Investing Strategy for Sideways Markets

stock prices move up most of the time but what can you do if you think that's not going to happen for an extended period well even in these sideways markets it's possible to turn the price fluctuations of stocks into income using a strategy called covered calls or buy rights in this video I'll talk about how that strategy Works in practice I'll talk about its drawbacks but also the kinds of environment where it works best and I'll finish by talking about some funds which Implement covered calls both in the US and in the UK now don't forget if you do enjoy our content please do subscribe to our Channel and like this video so let's look at covered calls strategies for sideways markets in a bit more detail now how often do these sideways markets occur well you can see that they do last for extended periods of time there are drawdown periods some of them are very long for example we had two seven year periods just after the.com bubble burst and then after the global financial crisis but usually they last less than a year but if they do happen it can be very annoying as an investor and it's easy to grow impatient and hope that things would turn around so if this does happen and you think we're going to be in a Range bound or sideways moving market for an extended period the strategy they will consider is called a covered call or alternatively a buy right they both mean the same thing so to use a nautical analogy this is a little bit like being be calmed in the age of sale once the wind dropped there was just no means of propulsion and sailors just had to wait for the wind to pick up again before they could get underway but it's not quite that bad when it comes to investment because you can get a little bit of a prevailing wind going by using one of these covered calls so how does it work well just as you would normally your buy group is stocks or a single stock but at the same time you'll sell the upside to somebody else via a derivative called a call option so why would you sell the upside of your stock the whole point of buying stock is that it goes up in value and you benefit well if you don't believe in that upside what you can do is sell that to someone else who does and today you can pocket that premium from selling the call option so let's say you do that every month well that way you can generate a steady income and boost your total return even if markets are moving sideways or downwards so when does this strategy work best well remember what we've done is to sell that upside to someone else so if the upside does materialize if the stock price does surge upwards well that's not in our benefit it's to their benefit and we're going to pay the price of our caution so in a strongly rising market covered call strategies underperform you'd have been better off just buying the the underlying index or the underlying stock NOW the price of an option depends on how volatile markets are when they're more volatile the price of the auctions increases so in a very volatile Market which is either trending downwards or sideways that's when these strategies work best you'll get the most bang for the buck from selling that upside to someone else the call options will be very valuable now in fact that's happened quite recently with the sell-off that we got in tech stocks in 2022 so if we look at the period from December 2021 until June 2022 markets headed downwards pretty fast and while that happened you could have actually mitigated your losses by generating income via selling upside so during that period the s p fell by 23 percent but if you've gone for the buy right strategy one implementation of it you'd have only lost 11 if we go back to the financial crisis and in 2007 there was a two-year period when buy rights would have worked very well this is from October 2007 until March of 2009 when markets turned around so again instead of falling 55 percent you'd have mitigated your losses you'd have only Fallen 39 due to that added income from the call options and in the aftermath of the.com bubble from March of 2002 to March of 2003 again you'd have done really well with the buy right strategy you'd have only lost 11 when the s p would have fallen three times as much by 27 percent if this is all sounding a bit too good to be true then remember what happens over the long term so if we zoom out and go all the way back to 2002 till the present day 2023 you can see that this strategy has underperformed the s p on its own and that's because most of the time stocks do go up and selling the upside is about bad idea so this isn't a good long-term strategy it's just a strategy for when you think markets are going to trade sideways so if you're right about that then this is a reasonable way to invest if we look at annual performance of this buy right strategy on the S P versus just holding the s p and we look at it year by year you can see that since 2003 there haven't been that many years when the buy right strategy has outperformed it's usually been after a crisis when markets have kind of trended downwards or sideways for an extended period now if you like investing for a high income wouldn't it be great if you had a map of all of the funds available so that you can see which ones generate the highest income well one of our trackers which is available to our premium members on our website does just that so if you zoom in on the section for the US for example for the ETFs their income heat map shows you you both jeppy but also kyld as offering a large amount of yield the size of these blocks tells you the assets under management for each fund and the color tells you how much income it generates so if you're interested in our membership you'll get access to all sorts of goodies such as members only videos but also a chat application so you can ask a question whenever you want to learn more about that just go to our website pensioncraft.com now for those who are interested we can dig into the financial engineering behind a covered call the first ingredient is that you buy the underlying stock now here I've shown the S P 500 as if it were a stock and we bought it at a price of 42.50 now if it goes up by one percent we'd gain one percent that would be our p l if it falls one percent we'd lose one percent this is a kind of linear relationship between the payoff the profit and loss and the underlying stock price or index movement now let's contrast that with the payoff for a derivative in this case we've sold a call option and that means that we get this non-linear payoff the strike price at which the p l starts going downwards is 42.50 but notice that we're a long way above the x-axis and that's because of the premium that we took in on day one now that's just over 300 in this imaginary scenario but that profit from selling the call option is the magic Behind These yield enhancement strategies notice the problems start happening if the actual index goes up a lot because then we lose our premium and we carry on losing money as the stock price or the index price moves upwards now if we add those two profits and losses together from owning the underlying index and then also having the short call option what we get is the buy right payoff notice that what we've achieved by selling the the upside is a kind of capped payoff where we won't make any more money above a certain level unfortunately however we've kept all of the downside it doesn't sound so attractive now does it what we've done is we've kept all of the downside and we've capped our upside but in return for that we've received a premium up front and that income is what makes these strategies attractive if I overlay the buy right strategy with the strategy of just buying the index you can see the benefits as long as the index doesn't move up a lot then we're better off with our buy right strategy and that's because of the income which we realize up front so by selling the upside every month with one of these call options what we're effectively doing is hoping that the underlying index will not go up a lot if it does we'll lose if it doesn't then we benefit from the continual income now let's look at some U.S covered call funds now remember what you want here is an index which is quite volatile because their view value of the option will be greater and the income from selling those options is also greater so the NASDAQ index is a notoriously volatile index it's also been great for Capital Growth historically but one of the strategies which many people find attractive is a covered call strategy on the NASDAQ and one of the funds which achieves this is created by globalx and it's called qyld that's the ticker now you can see the description of the fund here and one of the things to notice is the fees pretty high at point six percent per year and although the yield does vary quite a lot over time depending on what happens to the volatility of the NASDAQ and also the price of the NASDAQ but as I make this video the yield is around 12.5 percent which sounds incredibly high but bear in mind you are keeping all of the downside of the NASDAQ so if it does fall the capital you've invested in the fund would fall as well but of course you can apply this to any index and if you want the NASDAQ it's called qild as we saw Global X also has two other funds if you want to apply the strategy to the S P 500 the ticket for that is xyld or if you want to apply it to us small caps you can do it on the Russell 2000 Index and the ticket there is ryld in fact there are many of these covered call funds which are available in the US and if you look at etfdb now called vetify you can see this list of those funds in fact there's even one for Chinese internet stocks called klip and that has a huge yield of 24 that's because they're very volatile stocks another fund which is really popular in the US is called jeppy that's its ticker jepi and it's the JPMorgan Equity premium income ETF now here you can see the yield on that fund as of March 2023 compared with various other asset classes ones which are usually thought of as high income asset classes for example U.S high-yield bonds those yielded 8.5 percent over a comparable period and a global read fund over that same period would have generated just 4.5 percent what I also like about this fund is that the expense ratio is pretty low given what it is it also actively manages the stocks within the fund it doesn't just buy an index it chooses stocks which tend to have a high income and which also have a low volatility so if you don't like Capital losses and you like a high income and a low fee then I think this is a pretty attractive package you can see why it's had a lot of inflows recently and jeppy breaks down the income it generates into the income from the stocks it buys which is around one to two percent of course it varies over time and the income from the covered calls which it writes on the stocks it buys which is an additional five to eight percent again depending on the volatility of those stocks now let's look at covered call funds which are available in the UK there isn't that much choice for UK investors there used to be lots of funds available from but those were withdrawn but there are two from Fidelity which you can see here one of them does a covered call strategy on UK stocks that's the enhanced income fund at the bottom and the other one is a global fund which takes msci World developed market stocks and in both those cases it tries to boost the income on the underlying index by around 50 percent now recently on a YouTube live somebody told me in the comments section do you know that qyld is now available to UK investors so I checked and it was I was really excited so here's Global X's European site and what is different about this description is that it has the word use it before the word ETF use it stand for undertakings for Collective investments in transferable Securities and really that's just a stamp of approval by European Regulators for a given fund so this is the use its version of qyld now it turns out it's difficult to find all the information about this Fund in Europe but it does say that it trades two versions on the London Stock Exchange one of them has a ticker qyld that trades in dollars on the London Stock Exchange and the other one is qylp which trades in Sterling now for both of those you'll be taking the currency risk for one of them it'll be implicit that's the Sterling one for the other one it'll be explicit because you'll see it trades in dollars so if Sterling does strengthen versus the dollar both your income will fall and also the value of your fund will fall conversely if Sterling weakens it'll flatter the income and the value of your fund now there was also some confusion about whether these funds pay monthly or semi-annually some of the data sources I saw said semi-annual but if I look at the regulatory filings on the London Stock Exchange sure enough it says as you can see here that it's paid monthly if it's an income fund that's what you'd prefer presumably you want to see that income every month you don't want to have to wait six months to get hold of the income from selling those call options so I hope that's given you a bit of an insight into how covered call strategies or alternatively buy rights as they're called work and the kinds of environment where they work best but remember that over the long term these are not Buy and Hold strategies they will underperform the underlying index so it is best just to hold an index for a long period of time and make money out of that upward drift very cheaply now don't forget if you do want to learn more about investing we have our membership offer and if you want to become a premium member just go to our website pensioncraft dot com and as always thank you for listening

Channel: PensionCraft

Views: 15,846

Keywords: sideways market, covered call option strategy, yield enhancement strategy, buy write option strategy, stock market, pension craft, ramin nakisa, pensioncraft

Id: fLwq6OQutbI

Length: 15min 6sec (906 seconds)

Published: Tue Jun 27 2023