Use this Natural Resource for Income

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Posted by The Savvy Retiree on June 27, 2016 in Money Saving Strategies, Personal Finances

Karim Rahemtulla writing on financial freedom…

One of the biggest arguments against holding gold is that it provides no returns in terms of income. But there’s a very simple strategy that can produce a sizable income stream from gold holdings.

I’ll tell you all about it shortly. Here’s why the strategy might make sense for you.

Gold is not a stock that appreciates over time, nor is it an asset that pays a dividend yield. It simply sits in a vault somewhere. That’s why many investors dislike gold. They believe that owning gold “robs” them of an opportunity to make money in some other type of investment.

Of course, most investors who own gold aren’t looking for a short-term pay-off, but a long-term avalanche of profits…as fiat currencies are debased and financial catastrophe is all but inevitable.

Then there are those who are caught in between…

They don’t have the super-deep pockets to store a few hundred ounces away in some vault in Toronto, Zurich, Perth or their own backyard. They are the investors who look to gold and mining shares as a proxy investment, one that mirrors the price of gold and can vastly outperform the metal when it makes its inevitable runs.

But it’s between those runs that a gold investment sits dead in the water, paying no dividends and often underperforming the general stock and bond markets.

At times like those, it pays to know a simple strategy that can offer double-digit returns.

It’s called “covered call writing.” You may have heard of it. In case you haven’t, it means using the options markets to enhance your returns or reduce your cost.

It allows you to generate a return from your holdings without selling your shares… if you do it properly. Here’s how covered calls work:

• You have to own shares of stock.

• Against those shares, you sell call options in the options market that are equivalent to the number of shares you own. For example, if you own 1,000 shares, you would sell 10 contracts, as each options contract equals 100 shares.

• You pick a strike price, which is the price at which you are obligated to sell your shares at a future point in time.

• You pick an expiration date for the option.

By entering into a covered call, you are selling someone else the right to buy your stock at a specified price by a specified date. The key is to figure out at what price you are willing to sell your shares. That pretty much determines everything. If you are not really interested in selling your shares at any price, then you will sell calls that are way out of the money.

This means if you own shares of a company like Goldcorp (NYSE: GG), which is trading at $16.60, you would sell $30 calls expiring a few months out. You will generate some income – more than your checking account or a CD – but not a huge amount.

However, if you decide that you are willing to part with your shares at a more reasonable level that is still profitable, like $22 or $25, you can pull in some nice double-digit returns on your position while still having a very good chance at keeping your shares…unless gold really takes off.

Alternatively, what I like to do is hold a core position in gold shares and establish a secondary position just for selling covered calls. My rationale is that I want to build a position in gold shares, but I want to be able to reduce my cost to as close to zero over time and/or generate income from this secondary position.

So, I am interested in getting something more immediate from my holding, knowing that I may be forced to sell it at a higher price than I paid for it…generating a shorter-term return, which is just fine by me.

Here is an example of a trade that I would make. I would buy Goldcorp at current levels of $16.60 and sell the Goldcorp October $20 calls. They are trading at around $0.80 per contract.

Here’s how things could pan out: If I bought 1,000 shares, I would spend about $16,600. By selling 10 contracts against the position at $0.80, I would receive $800 back immediately, reducing my cost to $15.80. For doing this, I have obligated myself to sell my shares at $20 at or by expiration – but only if the price trades at that level or above.

If my stock got “called away” at $20, my profit per share would be $4.20, on a net cost of $15.80. That’s a return of 26% in less than five months. If the shares did not trade above $20 at expiration, then my return would be $0.80 over my net cost of $15.80, or 5% in less than five months.

I’ll take either one, knowing that I would either own Goldcorp at $15.80 and be able to sell more options against the position or that I would make a serious return of more than 25% in a matter of five months if gold shares rally.

(It’s worth noting that you can sell covered calls in a retirement account like an IRA as well, which allows for tax-advantaged investing.)

Of course, there is also the possibility that gold and gold shares will tank, which would result in either a paper loss or a real loss if I decided to unwind my position and sell. But then again, that is the case with any investment.

Selling covered calls is not ideal for every type of investment. But in the gold market, it can dramatically improve your results.

Image: ©ünay Mutlu