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Easy Money with Covered Calls by Jordan at Investing Blog

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A combination of cheap credit and volatile markets is paving the way for rampant investment in virtually everything, from stocks to futures. This trade, part of a play on negative real interest rates, is one of the biggest effects from quantitative easing.

A Perfect Storm

Negative real interest rates are known to create huge speculative bubbles where investors pile cash into an investment product to hold until rates rise. The idea is that an investor can borrow for less than the cost of inflation, making money in the change of their purchasing power should the asset rise in price at a rate equal to, or greater than inflation.

The investment looks even better if it can generate an income. From 2002 to 2006, negative real interest rates pushed virtually everyone into income producing real estate. Not only could you hedge against inflation, but the revenue also added even more to the bottom line. Since 2007, though, investors as a whole have attached a bad name to real estate. Today its all about equities and commodities.

Covered Calls and Income

Generating income with stocks and futures is easier than real estate, and clearly a number of investors are beginning to catch on. Whereas you have to find a tenant, strike a deal, and provide for upkeep on a home, owning a commodity or a company as a shareholder requires far less maintenance.

Besides dividends, covered calls are presenting an excellent way to draw income on holdings. Futures positions can be turned into monthly cash by writing calls at a far off strike, and the same can be done with shares of stock. With the cost to borrow in the pits, dividends paying decently, inflation above zero and volatility promoting higher options premiums, stocks and commodity futures are the new preferred inflation hedge.

The concern, though, is how this inflation trade affects commodities. Naturally, a small change in demand has a much larger impact on price. A huge change in demand brings a humungous change in price.

Holding stocks and bonds is now profitable, even if leveraged, financed, and generally purchased with borrowed money. What does that mean? Every dollar offered up as credit can be shoved into commodities and stocks and turned into more money. The gold rush has begun! An investor can borrow any amount of money, hedge through commodities, and generate positive cashflow with covered calls. That screams bubble and malinvestment.

Get Worried

The new bubble is underway. Already, the CME is increasing margin requirements on silver, cotton, and soon other commodities in order to cool the markets and reduce risk of nonpayment on highly leveraged speculative futures plays.

Before the CMEs move into silver, one could purchase a 5000 oz silver futures contract for just $5000, or $1 per ounce. Silver, of course, currently trades at a price of $27, for 27:1 leverage. Even after the adjustment to $6500 per lot, investors are levered to the tune of 19:1. That’s dangerous, but horrendously profitable, since investors can then sell calls against their 5000oz and bring in the cash flow.

If the Fed doesn’t cool soon, which even Bernanke admits it probably won’t, we’re going to see some serious bubbles in equities, commodities, and any other income investment.

About Jordan

Jordan is the web master of www.investingblog.org, a site dedicated to skillful investing, news and recent trends. You can read the original article here.

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