Dividend investments have dominated the investment landscape over the past two years.
But one day, the dividend bubble will pop. It might not be tomorrow, or even next year. But when it happens, you don’t want to be heavily reliant on most of the widely touted dividend stocks you hear about today.
Though I recognize that dividend investing is a great long-term strategy, I’m not terribly interested in reaching for yield in stocks.
That’s because as a self-directed investor, I know I have alternatives. I know I can bring in steady income using a small portion of the money that is just sitting stagnant in my account. How?
It’s a simple and straightforward concept, and one that I have been teaching self-directed investors for years.
Create Your Own Dividend
The answer: Credit spreads. In fact, it’s the #1 strategy used by options professionals. And for good reason.
Credit spreads afford you the ability to create your own dividend … a monthly paycheck, if you will. When you sell a credit spread, you collect cash (credit) up front while simultaneously transferring risk to the buyer.
Best of all, selling credit spreads allows you to create your own income targets. And the sum of all of your so-called targets, when set properly, gives you a targeted monthly income.
Let me explain using a recent investment in the iShares Russell 2000 Index (NYSE: IWM).
Over the past month or so, IWM has rallied more than 10%. Will it continue its advance?
As an options trader and a self-directed investor, I really don’t care. I only care about growing my portfolio through income-generating strategies like the one I use in my Options Advantage service.
So how can we take advantage of the recent price action in IWM? Look no further than the bear call spread – a type of credit spread.
What is a Bear Call Spread?
A bear call spread is a credit spread composed of a short call at a lower strike and a long call at a higher strike. The nature of call pricing structure tells us that the higher-strike call we are buying will cost less than the money collected from the sale of the lower-strike call. That’s why this spread involves a cash inflow (credit) to the trader/investor.
The ideal condition is for the spread to expire worthless, thus allowing you to keep the premium collected when you sold the spread. In order for this to happen, the underlying stock or ETF must close below the lower strike call option that you are short.
The basic premise of the strategy is easy: you choose the probability of the trade being successful (the spread expiring worthless). Increasing the probability of success will decrease your potential profits, while lowering the probability of success will raise the profit potential.
So with IWM recently surging above $85 – and into a very overbought state – I thought the stock was well overdue for a pullback, at least temporarily. With that assumption in place, let’s move onto my strategy of choice … the bear call spread.
With IWM trading at $82.00, I wanted to choose a short strike for my bear call spread that met my risk/return objectives. I prefer a win rate/probability of success in the 70%-95% range. As such, I invested in the Feb13 87/89 bear call spread. In other words, I sold the 87-strike call and simultaneously bought the 89-strike call.
I like to give myself a decent margin for error, which obviously increases my probability of success. For example, the $87 strike allows for a $5, or 6.1%, cushion to the upside. Keep in mind that my objective is for IWM to stay below $87 through the spread’s expiration in February.
The Feb13 IWM 87/89 bear call spread met my expectations, as it brought in a credit of approximately $.23, or $23 per contract.
As a result:
- The maximum gain on the trade – 12.9% (calculated by dividing the credit received, or $0.23, by the required margin – $1.77)
- Probability of success – 81.4%
IWM would have to move above $87.23 for the trade to move into losing territory. As long as the stock price stays below $87.23 through February options expiration, the trade is successful.
Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders' tool box. And I can use credit spreads as often as I like.
As always, if you have questions about credit spreads or any other options strategy, feel free to drop me a line at [email protected].
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