Editor’s Note: On Monday, Chief Income Strategist Marc Lichtenfeld explained how convertible bonds can offer investors “the best of both worlds” – the upside opportunity of a stock with the security of a bond.
But Marc’s not the only one with his eye on this unique investing vehicle…
This week, we checked back in with Karim Rahemtulla, our good friend and Head Fundamental Tactician at Monument Traders Alliance.
You might remember that Karim used to cover options trading for our readers. In his new role leading The War Room alongside Head Trade Tactician Bryan Bottarelli, he’s been helping regular folks profit by trading this volatile and quickly changing market.
Read on below for the full scoop on how Karim snagged a more than 20% gain in just a few days by merging the power of options with the appeal of convertible bonds.
– Mable Buchanan, Assistant Managing Editor
One system that I developed in the ’90s has never failed me…
The system relies on deep-in-the-money covered calls.
I know it’s been a while since I’ve written to you here at Wealthy Retirement, so if you need it, here’s a quick refresher…
A covered call is a type of options trade where you sell an option against a stock you already own. This can help you generate extra income, and you can do it in any kind of account.
It’s a great, lower-risk style of trading for investors who may be new to options.
That’s because covered calls are not a speculative type of trade, but a type of trade that falls in line with more “typical” investing, where you are looking to beat the market consistently.
Let me show you how it works with an example of a play we just did in my fast-paced research service, The War Room.
If you’ve been reading my free e-letter Trade of the Day (If you haven’t been, why not? Sign up at the end of this article), you know we made 20%-plus on Bloomin’ Brands (Nasdaq: BLMN) earlier this month.
It took a few days, and we used a “typical” covered call strategy. But that also meant taking on more risk if the play went south.
I went back to the well with Bloomin’ Brands and took advantage of some hypervolatility.
The company had just made an announcement that it was raising money with a convertible bond offering.
As Marc told you on Monday, when a company issues a convertible bond, it is saying, “I will pay you a lower interest rate and give you the opportunity to convert the bond into shares.”
If those shares are higher at the end of the term, there could be some massive profits in addition to the interest received.
But when the deal is announced, the underwriters never release the actual terms of the deal until a day or two later, after they gauge interest.
That’s when we take advantage of the anomaly. Basically, the market is flying blind. The share price goes down, and the volatility in the options increases. That’s the time to strike.
We bought in at the market. But instead of selling an option above the share price – like “typical” covered call sellers do – we sold an option well below the share price. This can be done when options premiums are elevated across the board.
So instead of buying the shares at $9 and selling the $10 options, for example, War Room members would buy the shares at $9 and sell the $7.50 options.
This gives us downside protection and locks in a profit unless the shares trade below $7.50 less the premium received.
We may not make as much… but in this market, we must look to the downside as well.
In this case, the $10 option was trading for $1 and the $7.50 option was trading for $2.20.
If we sold the $10 option, our cost would be $8 and our upside would be 25% ($10 strike price minus $8) only if the shares closed above $10 at expiration.
By using the $7.50 option, our cost was $6.80, and the profit potential was 10.2%.
But War Room members have less money at risk and will win if the shares stay at the same price, go higher or even go lower.
The only way we stand to lose on the play is if the stock drops below our cost, which is almost 25% below its current price.
We see anomalies like Bloomin’ Brands pop up in the market regularly. “Typical” investors pass them up all the time.
However, my probability calculator places the odds of winning with this trade at more than 83%.
I’ll take that any day.