Although buy low and sell high is a strategy that has resulted in big accumulations of wealth, this isn't how the professionals find their success. Instead, a savvy investor strategically deploys their money, in order to allow it to work in more than one way; they multitask their money.
TUTORIAL: Investing 101
The retail investor who is accustomed to working with stocks can simultaneously put their money to work in three ways:
- Price Action - The stock will hopefully rise in value
- Dividend - The fee a company pays you in exchange for using your money.
- Call Revenue - The money an investor pays you when you sell a covered call against your stock.
If investing were a game, the way you'd win would be to buy a stock at a low price and sell it at a higher price, on a later date. If you own a home, you understand this concept in a very practical way.
In order to make a profit on your investment, it's often best to use one of two strategies to do that. The first is called value investing. Stocks, just like the products you purchase every day, go on sale from time to time and value investors wait for that sale price. This makes it even easier to make a profit, because stocks that are undervalued (on sale) have more room to grow. (Learn how to value invest, read 5 Must-Have Metrics For Value Investors. and The Value Investor's Handbook.)
The second way is momentum trading. Some investors believe that the best time to buy a stock is when it continues to go higher, because just as we learned in grade school, an object in motion tends to stay in motion. The problem with momentum trading is that it tends to work better for shorter-term investors. For our strategy, we want to think long term. The more years you hold the stock, the better your potential returns could be.
How to Pick Your Stock
Your favorite stock may not work for this strategy, because it must pay a dividend, it must have a price that is cheap enough that you can purchase 100 shares, and it must trade a lot of shares each day; at least 1 million shares of daily volume is best. Remember that a company's value is not based on its price. There are a lot of high quality stocks that are under $30 per share and there are a lot of low quality stocks that trade above $100. I have found that stocks between $15 and $30, with at least a 2% dividend yield, are ideal. Finally, you don't want a highly volatile stock. If it has wild price swings, that will be much tougher to manage.
This is where you put your stock research and evaluation skills to work. Once you find your stock, assuming that you want to value invest, look for this name to be in the middle, or towards the bottom, of the trading range for the past 52 weeks. If it isn't there now, either wait for it to give you a price that you want, or find another company. There are plenty of worthy candidates for this strategy. (Learn more in Enter Profitable Territory With Average True Range.)
In a high-tech stock trading world, investing for a dividend might be considered boring, but dividends can be a big income source for the long-term investor. Between 1929 and 1990, 40% of all stock market gains were a result of that boring, quiet dividend, according to the research report "High Yield, Low Payout" by Credit Suisse.
The dividend gives us two advantages that help our money work for us in more than one way. Firstly, it gives us a stable income. Sure, a company can choose to pay or not pay a dividend, as they would like, but for a high quality company, with a low payout ratio, there is a lower chance of the dividend on a quarterly payment getting cut. Secondly, it lowers your cost basis for the stock you purchased.
Let's assume that you did your research and decided on stock XYZ. You bought 100 shares for $30 per share, which at the time had a 3% dividend yield.
$3,000 x 3% = $90 each year. Not only are you making $90 each year, but since a dividend is paid to you in cash into your account (most of the time), each year that you own your 100 shares, you can apply that dividend payment to what you paid for the stock and, in this case, subtract 90 cents per share. After just five years, your stock that cost you $30 per share, goes down to $25.50 per share. Many long-term investors reduce the price they paid for a stock to $0, just from the dividend. (Learn more about this in How do I figure out my cost basis on a stock investment?)
Covered calls are a little more complicated. If you don't feel confident with this leg of the strategy, buying a stock and collecting the dividend as it goes higher will still be an impressive gain. (If you don't know how a covered call works, read about them here: The Basics of Covered Call.)
Before we sell the covered call we have to make two important decisions:
- What is the strike price?
- How many months into the future do we want our contract to expire?
A covered call is an options contract strategy that gives the holder of the contract the right to purchase your 100 shares, if it is at or above the strike price. Presumably, you don't want your shares taken from you, although you may change your mind in later years, so your strike price needs to be high enough that the stock doesn't rise above the strike price, but low enough that you can still collect a healthy premium for the risk you're taking.
This decision is tough. If your stock is in a downtrend, you can probably sell an option with a strike that isn't much higher than the stock's current price. If the stock is in an uptrend, for the sake of safety, consider waiting to sell the call, until you believe the move up has run its course, and the stock will soon go the other way. Remember, when the stock rises in value, the value of your option falls. This also adds the benefit of the covered call acting as a hedge. (For more advanced reading on these types of strategies, check out An Alternative Covered Call Options Trading Strategy.)
The further into the future you take your option, the more of a premium you will be paid upfront, to sell the call, but that's also more time that your stock has to stay below the strike price, to avoid having it "called away" from you. For your first contract, consider going three months into the future.
The covered call will make money for you as soon as you sell it, because the premium that the buyer paid is deposited directly in to your account. It will continue to make money for you if the price of your stock falls. As the price falls, so does the premium. You can purchase the contract back from the buyer at any time, so if the premium falls, you can purchase it for less than you sold it. That equals profit. On the other hand, if the stock rises above the strike price, you can purchase the contract for more than you sold it and incur a loss, but it saves you from having to give up your 100 shares.
One of the best ways to use the covered call is for the collection of the premium at the beginning, and although you can buy the option back if it goes up or down, save this for severe circumstances. Also remember that the money you collect by selling your covered call can also be subtracted from the price you paid for the stock (For more, check out Cut Down Option Risk With Covered Calls.)
The best way to learn a complicated investing strategy, like the covered call, is by using a virtual platform where you don't have to worry about losing real money. You can still purchase the stock and collect the dividend, but wait to sell the covered call until you're comfortable with how it works.
The Bottom Line
For most investors, putting money in high quality stocks for long periods of time, while harnessing dividend income, is the best way to make money in the market. Later, once you understand how to use the covered call, you can significantly increase your yield. Although the fixed income side of investing isn't as thrilling to watch, it is the most appropriate for retail investors and as we can see, the numbers can add up fast.
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