A Simple Way to Limit Risk in Your IRA When Buying Stocks at Record Highs
Record highs in the Dow Jones Industrial Average have probably never occurred at such a bad time. The spring of each year is often when retirement account decisions are made. IRS rules require 2012 retirement accounts to be funded before April 15. With stocks at new highs, some investors may be skittish about adding to equity holdings. Fixed income investments are equally unappealing to many long-term investors given the record low interest rates that have persisted for several years.
Some people may want to wait to make new investments, but IRS deadlines could force them to make decisions about where to invest relatively large deposits. Yields on money markets are near zero and below the rate of inflation, which makes them a costly place to wait for a better buying opportunity. Rather than feeling pressured, investors could look at this as a chance to explore options strategies.
Covered calls can be written in retirement accounts. This strategy generates immediate income in bull and bear markets. To write a covered call in your IRA, you will need to obtain approval from your broker, which is usually completed with the submission of a single form. You will then be able to write call options on stocks or ETFs that you own in that account.
A call option gives the buyer the right to buy 100 shares of a stock or ETF at a predetermined price (the strike price) before a certain date (the expiration date). Call sellers will have to sell at the strike price if the stock or ETF is above that price at expiration. Since covered calls involve stocks you already own, the risks are limited with this strategy.
For example, you could buy 100 shares of SPDR Dow Jones Industrial Average (NYSE: DIA), an ETF that tracks the performance of the Dow Jones Industrial Average. With the index near record highs, the ETF is also near record highs.
At Monday’s open, buying 100 shares of DIA would cost $14,373 ($143.73 a share). When you buy DIA, you could immediately sell a call option on the position. In this case, the April $145 options currently selling for about $1.15 offer attractive income. Each options contract is for 100 shares of stock, so the total income brought in by the sale would be $115.
If stocks continue setting new highs, DIA could be above $145 when this option expires at the close of trading on April 19. You would then sell 100 shares of DIA for $145, no matter what the market price is. When the $115 in ncome for selling the call is considered, the gain on this trade would be 1.68% in six weeks, or about 15% a year if a similar trade is repeated every six weeks.
If the price of DIA falls, the $115 in income will offset the losses. You can think of this income as reducing the cost of the ETF to $142.58 a share. You can also continue collecting income by writing covered calls, further reducing the effective cost basis of the position.
Selling covered calls is generally considered to be a conservative strategy that helps generate steady income in a portfolio. This strategy could be an effective way to enter equity positions in a retirement account and minimize the risk of buying the high.
Recommended Trade Setup:
— Buy 100 shares of DIA at the market price and sell one DIA April 145 Call for every 100 shares purchased
— Do not use a stop-loss (this is a strategy to use with long-term positions in a retirement account)