An options strategy that generates additional returns on Nvidia
In equity markets, returns and market capitalization do not follow a normal distribution. Instead, they exhibit heavy-tailed, right-skewed, power-law characteristics: A very small number of companies account for a very large share of total wealth creation, while many (or even most) companies underperform. At a high level, this is because the potential growth of the biggest companies is “unlimited”. A shareholder can make many multiples of their initial investment, while, in the worst case, they have limited liability if a company goes bankrupt and can only lose the amount they initially invested. According to one study , the top ~4% of stocks generate all net long-term wealth creation while the median stock massively underperforms the index. Virtually every investor is familiar with Nvidia (NVDA) , Apple, Alphabet, Microsoft, Amazon, Meta, Tesla, Berkshire and Eli Lilly — the S & P 500’s 10 largest constituents. They might not realize that those companies delivered orders of magnitude more total return than the average constituent. A cap-weighted index fully captures these extreme right-tail winners in proportion to their success because their respective contributions to the index’s investment performance are functionally related to their size. As a stock’s market cap rises, its weight in the index automatically increases, and underperformers shrink in weight. We can observe this effect by comparing the total returns of two indices, both comprised of the same stocks, the S & P 500 (SPX) , which is cap-weighted and therefore doesn’t “rebalance” by selling winners and buying losers, and the other is the S & P Equal Weight Index (SPXEW) , which does rebalance, selling winners (strength) as their growth increases their share for the index to buy the losers (weakness) whose relative share of the index declines over time. Even before the results are reported, readers will likely suspect the outcome, as the equal-weight strategy does the exact opposite of what a common investing rule of thumb recommends: “Let your winners run, and cut your losses quickly.” Since March 1992, an investment in the equal-weight S & P 500 would have returned 2,528.6% — very nice, but an investment in the S & P 500 (cap-weighted) would have returned 3,046.76%, which is more than 500% nicer. If one stopped there, a reasonable conclusion is that one should simply buy a passive, cap-weighted index fund tied to the S & P 500 and leave it at that. It is a solid strategy and suitable for most investors. However, some might also observe that the stocks at the very top change over time. In the 1960s and early 1970s, Polaroid, Kodak, Digital Equipment and the predecessor to Kmart were among the stock market’s largest darlings. Polaroid, Kodak, and Kmart filed for bankruptcy. Digital was absorbed and essentially dissolved. Exxon was the largest company in the world for much of the 1990s, but it’s about a tenth of the size of Nvidia now. One reason top companies historically lagged was economic changes or management missteps. Few people use film today as imaging is almost entirely digital. PC’s took over from mainframes. While it’s true that some companies that were notable decades ago remain so now, such as Disney, McDonald’s, American Express, and Eli Lilly & Co., another reason the largest mega-caps rotate is the law of large numbers. Mathematically, growth rates for the largest businesses will either converge toward GDP-like growth rates or become larger than the economy itself. Something that cannot happen, will not happen. As I write this, the top 10 largest companies comprise more than 41% of the S & P 500 Index, a historically high level. Collectively, those companies generate about $2.5 trillion in revenues, or more than 8.5% of US GDP, and our actively managed fund held five of them: Alphabet, Lilly, Broadcom, Meta and Nvidia. Lilly’s success long predates the existence of the other four, and is unrelated, but it is unlikely that Alphabet, Broadcom, Meta, and Nvidia will all be in the top 10 of the S & P decades from now. Of the five, Nvidia’s growth has been the most extraordinary — and that’s the point. The growth hasn’t been good or even great; it’s unreal and cannot be sustained. I fully expect Nvidia to be the most profitable company in the S & P 500 in 2026, but I do not expect that growth rate to persist, and growth is the key to the power law’s benefits. If you own the stock, selling it may have adverse tax consequences. It is still a great company, but if you hope to generate additional returns from it, perhaps now is the time to consider selling covered calls, such as the January 195 calls at $5.65. Those offer nearly $10 in upside participation and offer a standstill yield of more than 3% ( > 22% annualized). DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. 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