How To “Cash Flow” The Stock Market
One of the things that makes The Rich Dad Company so different from other financial educators is that we do not tell you what to buy or what to invest in.
Instead, we teach why an opportunity is good and we show you how many different things there are to invest in.
Real estate may be a good fit for many investors, but it’s not a great fit for all investors.
Similarly, stocks may make a lot of sense to most people, but certainly not all.
A good investment vehicle (stocks, real estate, business, commodities) needs to fit with your lifestyle, your personality, and your philosophies. There is no investment vehicle that is one size fits all.
Most people believe that stock investing is at odds with the Rich Dad philosophy of investing for cash flow. The reason people believe this, is because they think stocks are simply buying low and selling high. But an educated stock investor knows how to cash flow with the stock market, not just invest for capital gains.
As a stock investor, there are three ways you can use the stock market to accomplish your goals:
- Capital gain: Buy a stock share at a low price and sell it at a higher price — the difference between your buy and sell price is your gross profit.
- Cash flow: Have a stock portfolio that pays out dividends, or buy a stock share and option it to earn income for ongoing cash flow.
- Hedge: Buy insurance (options) on your stock share to protect it.
All three of these are valid actions. It’s important that you know about all of these different strategies so you can make smart decisions. Ask yourself this important question:
“What are my investing goals? Is one of them to increase my net worth? If so, what investments should I buy to accomplish this?”
There are three characteristics of the stock market that make it such a great vehicle to build wealth. Remember the richest man in the world, Warren Buffet, used the stock market to build his wealth.
The three characteristics are:
No investment is good or bad. There are no such things as bad investments, just bad investors. Your investment is only as good as you are. Before you get in the stock market you need to get educated.
Investing In The Stock Market For Capital Gains
If stock investors want to increase their net worth with stocks, they can buy shares and hold them in their portfolio, hoping they increase in value. Many people are already doing this through retirement plans such as a 401(k), an IRA, and mutual funds.
We’ll talk about it later, but this is the most common way to invest in the stock market. It’s what most people have in mind when you talk about how to invest in the stock market.
And it’s also the worst way to do it.
Investing In The Stock Market For Cash Flow
If your goal is to generate cash flow, you may want to use the strategy of selling options to meet your cash flow goal. Cash flow is valuable to you because it’s how you are able to feed your family and pay your bills.
Cash flow is better than capital gains for three reasons:
- It is resilient from market swings and market chaos.
- It brings money into your pocket on a regular basis (not imaginary “paper wealth” such as net worth).
- It is generally taxed at a lower rate.
Simply having an asset that increases your net worth does nothing to improve your cash flow situation.
There are many people who are rich on paper, but poor in cash. Lots of people found that out the hard way when the dot com bubble popped in the early 2000s. Thousands of “millionaires”, people who had stock options in high-flying tech companies, became “poor” overnight. That’s why Rich Dad encourages people around the world to think differently and seek assets that give them cash flow.
When you have assets that generate cash flow for you, it can help you now and through retirement. Remember: Net worth doesn’t help you retire; cash flow does. Your net worth doesn’t pay the bills; the cash that comes into your bank account each month does.
There are two ways that you can invest in stocks and follow the Rich Dad philosophy of cash flow…
The NASDAQ website says this about dividends:
At its core, a dividend is your share in the profits of a company you own. In return for purchasing stock, or investing in, a company you are given two basic rights. First, you have the right to participate in electing a board of directors to run the company, and second, you have the right to be paid a share of the company’s profits, at the discretion of that board. This is paid in the form of a dividend. When the board of directors releases company results at the end of each quarter, they will also announce the amount of dividend (if any) to be paid per share. Thus, if a company declares a $0.50 dividend for a given quarter and you own 100 shares, you will receive $50.
So if you were to buy stocks that pay regular dividends, then you are purchasing assets that add to your cash flow. With enough assets like this, you can eventually have the income to do whatever you like, right now, or in retirement.
#2 Covered Call Cash Flow
The covered call strategy is not for the uneducated. This is going to get a bit crazy. But once you get it, it’s very exciting!
Now, let’s explain cash flowing a covered call (a stock option):
A stock option is a promise by someone to sell a certain stock at an agreed-upon price until 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.
Stock options can be confusing so I’m going to use an example as it relates to real estate.
Let’s suppose that you are a landlord who owns a house. You find a family to buy the house, but they don’t want to buy it outright today. Instead, they decide to lease the house for three years with the option to purchase the house at an agreed-upon price at the end of the lease term.
While you are waiting for the lease to expire, you are earning money on the movement of time through rent. As the owner of a lease-to-own house, you will make money no matter what happens. It doesn’t matter if the value of the house increases or decreases. If the house increases in value beyond the agreed-upon price, the family got a good deal but you still got what you wanted since you set the price.
If the house goes down in value, the family will likely not buy the house at the end of the lease and you get to keep the house. Now you can go out and lease-to-own the house again. Rinse. Repeat.
While not exactly the same (you don’t receive payments during the term of the option contract), you now have a general idea of how a stock option works:
- You own Stock XYZ
- You sell an Option to buy Stock XYZ after a predetermined amount of time at an agreed-upon price
- At the expiration of the term, you receive the option premium.
- You either sell Stock XYZ at the agreed price or you retain ownership
The truth is, no one is truly free who is a slave to his job, his creditors, his circumstances or his bills. Wealth is the great equalizer.
Cash Flow From Selling A Covered Call Option
Now let’s shift from real estate examples into actual ways we can use this cash-flow strategy to make real money with options in the markets.
This is especially useful in difficult markets where buy-and-hold investors are suffering from crazy up-and-down conditions.
Let’s have Rich Dad Advisor on stocks, Andy Tanner, explain a covered call option:
As mentioned earlier, an option is a promise by someone to sell a certain stock at an agreed-upon price until 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 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 was 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 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.
As I said earlier, most people think that stock investing is at odds with the Rich Dad philosophy of investing for cash flow.
If they’re thinking of most people’s idea of stock investing—buy, hold, and pray—then yes. However, an educated stock investor knows how to cash flow with the stock market and knows the rewards of cash flowing the stock market.
Editor, Rich Dad Poor Dad Daily