With interest rates at the lowest levels since the 1960's, anyone interestest in a high rate of return has to consider the stock market. This might seem like a "no brainer" since the stock market has posted incredible returns over the past five years. However there are reasons to be concerned.
The drop that occured in the market from the end of August to the start of October 1998 should serve as a reminder that while the stock market goes up, it can go down. Most stocks are fairly valued to overvalued, which means when stocks go down, the can go down hard. The danger is increased by the weakness in the global economy. Should the U. S. fall into recession, stocks would likely be hit hard.
When I first started the web page I made lots of bold declarations about the stock market and covered calls. I've now learned that it's not fool proof and while you try to make intelligent decisions, due to the amount of uncertainty inherent in stock picking, it pays to hedge your bets whenever possible. Further the "guts test" is extremely important: you must be sure that if the stock market drops you won't bail out due to fear.
When I first wrote this I described covered calls as "money for nothing." That's the ideal. The perfect covered call is one that's written at a good premium then expires with the stock a dollar or two out of the money. Covered calls are a way to hedge your bets.
You must be prepared for two things: One, your call could expire in the money and your stock is sold. You might ask, "What's so bad about that?" Well, if it's a good stock with good growth prospects, you might have settled for selling the stock at 60, when it was on it's way up to 80. You'll have made money, but you'll kick yourself for selling out so cheaply. You should buy a stock to sell covered calls only if you believe the stock has good growth prospects. Never sell calls on all of your position: you want to make sure that if the stock rises to a higher level than you expected, you're still in a position to profit from that.it.
The second problem is, what happens if the price of the stock drops? Sure your call expires out of the money, but now your investment is worth much less. You might have to wait a while till the company turns around, and depending on the company it might never turn around. Granted, there are ways to compensate, such as "rolling down" your calls, but that reduces profit potential and could result in a loss if the stock has dropped significantly below the purchase price.
In short, there is no safe haven. Not in covered calls or any scheme to protect you stock's value. You must have faith that two things are true to invest in the stock market. 1. Over the long haul, the economy of the United States will continue to grow. 2. You are able (with some degree of probability, but certainly not perfection) to analyze the prospects of a company so that you choose winning companies.
Remember, if the first is true, the second is easier. If the economy over the long haul grows, then there must be companies driving that growth. The job is then to find which companies have the best growth prospects.
Since 1982, we have enjoyed one of the most incredible bull markets
the country has ever seen. How much longer can it go on?
I believe the bull market is due in part to demographics. The baby-boomer
generation has been putting away money for retirement. In the old days,
they would depend on a pension from the company they worked for. However,
fewer and fewer companies are offering pensions. Fewer and fewer employees
are staying long enough at one company to qualify for a pension if they are
offered?
The result? More people are depending on 401K's and IRA's for their retirement
savings. 401K's, because they've largely replaced pensions as the retirement
benefit of choice in large corporations. IRA's for people who consult, or don't
stay long enough at one company to become vested.
This surge of money into stocks and mutual funds (it's one in the same really:
most money in mutual funds winds up in the stock market) plus a fairely healthly
economy and low inflation have produced a boom in the stock market. A boom to
the extent that as of now (June 1998) any sane investor would be experiencing
verigo. The S&P 500 is trading at a P/E of 27. The stocks are incredibly
pricey, but I don't expect a fall until:
I was introduced to stocks by my grandfather. I was doing some work at his house,
and he asked me if I would like him to give me money or stock. I chose the stock.
It seemed like a good choice at that time; the company, United Cansoil and Gas, was
an oil exploratory company in western Canada. These were the dark days of 1979-80
when the price of oil was going through the roof. An oil exploratory company seemed
like to the perfect investment. In fact the stock rose from about $5.00 per share to
over $20.00. I felt the stock should be a long term investment, rather than cash it in,
I held it. By the mid 80's the oil crisis was over and the stock went bust, but by then
I had other stocks that were doing well.
I didn't know it at the time, but my grandfather found out from his doctors in the early
80's that he only had a few years to live (he died in 1985). Since the inheritance tax on
Canadian stocks can be rather stiff for Americans, he chose to give his Canadian stocks to
his grandchildren. I got 100 shares of Hiriam Walker preferred stock. The first thing I
liked about the stock was every three months I got a dividend check. When you're in high
school and you don't have a lot of money, you really appreciate dividends.
However, I wanted to be a "hands on" owner of stock, and I knew nothing about this Hiriam
Walker Company except that it was Canadian, it sold liquor, and it sent me a dividend check
every three months.
I told my grandfather I wanted to buy stock in an oil company. My reasoning was sound at the
time: in my lifetime I'd seen two oil shortages, one in 1973 and one in 1979, I figured I'd
look at all the oil companies, find which ones had the most reserves IN the United States, and
when the next oil crisis occured I'd clean up. I think he was pleased that I wanted to buy stock
based on a reasonable theory. My research at that time pointed Exxon and ARCO as being the oil
companies with the biggest U. S. reserves, so I bought equal dollar amounts of each.
Both did well for me. ARCO gained about 60% by the time I wound up selling it in the mid 80's
to cover college tuition costs. Exxon I held onto until the Valdez incident, and for mostly
emotional reasons I sold it then, by then it had about doubled in value.
After college I worked as an electrical engineer, doing digital hardware design and software
programming. I couldn't help but notice some companies we bought products from were very good
and were growing by leaps and bounds, but I was always afraid to invest, thinking I'd lose my
money.
Finally I read "One Up on Wall Street" by Peter Lynch. The book told me, that what I was seeing
was no fluke, and that the best stock tips are picked up by looking at the companies you are familar
with, and using that as a starting point for your analysis.
Based on that information, I went out and researched
Linear Technology. Linear was a company who's products
I'd long admired. Everytime I went to their design seminars, they'd usually include a slide showing
how they were achieving consistant 25-30% growth each year.
Still to come: