Staying One Step Ahead of the Fed

Stay ahead of the Fed by selling puts for income

In one week, Federal Reserve Chair Janet Yellen will step up to the podium and address the press, announcing changes, if any, to America’s interest rates and its policy statement.

No one is expecting a rate hike next Wednesday, but they are looking for signs. Will the Fed tip its hand and signal that we’ve got a hike coming this fall? The whisper on the Street is September…

But whether the hike comes in three months or much later, the key is preparing your portfolio now for the Fed’s actions. That’s why I sat down with an income expert to help you prepare for the future that Yellen has planned for America…

Staying Ahead of the Fed By Selling Puts for Income

Jocelynn: With all eyes turned toward the Fed, the first question is, of course: When do you think the Fed will actually boost rates for the first time?

Chad: I agree with what Jeff Opdyke told Sovereign Investor subscribers on Sunday:

…the Fed Heads, who’ve been running around the speaking circuit in recent weeks, are not sounding like they’re eager to raise rates at the September meeting, as Wall Street widely expects. We very well could see the first rate hike pushed back even further. It helps to remember that Wall Street has been predicting the first rate hike since about 2013…

The key thing to remember with the first rate hike is not when, but how much the Fed is going to raise rates. The U.S. is sitting on more than $18 trillion in debt and every day we add to the figure. Increasing rates will only raise our interest payments on that debt. With a GDP that has dropped 0.7% in the first quarter and a jobs recovery populated by low-paying, part-time positions, we have an economy that isn’t strong enough to sustain significantly higher rates right now.

When the Fed finally decides to act, we are likely to see a smaller-than-expected hike of 0.1 percentage point rather than the typical 0.25 percentage point hike we’ve seen in the past, followed by another long pause. It’s going to be a very slow crawl back toward normalized rates.

Jocelynn: With Americans stuck in this low-rate environment for the next several years, the search for sources of income becomes more critical since Treasurys and bank CDs are offering far too little income. Where are you looking to add income and what is your criteria?

Chad: Your best way to add income to your portfolio will be to add companies that are able to return more cash to shareholders each year. But adding just any company with a nice dividend yield isn’t a good plan. I would find companies that are increasing dividend payments while also conducting share buybacks to reduce its amount of shares outstanding — which boosts earnings.

While it’s fine to find a company that is either buying back shares or increasing dividend payments, I like to find companies that can do both. That’s a tell-tale sign that a company is experiencing real, stable growth and it is confident enough to return increasing amounts of cash to shareholders.

It’s important to remember that you’re not settling for any old company that occasionally tosses out a pittance of a dividend to shareholders. The trick, however, is to spot companies that have a long history of increasing or maintaining its current dividend payments through tough economic spots. For example, a company that managed to maintain or raise its dividend through the Great Recession (2008 to 2009) is a good indication of strength.

Jocelynn: Since putting in a bottom in 2009, the S&P 500 Index has rallied more than 200% in the past six years. That’s lifted many stocks to some lofty valuations. If I’m not willing to purchase the stock at its current price but would rather see it come down, do I have any options to make some money while I wait?

Chad: Actually, you do. This is a great instance of selling puts for income. When you sell put contracts, you’re agreeing to buy someone else’s shares of a particular stock at a set price for a limited period of time. In return for agreeing to buy the stock, you receive a cash premium from the other party. The buyer of the put will exercise their right to sell you their stock if the price of the shares falls below the strike price.

Let’s look at an example of selling puts for income. Say you want to buy XYZ Company shares because it fits your criteria of rising dividends and existing stock buyback program. It is trading for $78, but you don’t want to pay more than $75. You sell one August $75 put option on XYZ and you receive $325. If the shares of XYZ fall below $75 before the contract expires in August, you will buy 100 shares of the company at a price of $75 each, which is what you wanted. Plus you made an added $325 on the deal. If the shares don’t fall below $75, then you don’t buy them but you get to keep the $325. You pay the price you want for the shares you want, and you get paid to wait.

Jocelynn: Do you have any other advice for investors seeking to improve yield within their portfolio?

Chad: Investors shouldn’t feel limited to only the U.S. market when it comes to looking for income. The euro zone is rebounding from its long financial woes, with the most recent GDP rising 0.4% — which is significantly more impressive than America’s 0.7% decline.

Mario Draghi (president of the European Central Bank) and his posse have kicked off their own version of quantitative easing (QE) — which tells me investors’ hopes for yield throughout the euro zone is going to be in the stock market, because you’re just not going to find significant yield in fixed income. As a result, local stocks, trading in the heart of the euro zone, are going to be the biggest beneficiaries of Draghi’s version of QE and the euro zone’s ultra-low interest-rate policy for several years to come.

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Jocelynn Smith,
Sr. Managing Editor, Sovereign Investor Daily