Need Cash Flow? Try This Options Trading Strategy
If there’s one thing the rich do differently than the poor, it’s that they put their money to work instead of working for their money.
What does that mean?
Their money isn’t just sitting around in a savings account, accruing little-to-no interest, waiting for a rainy day. Their money is being invested — and delivering a return!
Different investments produce different results.
Most investors today are chasing capital gains in the stock market through stock purchases, mutual funds, and 401(k)s. These investors are hoping and praying the money will be there when they get out. To me, that’s risky.
As long as market prices go up, capital-gains investors win. But when the markets turn down and prices fall—something nobody can predict—capital-gains investors lose.
The cash-flow investor is not as concerned as the capital-gains investor whether the markets are up one day or down the next. We want to make money if the market goes down; we want to make money if the market goes up; we want to make money if the market goes sideways.
The best thing about cash flow is that it’s money flowing into your pocket on a continual basis—whether you’re working or not. You could be on the golf course, jet-setting around the world, watching Netflix, or building a business, and your money is busy working for you.
Buy-and-hold investing, such as what you typically see with mutual funds and 401(k) plans, is usually an attempt to increase the value of an entire account through capital gains. When the market goes up, the account goes up. When the market goes down, the account goes down. That is not cash flow investing.
My advisor on paper assets, Andy Tanner, says cash flow investing should offer:
- Proven strategies to extract cash from the market on one’s own timetable
- Ability to make profits at regular intervals
- Excellent rates of return
- Ways to manage the risk to protect capital
- Simple enough strategies for the average person to learn and implement on his or her own
Cash Flow From Selling A Covered Call Option
As a reminder, an option includes a promise by someone to buy or sell a stock at an agreed-upon price on or before a certain date.
In return for this promise, he receives a premium as income. This premium is not just based on the movement of the stock price, but on the movement of time.
As you advance in your knowledge and experience with options, you might be surprised to find just how much stock you can take control of for relatively small amounts of money and risk.
Let’s have Andy Tanner explain a covered call option:
As a teacher, I’ve seen how hard it is for many people to grasp the ideas of time decay and cash flow in the stock market. I know it certainly took some time for the light to come on for me. So a few years ago I made a small trade just for the purpose of teaching. I chose to hold a stock for a long time regardless of the fluctuation in its value, just as many real estate investors hold their rental property regardless of fluctuations in the price.
To show my students the similarities between stock investors selling options and real estate investors collecting rent, I bought an Exchange Traded Fund (ETF) and held it for a year. It’s not my usual practice to hold stocks that long, let alone buy anything that is heading down. But my goal was to prove that it is possible for a falling stock to generate income just as a house that is declining in value can still generate rent. This is not hypothetical. This is an actual series of very small trades I did during the subprime meltdown of 2008.
My first step was to buy 500 shares in an exchange-traded fund called the Spyder Trust (SPY), which mimics the S&P 500. This was very important because the SPY simply mimics the S&P 500. I was going to hold it for a year, come what may. After buying it, I watched it closely to see if it going up, down, or sideways.
Since I owned the shares, I was positioned to be the seller of an option instead of the option buyer.
After buying 500 shares of the SPY exchange-traded fund, I then sold five, one-month call option contracts on SPY at a premium of $2.15. I promised the buyer that he could buy the Spy for $154 (which was more than I paid for the SPY) at any time before the expiration date.
The stock could now go in one of three directions:
- If the stock went up and he wanted to buy at $154, I would have made money since I bought it at a lower price.
- If the stock went sideways and stayed below $154, the option would expire worthless, and I would have kept my $2.15 (multiplied by 500) premium in cash flow. This is just like a house where the value remains the same. I would still be getting that rent as income.
- If the stock went down, the option would expire worthless, and I would keep my $2.15 premium (multiplied by 500).
You can see that I have set up a scenario where no matter what happened, I would generate income from an asset I had purchased. To me, this was a very attractive way to generate my own income. I bought 500 shares and then I sold those options. That’s five one-month contracts of 100 shares, each at a premium of $2.15. When you do the math, you’ll see that I created an income of $1,075, less the brokerage fee, so I received a net $1,061.
Even though the stock was falling in value, I continued to sell options on my shares of the SPY month in and month out for a whole year. Why? Because I am not much different than a real estate investor who sees the value of his rental house decline for a season. He is receiving his rent each month and I am also receiving my income every month from options. This income flows in even as we both wait for the underlying value of the assets to bounce back. I get to keep the stock while the time decay is bringing in cash.
This shows you how to own stock assets and generate an income from them.
True cash-flow investing is when the underlying asset, whether it’s a house or a stock, can go down but cash flow stays fairly consistent.
What Everyone Can Do
To me, Selling options for cash flow is fun. One of the reasons I do not worry about money is simply because I know I can go to the market and make more money in minutes than most people make in months, and pay less in taxes.
Can everyone do what I do? Absolutely, but only if they are willing to invest some time in expanding their context and increasing their financial context.
After Kim and I were married, while we were building our business and our investments, we allocated three to four times a year for business or investment education. The good thing about building a business and working on our investments was that we could apply what we learned immediately. Together, we took classes on advertising, gold, options trading, writing sales letters, foreign-exchange trading, creative financing, foreclosures, and asset protection.
Like rich dad, this is how Kim and I gained and continue to increase our financial knowledge.
So what can everyone do? The following are some suggestions:
- Borrow a book from the library on options trading. First, learn the definitions of words. Then read for greater understanding.
- Buy a book. I recommend physically reviewing the book before buying it because you may want to start with a simple book first.
- Attend a seminar or class on options trading. There are many available.
Editor, Rich Dad Poor Dad Daily