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Increasing Income Part II: CDs + Options = 5%?

 

To begin with, let’s understand that in an era when the 30-year Treasury bond is yielding less than 2%, the 1-year T-bill less than 1.7%, and most 1-year bank CDs paying less than 2.25%…and with most experts expecting rates to go even lower…to talk about achieving a safe 5% yield must sound ludicrous. But with some ingenuity and a very minuscule amount of risk it can be done.


Let’s assume we have $100,000 and want to earn 5% in 1 year. First, we are going to invest $99,000 in a 1-year FDIC insured bank CD paying 2.25%. (Example: Goldman Sachs Bank (“Marcus”). 


Regardless of what we do with the other $1,000 the CD will have returned $101,227 at maturity!


But ultimate our aim is to use the $1,000 to secure a very low risk option strategy which could generate an average profit of up to $53 per week, resulting in a total return of up to $3,773 for the year. ($53 x 52 + $1,000) This, together with the return on the CD, would result in a total return on our original $100,000 of $5,000 or 5%. Even if only partially successful, total returns of 2.5% -4% on the original $100,000 are highly probable.


So what is this option strategy?


First, understand that there is a commonly accepted method of assigning a probability that a stock or index will reach a particular level within a particular time period. For example, with the S&P 500 recently at 2900, there was a 90% probability that the index would NOT close above 3000, or below 2800 in 7 days. Our option strategy will be to take advantage of those 90% (or higher) odds every week or two to execute spreads and generate small profits with S&P 500 index options. 


This strategy does not care if the S&P goes up or down, only that it doesn't exceed the 90% probability range in either direction within the 1-2 week time period. If it approaches that level, a mid-course correction is done by "rolling" the appropriate spread. These spreads may be be held to expiration or closed at any time prior to that date to either (1) capture a smaller but still positive return, or (2) to prevent a negative return that would result if the S&P violated the 90% probability level. 


Finally, please note that all profits resulting from these option spreads receive special tax treatment: 60% of the profits are treated as long term capital gains, and 40% as short term gains...regardless of how long the spreads were held.


For more information, see "Going Forward"