The Simple Strategy Appears to Be Working

by JDH on January 30, 2016

As I have said on numerous occasions, I have no idea what the markets will do next.  Not a clue.

SPXJan29-2016

In the last year and a half the S&P 500 has had four big corrections (circled in the chart on the left) and in three of those four times the market has bounced significantly higher.

We are in the middle of a bounce now.  What will happen next?

The market was up 2.5% on Friday.  Great.  Year to date it’s still down, considerably.  This bounce may be over, in which case we get to retest the 1,825 level.  Or it may bounce like it’s done three times before, and we’ll be at 2,050 by the end of February.

Could be either.  I don’t know.

Common sense tells you that with the market making a series of lower highs for the last six months the direction is more likely down than up.  But if the Fed turns on the money printing again it could be onward and upward.

I have no idea.

So how do you play it?

My strategy this year has been relatively simple.  I own TLT – iShares 20+ Year Treasury Bond ETF.  It’s a long bond fund, so as interest rates decline, it goes up.  It also pays interest.

Every week I do covered writes against my shares.  I sell call options against the shares I own.  I generally sell options that expire at the end of the week, and I sell them at slightly out of the money.

So, for example, with TLT closing on Friday at $127.30, I can sell a February 5, 2016 call with a strike price of $128 for around 50 cents (“sell to open”).  So, if by the end of next week TLT is trading below $128, I keep my shares, and I keep the 50 cents in premium.  If it’s trading at $128.50 my shares will be called and I’ll be paid $128, but I also have my 50 cents, so I’m still happy.

If it is trading above the strike price on Friday, I buy the options back (“buy to close”), take my loss, but then sell next week’s options and do it all over again.

So here’s the last month’s worth of transactions, based on 1,000 shares to keep the math simple:

  • December 31, 2015 dividend + $254.03
  • Covered write, January 4, $122 strike, expiring Jan 8 +$992.46
  • Buy back Jan 8 calls – $767.50
  • Covered write, January 12, $123.50 strike, expiring Jan 15 +$582.49
  • Buy back Jan 15 calls -$2,117.50
  • Covered write, January 19, $126 strike, expiring Jan 22 +$477.50
  • Buy back Jan 19 calls -$2,072.49
  • Covered write, January 20, $128 strike, expiring Jan 22 +$797.49
  • Jan 20 calls expire worthless
  • Covered write, January 26, $126.50 strike, expiring Jan 22 +$632.49
  • Buy back Jan 26 calls -$937.50

The net result of all of these transactions, if you add up the pluses and minuses?  A loss of $2,158.53.

Not very good, eh?

Not good, except that I still own the stock, which on December 30 was worth $120.04 per share, and on January 29 it closed at $127.30.  That’s a gain of $7.26 per share, so on 1,000 shares that’s a paper gain of $7,260, so the net impact of this strategy is a gain of approximately $5,000.

Assuming an opening investment of 1,000 x $120.04 or $120,040, that’s a gain of just over 4% in one month.

That’s not bad.  Not bad at all.

In hindsight, of course, the covered write strategy lessened the returns.  Without the strategy the gain in one month would have been over 6%.

But the risk with this strategy is much lower.

I don’t expect a conservative bond fund to increase by 6% every month.  It’s unlikely it will have a 6% gain in any other month this year.  It’s more likely that there will be many weeks where it is flat, or down.  In those weeks the covered write strategy mitigates those loses.

Does this strategy make sense?

Ask me in a few months and we’ll see.

For now, in the absence of any better strategy, that’s the plan.

Thanks for reading.  Next week I’ll address the issue of whether or not gold’s recent bounce is real, or illusory.