See how to earn an extra monthly “dividend” by investing in stocks – 07/17/2023 – From Grão to Grão

Whenever I write about insurance, I get comments that it’s expensive. However, many who believe that insurance is expensive do not know that they can take advantage of it themselves. Yes, there is a strategy that amounts to selling insurance against a stock market crash. Do you have the courage to enter? I explain how it works.

An insurer earns earnings by collecting insurance premiums so that these premiums offset losses generated by claims.

This process can be replicated in the stock market and is carried out by a number of investors as an alternative to obtaining monthly income, but with less risk than that normally attributed to the stock market. If well implemented, it can result in yields greater than a few times the return on the CDI.

When we talk about earning income from the stock market, we immediately think of dividends distributed by companies.

However, this is not the only way, nor the one with the lowest risk.

Another strategy employed by institutional and individual investors is the so-called “Covered Call”. In Brazil, this strategy is also called financing with call options or covered launch.

To set up the operation, a derivative called a call option is used. A call is a right to buy an asset, for a certain price, called the strike price, and at a specific time in the future. The name covered call comes from the way the operation is structured. I explain next.

How to build the strategy?

The strategy is formed by buying a stock and selling a call option on the same stock. That is, the right is sold so that another investor can buy its share at a certain price, called the exercise price, at a time in the future.

The sale of the right provides the gain of a premium to the seller, in case you are an investor.

This premium is similar to the premium you pay an insurance company for car insurance. Making an analogy to car insurance, the claim would be the share price falling and in this case, the premium received may not be enough to cover the loss with the share you own.

For example, let’s set up the operation with Petrobras preferred stock (code: PETR4) which had a closing price on Monday of R$28.99 per share and the call option (code: PETRH299) on same share due on 08/18/2023, exercise price of R$28.69, which ended today at R$1.57.

The strike price is the price that the buyer will be entitled to pay for its share on the expiration date. The strike price that provides the highest return to the investor is usually the one that is closest to the price of the underlying asset at the time. However, there is a more relevant factor that I address at the end of the article.

Disregarding the transaction costs, if the share rises and is above R$27.42 (=28.99 – 1.57) on 08/18/2023 – the option expiration date – the investor would make some profit. Otherwise, it would be at a loss.

The maximum profit occurs if the share closes exactly at the price of R$ 28.69 at expiration.

In this case, you earned BRL 1.27 for each share.

Note that the premium received on selling the option represents a yield of 4.38% (=(28.69 + 1.57 – 28.99) / 28.99) over the period of almost one month.

This is a gain well above the CDI in the same time frame, which would be 1.05%.

Imagine that if you invest BRL 200 thousand in this strategy, you can receive around BRL 8.7 thousand per month.

However, there is a risk that the stock will fall, which we would call a claim in the language of the insurer and the investor could have a loss in that period.

As with insurance, there are some ideal conditions for setting up the strategy that I will discuss below.

When to set up the strategy?

An insurer may adjust the premium received when the risk of a claim increases. For example, car insurance for a young person is more expensive than for an older couple. However, in this strategy in the financial market, you cannot adjust the price of the premium received by your expected claim.

Therefore, you should only set up this strategy if you believe that the stock will continue to rise, or at least not fall, as, in this way, you earn the premium on the sale of the option. Therefore, the ideal time to set up the operation is when the stock has already fallen a lot and you believe it should not fall any further. It would be equivalent to an insurance company only selling insurance to people it believes will not crash their car.

However, here’s a warning. Contrary to what some say, this strategy can cause severe losses to the investor in case the market shows devaluation.

Every investment in stocks deserves caution. It is no different here, as this strategy does not have a risk similar to that of fixed income. This strategy is not suitable for the conservative investor.

For those who have a stock portfolio, carrying out this strategy is a good way to obtain additional income to the dividends received by the company.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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