Dear Reader:
Here you will learn how to use stocks, bonds, and stock options to generate regular (e.g., monthly) cash flow and for long term growth of capital. (No day trading involved.) Let me start with this two year (March 16,2015 to March 17,2017) stock chart of General Electric (GE). GE is a Company that you do not hear about much in the financial stock market news. To many investors, GE is a 'boring' company because its stock price has no recent upwards momentum. In fact, over the last one year (as of this writing 3/18/17), GE stock lost 4%; although over the last two years it gained about 18%. So, why am I interested in GE? It is because, as I said above, one of our goal in investing is to generate regular cash flow, and GE helps me to do exactly that. So, how do I do that? The answer lies in the chart of GE. I can not overemphasize the importance of studying a stock chart before investing in the Company. So, what do we see in the GE stock chart?
First, we observe that over the last year and a half GE stock price fluctuated - with some regularity - between 28 and 32. We say that GE stock price has a support at 28 and resistance at 32. This is a very highly desirable attribute of a stock for generating cash flow. For example, we could buy GE shares when it enters its lower price range and sell at upper price range. Also, note in the chart, that GE pays regular dividends as noted by the blue diamonds. So, we could also collect the dividend while we wait for the stock to go up. But here is the more interesting and useful technique that I use over and over again to generate monthly cash flow - I sell GE stock options, both Call and Put options. If you are not familiar with Stock Options do not worry. I will demonstrate these cash generating techniques by the use of a real and ongoing investment account as discussed below. Model Portfolio Now I will discuss the portfolio of a real ongoing investment account. An investment portfolio consists of a number of investment vehicles, e.g., stocks, bonds, cash, stock options, etc. This account was initiated on December 13, 2016 with an online brokerage house. Total capital invested is $20,000.00. Below is a screenshot of the account portfolio (as of Jan. 20,2017).
Fig. 1 Model Portfolio Status (Jan. 20,2017)
 Fig 1.Model Portfolio Status (1/20/2017) |
We acquired Johnson & Johnson(JNJ) on 12/20/16 at a price of $115.96 per share. JNJ is a large capitalization company in the Healthcare Sector, and a component of the Dow Jones Industrial Average (DJIA). Recently the price has come down to about $115.00 from a high of $126.00 in July, 2016. The long term price trend is upwards. The current dividend yield is about 2.8%, and JNJ increased dividend every year for a long time. So, it was considered a good buy. If JNJ price goes down further appreciably, we will acquire some more.
Next, Nuveen Preferred Stock Fund (JPS). One reason we acquired JPS is that Preferred Stocks pay high dividend. At our purchase price of $8.81,the dividend yield is 8.4%. In addition, it pays dividend every month, and from the 200 shares we would receive $12.40 every month to be credited in the account. They are not necessarily good for long term growth and fluctuate within a range for most part. But having some of these in a portfolio brings decent amount of regular cash. So, the trick is to buy them at the low price range. Over the last two years, JPS fluctuated between 8.25 and 9.75.
Our next holding is Nuveen Municipal Bond Fund(NUV). As in preferred stocks, municipal bond prices fluctuate in a range. But they pay good dividend which exempt from Federal Tax. Over the last two years NUV fluctuated mostly between 9.50 and 10.75. We acquired NUV at $9.52 per share. At this price the dividend yield is 4.2% paid monthly.
Next is SPHD. This is the Powershares High Dividend S&P 500 ETF. This ETF holds stocks from the S&P500 stock pool which are of low volatility and pay high dividend. So, overall, its growth will keep pace with the S&P500 index. Its current dividend yield is 3.83%.
Now, let us look at the allocation proportions of the total capital of $20,000.00 to various investment vehicles. An amount of $5,355.00 was allocated to stocks and bonds which is about 27% of the total $20,000.00 capital. Of the $5,355.00, $737.00 (i.e., 14%) was allocated to stocks for long-term growth (JNJ, SPHD), and the rest for producing monthly cash flow.
Over the last one year the stock market (as measured by the DJIA) has gone up by 23% - a substantial portion of it was contributed after the Presidential Election of 2016. So, we are taking a cautious approach in allocating funds to stocks at this point. But, in the meantime, we picked up some income generating instruments (JPS, NUV) at bargain prices; and as you can see in the account output, they are showing good gains. We will add to stocks when prices are 'reasonable'.
As I stated previously, one of our Core Principles in investing is "Cash is King" - generate as much cash as possible with as little risk as possible. Regardless of which way the market is going we wish to generate cash flow month in and month out. Once we have enough cash to spare, we will look for stocks to buy at a bargain price. The two main sources we will use for generating cash flow are (1) dividends from stock holdings, and (2) proceeds from sale of stock options. So, let's look at the portfolio to see how much cash we would generate from the current holdings. This portfolio will produce $290.00 per year from dividends from the $5,355.00 invested in stocks and bonds. Now, this is only from the dividends from stocks and bonds. The portfolio will also generate income from the sale of stock options on an ongoing basis. We will go over in details how to do this. For the moment, we just point out that we received $282.00 as proceeds from sale of stock options. So, for now, the total amount of cash for the year= $290+$282=$572.00. This is (572/20,000*100=) 2.86% annual cash flow for now. (The amount of cash flow will be higher since we plan to sell more stock options as time permits.) Next, we will discuss stock options.
Stocks Options These are financial instruments tied to an underlying stock. There are two types of stock options - Puts and Calls. We will first discuss how to generate income by selling Put Options Contracts. So, let us check the screenshot. Let us consider the first row in the holdings list. It starts with the code "GE Apr21'17 29PUT". This particular code defines a Put Option. So, let us take apart this cryptic code "GE Apr21'17 29PUT". GE is the stock General Electric. April21'17 is the Expiration Date. The figure 29 stands for the Strike Price. PUT tells that it is a Put option (and not a Call option.) The other parameter of this option is the "Premium" or "Price", and this is listed under the "Average Price" column as 0.44. Now, options are bought and sold in units called "Contracts". One Contract = 100 options. The "-1" under the "Positions" column tells that we sold one contract of this option, and as a result we received 0.44*100=$44.00. Now, when we say we sold a "Put Options Contract", it implies that there is a buyer and we are the seller. In addition, since it is a contract between the buyer and the seller, what are the terms of the contract? So, let us go over this. We sold this contract on December 19,2016. The contract expires on April 21,2017 (at market close at 4pm). The terms of the contract are "In the event that GE share price falls below $29.00 (the strike price) any time between December 19,2016 and April 21, 2017 we, the seller, are obliged to buy 100 shares of GE from the buyer at $29.00 per share IF the buyer wishes to sell them to us". Now, regardless of whether or not the buyer wants to sell the shares, the Brokerage House would like to make sure that we have the funds (here $2,900.00 in the account) to buy the shares if we have to. So, in a sense, our $2,900.00 is tied up for the contract period. (There are ways to get around this issue which we will discuss later.) Under the situation where the buyer exercises his/her right to sell the shares to us, we say that the contract was exercised. As a seller of the contract, we would like that the contract is not exercised so that after expiration date our tied up money ($2,300.00) would be free for use in whatever way we wish including selling of another options contract with the backup capital. At the time we sold this contract, GE share price was about $31.90. Now, at the time we sold this contract how could we be certain that GE share price would not go below 29? Of course, we could not be 100% certain about that. But, after various considerations of the company and its price history, we were reasonably certain that the chances of GE share price going below 29 during the life of the contract is very small. We will talk about these things later. Now, currently we have six open contracts of GE. How much cash do we need to have in the account to secure these six contracts? We already know that we need $2,900.00 for the first contract. For the second contract
"GE June16'17 27PUT" we need $2,700.00. So, let's add them up: 2,900+2,700+2,800+2,600+2,700+2,300=$16,000.00. So, ideally we need $16,000.00 in cash to secure the six contracts. But we have only $14,929.00. So, in a sense, we have oversold by an amount of (16,000-14,929=) $1,071.00. The Broker allowed us to do this because they take into consideration the value of the entire portfolio which is $20,133.00; the NLV. For our own record keeping we say that we are using a margin of $1,071.00, as if we took a loan from brokerage of this amount. Now why we did this? Answer to this question is complicated; and we will learn more in time.
Strategic Considerations in Put Options Selling A reader has raised the question "How to choose strike price and expiration date in put options selling?" This is an involved question, and may require a lengthy discussion which might raise more questions. But let me start. At the heart of this question lies the concept of "risk/reward". The strike price and expiration date needs to be selected simultaneously to optimize risk/reward. So, first, when we sell a Put Options Contract what risk we are taking? The risk is that we might have to buy 100 shares of the stock at a price higher than the market price, and hence might take an unrealized loss of capital. So, consider the first GE options contract "GE Apr21'17 29PUT". If during the life of this contract (i.e., from the date of sale of this contract Dec. 15,2016) to the expiration date of April 21, 2017) the price of GE share falls below 29 to, say, 28 (and buyer of our contract exercises his/her right to sell 100 shares) we would have to buy 100 shares of GE at $29 per share. In that event, we would take an unrealized loss of $100.00 of capital. So, we must make an assessment of this risk by asking ourselves the question "what is the probability of the stock price falling below the strike price during the life of the contract?" Now, it turns out, based on experience and options data, that for the great majority of options which are exercised, this takes place on the expiration date and not before that - but there are exceptions. So, for all practical purposes the question may be phrased as "what is the probability of the stock price closing below the strike price on the expiration date?" This probability can be numerically computed prior to selling the contract. We will come back to it later. But we can address the issue from a more pragmatic viewpoint. First, we do not like stocks which are highly volatile so that the price range of the stock during the life of the contract can not be predicted with any certainty. We like stocks of "low volatility" and having "somewhat predictable" price patterns. We can learn about price volatility by studying the price chart of the stock. (Yahoo Finance is a good source for obtaining price chart) So, let's consider the GE contract "GE Apr21'17 29PUT" which we sold in mid Dec.'16. We observe from the one year chart of GE that the price fluctuated mostly between $29.00 and $32.00 except for a brief period in late October when it dipped below 29. At the time we sold the contract in mid-Dec.'16, the price of GE was about $31.25. So, based on the above reasoning, one might conclude that it is unlikely for GE stock price to fall and stay below 29 during the life of the contract. So, a strike price of 29 seems a reasonable choice for GE for a put option 2 to 4 months ahead of mid-December. Now, before we make a final decision on the strike price of 29, we also need to choose the expiration date and the corresponding premium to make sure we receive a reasonable return for our capital. (Remember, ideally we need to have $2,900.00 in cash to secure the contract. ) In this process of selecting the expiration date, it is desirable to have an estimate of the Annualized Rate of Return (ARR). ARR=(Option Premium/Strike Price)/(Duration of Contract in Weeks)*52*100. In our example contract ARR=(0.44/29)/16*52*100=4.93%. Here, the duration is from Dec.15,2016 to April 17, 2017 which is approximately 16 weeks. The ARR tells us that if we repeatedly sell a large number of options throughout the year each with an ARR of 4.93%, we will receive 4.93% annual return of capital. It is essential to have an estimate of the ARR prior to selling an options contract. Now let us talk about the last options contract "GE Jan19'18 23 PUT". We received a premium of $0.53 per option or $53.00 for the contract. Now why did we select the $23.00 strike price ? We sold this contract in mid-December,'16, and the expiration date is Jan 19, 2018. So, the duration of the contract was about 56 weeks compared to only 16 weeks in the first contract. Since historically higher stock price ranges are associated with longer time intervals, we must take into consideration a much lower price than 29 as the strike price for this contract. Additionally, we must check the price history for longer periods to get a feel of how low the price has been over that time period. So, when we check the two year chart of GE, we observe that the lowest price was between 23 and 24. At this point, let me also introduce the concept of "safety margin" of a strike price. It is the percent difference of the strike price from the current stock price. Safety Margin=(Stock price-Strike price)/Stock price*100. So, the safety margin of this contract is (31.25- 23)/31.25*100= 36%. So, we are allowing for the possibility of a 36% drop of GE's stock price between Dec. 15, 2016 and Jan. 19, 2018 if we select 23 as the strike price. Now, the ARR. For this contract ARR= (0.53/23)/56*52*100=2.14%. (Note: The duration of this contract is about 56 weeks.) So, this is where the risk benefit consideration comes in. We are allowing for the risk of a 36% drop in GE's stock price and accepting a much lower return. For the purpose of comparison, let's compute the safety margin for the first contract : (31.25-29)/31.25*100=7.20%. Recall that the ARR for that contract is 4.93%.
So, let's summarize. Stock options provide us a wide range of flexibility in managing risk/reward for generating regular income. For selling a stock options contract, our first and major consideration is the underlying stock. We want to select stocks with low volatility of share price so that price movement is not erratic but somewhat predictable. Usually, stock prices of very large and established companies and large ETFs will have this attribute. Second, we must simultaneously consider the 'safety margin' and ARR for choosing the strike price and expiration date. Sometimes, it may take few iterations to finalize the structure of the contract. Also, keep in mind that there is an inverse relationship between safety margin and ARR. Sometimes we have to settle for lower ARR for greater safety. As the saying goes - " It is better to be safe than sorry."
Model Portfolio Update 1. (2/25/2017) Now I will go back to the Model Portfolio. Today is February 25,2017. So, the account is little more than 2 months old. (9 weeks to be exact). A screenshot of the portfolio is depicted in Fig. 2 below. First, from the summary line at the top we observe that the account has appreciated to a Net Liquidation Value of $20,541 having an unrealized profit of $475.00, and $34.00 of dividend to be received in about a month. Now, let us go to the holdings. We added shares of GE, SDIV (Global X Super Dividend ETF), AT&T, XLY (Spider Consumer Discretionary ETF), and XLK(Spider Technology ETF). Total value of stocks is $8,521.00 and we have $12,388.00 of cash (see Summary line). So, why did we by these stocks? Again, our decision about stock selection is driven by two criteria- generation of cash flow and growth (and , of course, prices should be reasonable). SDIV pays 6.81% annual dividend and is paid monthly. XLY and XLK are for long term growth. (To get a better feel about the stocks in the portfolio, you may wish to examine their stock chart via Yahoo Finance. At some point we will discuss how to select stocks for investment.) On the stock options side we sold a few more GE Put options contracts, and 3 XLU (Spider Utility ETF). Next I would like to draw your attention to the Unrealized P&L column and compare it with that of previous Figure 1. We observe that all of the entries (except one) in Fig. 2 are showing profits. Now for the stock positions it is easy to understand profit or loss - if the share price is higher than our purchase price we have a profit, otherwise a loss. However, when we sell stock options, it is the opposite meaning if the price of the stock option goes down below our purchase price we make a profit. ,I will go over this issue in detail later but for now let us compare the Unrealized P&L column of Fig. 2 with that of Fig. 1. We see that in Fig. 1, almost all the stock options positions of GE are negative meaning showing a loss (as of Jan. 20, 2017). Also note that in Fig. 1, the Market Price column shows a higher value than purchase price for the options - hence a loss. Now compare it with Fig. 2. You see opposite. The market prices of options are lower than the Average price - hence results in profit.
Figure 2. Model Portfolio Status (2/24/2017)
(4/5/17) Now, I will go over the status of the model portfolio as of 3/31/2017. A screenshot is given below in Figure 3.
Figure 3. Model Portfolio Status (4/5/2017)
"GE June16'17 27PUT" we need $2,700.00. So, let's add them up: 2,900+2,700+2,800+2,600+2,700+2,300=$16,000.00. So, ideally we need $16,000.00 in cash to secure the six contracts. But we have only $14,929.00. So, in a sense, we have oversold by an amount of (16,000-14,929=) $1,071.00. The Broker allowed us to do this because they take into consideration the value of the entire portfolio which is $20,133.00; the NLV. For our own record keeping we say that we are using a margin of $1,071.00, as if we took a loan from brokerage of this amount. Now why we did this? Answer to this question is complicated; and we will learn more in time.
Strategic Considerations in Put Options Selling A reader has raised the question "How to choose strike price and expiration date in put options selling?" This is an involved question, and may require a lengthy discussion which might raise more questions. But let me start. At the heart of this question lies the concept of "risk/reward". The strike price and expiration date needs to be selected simultaneously to optimize risk/reward. So, first, when we sell a Put Options Contract what risk we are taking? The risk is that we might have to buy 100 shares of the stock at a price higher than the market price, and hence might take an unrealized loss of capital. So, consider the first GE options contract "GE Apr21'17 29PUT". If during the life of this contract (i.e., from the date of sale of this contract Dec. 15,2016) to the expiration date of April 21, 2017) the price of GE share falls below 29 to, say, 28 (and buyer of our contract exercises his/her right to sell 100 shares) we would have to buy 100 shares of GE at $29 per share. In that event, we would take an unrealized loss of $100.00 of capital. So, we must make an assessment of this risk by asking ourselves the question "what is the probability of the stock price falling below the strike price during the life of the contract?" Now, it turns out, based on experience and options data, that for the great majority of options which are exercised, this takes place on the expiration date and not before that - but there are exceptions. So, for all practical purposes the question may be phrased as "what is the probability of the stock price closing below the strike price on the expiration date?" This probability can be numerically computed prior to selling the contract. We will come back to it later. But we can address the issue from a more pragmatic viewpoint. First, we do not like stocks which are highly volatile so that the price range of the stock during the life of the contract can not be predicted with any certainty. We like stocks of "low volatility" and having "somewhat predictable" price patterns. We can learn about price volatility by studying the price chart of the stock. (Yahoo Finance is a good source for obtaining price chart) So, let's consider the GE contract "GE Apr21'17 29PUT" which we sold in mid Dec.'16. We observe from the one year chart of GE that the price fluctuated mostly between $29.00 and $32.00 except for a brief period in late October when it dipped below 29. At the time we sold the contract in mid-Dec.'16, the price of GE was about $31.25. So, based on the above reasoning, one might conclude that it is unlikely for GE stock price to fall and stay below 29 during the life of the contract. So, a strike price of 29 seems a reasonable choice for GE for a put option 2 to 4 months ahead of mid-December. Now, before we make a final decision on the strike price of 29, we also need to choose the expiration date and the corresponding premium to make sure we receive a reasonable return for our capital. (Remember, ideally we need to have $2,900.00 in cash to secure the contract. ) In this process of selecting the expiration date, it is desirable to have an estimate of the Annualized Rate of Return (ARR). ARR=(Option Premium/Strike Price)/(Duration of Contract in Weeks)*52*100. In our example contract ARR=(0.44/29)/16*52*100=4.93%. Here, the duration is from Dec.15,2016 to April 17, 2017 which is approximately 16 weeks. The ARR tells us that if we repeatedly sell a large number of options throughout the year each with an ARR of 4.93%, we will receive 4.93% annual return of capital. It is essential to have an estimate of the ARR prior to selling an options contract. Now let us talk about the last options contract "GE Jan19'18 23 PUT". We received a premium of $0.53 per option or $53.00 for the contract. Now why did we select the $23.00 strike price ? We sold this contract in mid-December,'16, and the expiration date is Jan 19, 2018. So, the duration of the contract was about 56 weeks compared to only 16 weeks in the first contract. Since historically higher stock price ranges are associated with longer time intervals, we must take into consideration a much lower price than 29 as the strike price for this contract. Additionally, we must check the price history for longer periods to get a feel of how low the price has been over that time period. So, when we check the two year chart of GE, we observe that the lowest price was between 23 and 24. At this point, let me also introduce the concept of "safety margin" of a strike price. It is the percent difference of the strike price from the current stock price. Safety Margin=(Stock price-Strike price)/Stock price*100. So, the safety margin of this contract is (31.25- 23)/31.25*100= 36%. So, we are allowing for the possibility of a 36% drop of GE's stock price between Dec. 15, 2016 and Jan. 19, 2018 if we select 23 as the strike price. Now, the ARR. For this contract ARR= (0.53/23)/56*52*100=2.14%. (Note: The duration of this contract is about 56 weeks.) So, this is where the risk benefit consideration comes in. We are allowing for the risk of a 36% drop in GE's stock price and accepting a much lower return. For the purpose of comparison, let's compute the safety margin for the first contract : (31.25-29)/31.25*100=7.20%. Recall that the ARR for that contract is 4.93%.
So, let's summarize. Stock options provide us a wide range of flexibility in managing risk/reward for generating regular income. For selling a stock options contract, our first and major consideration is the underlying stock. We want to select stocks with low volatility of share price so that price movement is not erratic but somewhat predictable. Usually, stock prices of very large and established companies and large ETFs will have this attribute. Second, we must simultaneously consider the 'safety margin' and ARR for choosing the strike price and expiration date. Sometimes, it may take few iterations to finalize the structure of the contract. Also, keep in mind that there is an inverse relationship between safety margin and ARR. Sometimes we have to settle for lower ARR for greater safety. As the saying goes - " It is better to be safe than sorry."
Model Portfolio Update 1. (2/25/2017) Now I will go back to the Model Portfolio. Today is February 25,2017. So, the account is little more than 2 months old. (9 weeks to be exact). A screenshot of the portfolio is depicted in Fig. 2 below. First, from the summary line at the top we observe that the account has appreciated to a Net Liquidation Value of $20,541 having an unrealized profit of $475.00, and $34.00 of dividend to be received in about a month. Now, let us go to the holdings. We added shares of GE, SDIV (Global X Super Dividend ETF), AT&T, XLY (Spider Consumer Discretionary ETF), and XLK(Spider Technology ETF). Total value of stocks is $8,521.00 and we have $12,388.00 of cash (see Summary line). So, why did we by these stocks? Again, our decision about stock selection is driven by two criteria- generation of cash flow and growth (and , of course, prices should be reasonable). SDIV pays 6.81% annual dividend and is paid monthly. XLY and XLK are for long term growth. (To get a better feel about the stocks in the portfolio, you may wish to examine their stock chart via Yahoo Finance. At some point we will discuss how to select stocks for investment.) On the stock options side we sold a few more GE Put options contracts, and 3 XLU (Spider Utility ETF). Next I would like to draw your attention to the Unrealized P&L column and compare it with that of previous Figure 1. We observe that all of the entries (except one) in Fig. 2 are showing profits. Now for the stock positions it is easy to understand profit or loss - if the share price is higher than our purchase price we have a profit, otherwise a loss. However, when we sell stock options, it is the opposite meaning if the price of the stock option goes down below our purchase price we make a profit. ,I will go over this issue in detail later but for now let us compare the Unrealized P&L column of Fig. 2 with that of Fig. 1. We see that in Fig. 1, almost all the stock options positions of GE are negative meaning showing a loss (as of Jan. 20, 2017). Also note that in Fig. 1, the Market Price column shows a higher value than purchase price for the options - hence a loss. Now compare it with Fig. 2. You see opposite. The market prices of options are lower than the Average price - hence results in profit.
Figure 2. Model Portfolio Status (2/24/2017)
(4/5/17) Now, I will go over the status of the model portfolio as of 3/31/2017. A screenshot is given below in Figure 3.
Figure 3. Model Portfolio Status (4/5/2017)
