When countries run persistently large budget deficits, politicians will tend take the path of least resistance and inflate away the amassed debt by depreciating their currency. Our politicians in the U.S. are no different than the ones in other semi-developed countries. Oil and other basic commodities are priced in $$. As the dollar depreciates, the $ price of these commodities will rise. You are now seeing this in the price of oil and gasoline and other commodities. Therefore, what is a simple strategy to protect yourself against rising fuel costs?
Why not buy shares in a very large integrated oil company that pays a good dividend and sell a call option against these shares to generate extra income. A call option gives someone the right (not the obligation) to buy your shares from you at a certain price within a certain time limit.
For example, let’s say you buy 100 shares of Exxon Mobile Corp. (symbol XOM) at today’s price (Apr. 12, 2010) for $6,871.00. You sell a call option for someone to buy your 100 shares (one call option =100 shares) from you between now and the third Friday in October for $7,000. For this you will receive $274.00 (today’s closing price). This $274.00 is yours to keep no matter what.
Assuming prices remain constant (which they will not), what is your annual rate-of-return? You earned $274.00 in six months or $548.00 on an annual basis. Divide $548.00 by the cost of your 100 shares of XOM ($6,871) and you get an annual return of 8.0%. In addition, you earn a 2.40% annual dividend return on your 100 XOM shares. This gives you a total annual return of 10.4%. Not bad, but there are risks.
RISKS: There is no such thing as a riskless investment. If your 100 shares stays at or north of $6,871, you will make your 10.4% return. Of course, if it should shoot up to $90/share, you could have made more by just owning the shares and not selling a call option. But, this is a hedging investment strategy.
The real risk: Oil is a commodity and it can and most often is very volatile in price swings. If the price of oil should plummet, so will the price of XOM stock. You will then incur a real loss. The premium you collected, $274.00, will give you some downside protection but not enough in a highly volatile market.
You should only employ this investment strategy if you feel it is suitable for your investment objectives
. In the calculations above, I omitted commission costs. If you wish to employ this strategy, do not use a full-service brokerage house. Their commissions will decimate your rate-of-return. You should use a discount broker and do it online.