Make the Most of Higher Interest Rates With This Options Strategy

A reasonable risk-free return is attractive after decades of one historic market event after another—the Asian contagion in 1998, the bursting of the internet bubble in 2000, the global financial crisis of 2008-09, the Covid meltdown of 2020, and whatever is happening now as global central banks raise interest rates to battle inflation.

The cash return is below the stock market’s long-term annual average of about 9%, but investors interested in enhancing yields without sharply increasing risk may find attractive opportunities in the equity options market.

Here’s the plan: Put 80% or 90% of your cash into bonds and the remainder into whatever interest-bearing account your broker allows to be used to finance options strategies. You then will sell puts on a blue-chip stock worthy of long-term ownership.

Right now those puts, giving the buyer the right to sell the stock at a certain price, command attractive premiums as buyers pay up for downside protection. The special brokerage account ensures that you’d be able to buy the stock should it fall below the strike price.

Think about selling puts that are about 10% out-of-the-money and that expire in four to six weeks. This could generate about a 1% monthly return on the cash used to secure the put.

The upshot: Investors can benefit from attractive fixed-income yields while monetizing the rising fear-premiums in put options. The bulk of an investor’s money is invested in bonds, and money that is needed to finance cash-secured put sales is also in an account that pays attractive interest rates. The put premium is gravy.

The risk to selling cash-secured puts is similar to buying stock: You can lose money. If the stock market plummets, which could happen if the Federal Reserve raises rates more than expected, or China’s economy craters, or corporate earnings deteriorate, short-term feelings tend to overshadow long-term objectives.

Of course, investors must proceed according to temperament and risk tolerances while keeping one eye on the yield of the 10-Year Treasury bond yield—it arguably holds the key to the stock market.

We have seen, again and again, that stocks do not like 10-year yields of 4% or higher. At that level, yields disrupt popular valuation models used to value multiyear earnings.

Market leading big technology stocks, whose equity prices reflect the perceived value of multiyear revenue streams, are particularly vulnerable to valuation vicissitudes. If yields keep rising—and that is the biggest if in the financial world—stock prices will likely drop.

The blended bond and options approach puts investors into a fighting stance that we have long described as time arbitrage.

The stock market seems unstable, so be judicious with strike prices and expirations and never sell puts on a stock that you are not willing to own.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.

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