Buy and Hold Is Dead

You want more, and you deserve better.

The '90s rocked like Bono, and your investments in blue-chip companies paid off. Hard work and savings were rewarded. The next decade, though? Well, the "aughts" rocked more like Hasselhoff. In fact, some have called the years 2000-2009 a "lost decade" for stocks, because each $1 you invested over that time magically turned into $0.76. (Including dividends, investors nearly broke even over that time frame.) While things have gotten better since then, the S&P 500 has provided an annual return of only 6% in the first two and a half years of this decade.

So what can we learn from the past decade? Well, first and foremost, those years were a clear sign that the traditional strategy of "buy and hold" (or "buy and hope," as it was for many) was not the way to go. Yet it's what we've all been taught to rely upon for years. So where do we go from here?

Consider your (call) options
Your best option (pardon the pun) might be to consider covered-call options. Over the so-called "lost decade," using this strategy trounced the S&P 500 by 53 percentage points, and with less volatility. Using a simple covered-call strategy, that $0.76 you earned could've been $1.29 instead. Intrigued?

Source: The Chicago Board Options Exchange.

A crash course in covered calls
Don't be intimidated by the terminology; a covered call is actually one of the simplest of options strategies. In essence, it's a combination of two things: a stock you own and a call option contract you sell regarding that stock. Here's how the two dance:

  1. The stock: You own it! If it goes up, you win; if it goes down, you lose.
  2. The call option: It's an agreement you enter into. You promise to sell 100 of your shares of the stock if its price rises above a level you choose (called the "strike price"). (The call is "covered" because you own the underlying stock. Otherwise it would be "naked," which -- as the name implies -- is much riskier.)

Think about it for a minute, and you'll see that there are two apparent downsides to a covered-call scenario:

  1. Since you own the stock, you lose out if its price falls (you face this risk even if you don't mess with the call option).
  2. Your covered call requires you to sell the shares in question at the strike price you've chosen. So if your stock rockets skyward, you've given away any profit you stood to make beyond that strike price.

You can do better ...
Yet I've just said this strategy beat the market handily from 2000 through 2009. How? As the seller of the option, you get to choose the terms (the strike price and the expiration date) and the option's buyer pays you some cold, hard cash (the "option premium") for entering into the arrangement. Of course, you'll want to make sure the option premium is high enough to sufficiently compensate you for the risk you take. In general, such premiums aren't too difficult to find.

The fancy blue line in the chart above tracks the CBOE S&P 500 BuyWrite Index, which pretends to invest in the S&P 500 and then to write call options that expire in 30 days. At the end of that period, it does the same thing over again. The "BuyWrite" name comes from the act of buying the S&P and then writing call options. Since the index fairy created the BuyWrite index, it has bested the S&P through both up and down markets, thanks to its ability to generate that little bit of extra option premium each month.

... even better than Robocop
Attempting to employ the BuyWrite strategy day in and day out, Robocop-style, is a tall order. But even if you don't happen to be crime-fighting cyborg Alex J. Murphy, using covered calls as a supplemental strategy to picking great stocks could actually bring you even better results than blindly writing and rewriting covered calls.

Large, stable, quality businesses trading at reasonable prices make the best covered-call candidates. Their stock prices tend not to soar or crash, so the possibility of losing money (either from a plummeting stock or a too-low strike price) is relatively remote. Plus, owning these blue-chip companies is a good strategy in its own right; they make great ballast for your portfolio, and they often pay a dividend. Writing a series of covered calls over the course of a year can boost your returns on such companies by 10% to 15%.

Here are a few covered-call candidates that offer attractive annualized yields:

Company

Dividend Yield

Expiration Month

Strike Price

Upside Retained

Option Premium Annualized Yield

Caterpillar (NYSE: CAT  ) 1.77% August $105.00 7.5% 12.5%
CVS Caremark (NYSE: CVS  ) 1.32% August $39.00 4.3% 11.2%
Goldcorp (NYSE: GG  ) 0.86% October $50.00 5.5% 13.5%
Halliburton (NYSE: HAL  ) 0.73% October $52.50 8.1% 14.5%
Home Depot (NYSE: HD  ) 2.99% August $35.00 2.9% 10.6%
MasterCard (NYSE: MA  ) 0.22% October $280.00 5.9% 12.4%
Visa (NYSE: V  ) 0.79% September $80.00 7.0% 13.7%
ExxonMobil (NYSE: XOM  ) 2.32% October $85.00 5.8% 6.1%

Sources: Yahoo! Finance and Capital IQ. Option prices as of June 9, 2011.

A prescription for income
Let's look at CVS Caremark as an example of how writing a covered-call option might play out. The stock is currently selling for $37.40, and we can sell a $39 covered call expiring in August 2011 for $0.77. Here's what could happen over the next year:

  • Since we own the stock, we gain or lose according to its performance, all the way down to $0 and up to 4.3% above its current price ($39 is 4.3% more than $37.40).
  • Selling the August $39 call option brings us $0.77, which we can think of as a 2% "extra dividend" of sorts.
  • We repeat this strategy every few months, so that "extra dividend" boosts our results by 11.2% (the 2% annualized).
  • In addition, CVS pays a $0.50 dividend each year, so that adds 1.3% more in returns to our pocket.

If all goes well, we could earn 4.3% from share appreciation, 11.2% from writing a series of call options, and 1.3% in dividends for a total return of 16.8%. That's enough performance to give Bono return-induced vertigo!

This example highlights why it's so important to be familiar with the underlying business when you write covered calls. If we're right about CVS Caremark being a quality business that'll grow over time, we'll pocket some extra income. But if things don't work out like we've planned -- if, say, CVS Caremark remains flat or even declines?

Well, it's kind of a trick question. In such cases, we'd still likely end up ahead, because of the added income we gained from writing our covered-call options. Besides the possibility that shares would fall dramatically, the only real downside we face would come if they instead rose quickly -- we'd miss out on all the gains above $35.

The Foolish bottom line
Because of the income they bring and the defensive power they can add to a portfolio, covered calls have approximately doubled the return of the S&P 500 over the past 20 years. Combining covered-call writing with solid stock selection and a buy-and-hold mentality is a Foolish recipe for even better performance -- making you extra money on quality companies while letting you sleep well at night.

To learn more about the profitable options strategies we've been using in real-money portfolios for y ears, simply enter your email address in the box below to receive information on Motley Fool Options, plus our free options guidebook.

Bryan Hinmon does not own shares of any company mentioned. Home Depot and Visa are Motley Fool Inside Value recommendations.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 13, 2011, at 3:33 PM, davaidesign wrote:

    Oh wow... where to begin?

    a) Yes, buying the S&P 500 in 12/99 and selling in 12/2009 would produce a terrible return, but using the height of the tech bubble as your starting point is like saying that 95% of serial killers regularly eat bread. Do you like bread?

    Stats can be manipulated to make any point seem valid. For those who stuck to buying companies based on valuation and not hype made out like bandits and my bet is are now sitting pretty.

    b) If people wanted to track the S&P 500 as an investing strategy, they wouldn't be here in the first place.

    c) Buy and hold is about buying the business at a favorable price. How could that possibly be dead?

    Besides all that, there's the constant short term focus on price, cost of transaction, etc. All of which either diminish returns or take up valuable time that can be used to scope up some more great businesses to own.

  • Report this Comment On June 13, 2011, at 3:38 PM, catoismymotor wrote:

    Well said, davai.

  • Report this Comment On June 13, 2011, at 6:43 PM, blearynet wrote:

    Davaidesign, your comments are excellent. This article was just playing fast and loose with statistics and drawing unwarranted conclusions.

  • Report this Comment On June 14, 2011, at 10:10 PM, TMF42 wrote:

    Davaidesign:

    I'd like to respond to your points (in general, I agree with your natural response to be skeptical).

    a) I chose the dates for the last decade, well, because it is natural convention to measure decades in that fashion ('00 to '09). I don't think there is anything wrong with that, especially given that I provided the additional information of what has happened since the end of '09.

    b) Fair enough. But most investors do benchmark, and the S&P is a reasonable proxy for someone who has US dominant exposure.

    c) Agreed, but the title was meant to be dramatic and cause readers to at least question a very long-standing investing dogma. Questioning convention is a-okay in my book.

    Overall, the Buy-Write Index has just outperformed the S&P and has done that with less risk. So calling into question a simple buy and hold strategy is a worthwhile, thought-provoking exercise.

  • Report this Comment On June 15, 2011, at 4:08 PM, davaidesign wrote:

    I think the article could have been titled "Buy and Hold the S&P 500 Is Dead", in which case I would agree, but Buy and Hold is not about the S&P 500, but individual businesses and their intrinsic value vs price paid equation.

    Sure, Buy-Write Index may have outperformed the S&P 500 in the last decade, but what does that have to do with Buy and Hold? Take an obvious defensive stock (ex: EXC - reinvest dividends) and let it ride the decade. How does that curve look?

    Ran into a 1977 Buffett article today from which a quote sums it up nicely: "Throw in an active options market, which adds nothing to the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further". It isn't different this time.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1506552, ~/Articles/ArticleHandler.aspx, 10/31/2014 5:37:30 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement