can do a covered write on it, and let the stock be called away. So, for example, if a stock is trading at $46.75, I can sell it for $46.75. Or, I could sell the $46 call options for $1.20. If my stock gets called, I get paid $46 plus my $1.20 premium, or $47.20 in total. My only extra cost is the commissions on the sale of the options (I’m paying commissions on the sale of the stock either way). Given a choice between selling for $46.75 or $47.20, I’ll take the extra cash either way. That’s how you can juice your returns on a stock you are selling.

Also, as downside protection, I picked up some RSW – Rydex Inverse 2X S&P ETF, which goes up when the market goes down. This is a short term play, so on Monday I’ll place my sell orders for something in the range of 5% or 10% above my purchase price, and pocket the cash on further market weakness.

That’s my report for the week; thanks for reading, and see you next week.

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