How to Earn the Income You Need in Retirement (Part 1)
- Nov 26, 2019
By Ed Pawelec
WHY ISN’T MY MONEY MAKING ME 20% ANNUALLY?
Most people either have a financial advisor or blindly put their money in mutual funds hoping for the best.
My friends, let me tell you right now, hope is not a way to make money.
My goal in writing this series is to help you turn your money into a stream of income.
To help show you how to generate the income you need to support the lifestyle you want.
How am I going to do that?
First, I’m going to show you how to use options to generate a consistent and reliable stream income.
But that’s not all I’m going to do for you.
The best way to learn something is to see it in action. That’s why I’m also going to make eight recommendations over the next eight weeks to show you how this strategy looks in action.
Not only will you see how this works first-hand…but you’ll be able to earn some extra income in the process!
So let’s dive right in one of the great tools you’ll need to generate the income you want – PUTS. WHAT IS A PUT?
A put option is a contract that gives its owner the right to sell a stock at a specific price (the strike price) within a specific time period (the expiration date).
The value of the put is derived from the price of the underlying stock and how much time you want to own that right to sell. If you were bearish on a particular stock, meaning you were expecting the stock to go lower, you might buy a put option.
The lower the stock price goes the more valuable the right to sell becomes. It costs money to buy a put and if the stock doesn’t go down, you could lose some or all of that cost or premium.
It stands to reason that if you buy a put option and you have to pay something, then the person who sold the put gets paid that something. Also, and this is important, as the seller of a put option you might be obligated to buy that stock.
But that would only happen if, and only if, the owner of the put chose to exercise his or her right to sell.
In other words, you can make money if the stock goes up or just goes sideways.
|Owns the RIGHT to sell stock at the strike by the expiration.||Has the OBLIGATION to buy stock at the strike by the expiration.|
|Buyers can exercise their rights.||Sellers can be assigned on their obligations|
|Pays a premium for the option.||Collects a premium for the option|
|One way to win: stock must go down to make money.||Two ways to win: stock goes sideways or higher to make money.|
LET’S PUT (pun intended) THE CONCEPT TO WORK
Let’s say that a stock is trading at $52 and, while you would like to own the stock, you are not willing to pay $52.
However, if the stock pulled back to $50, then you would be willing to pay that price. Now, you could place an order with your broker to simply buy the stock at $50, but if it never pulls back to that level you won’t own the stock and won’t be making any money. Instead you decide to sell the 50-strike put and you are able to $1 for that put sale.
(When we talk about trading options, we need to multiply everything times 100 because each option contract controls 100 shares of stock. That means that you would actually collect $100 for the sale).
The value of the put is represented by the blue line in the graph above.
If the stock is anywhere above $50 on the expiration date, you get to keep the $100. $50.01 is just as good as $150.01, but that $100 is the most you can make. With the stock above $50, the owner of the put is not going to exercise his or her right to sell at $50.
If, on expiration, the stock price is greater than the strike price, the put is considered out-of-the-money (OTM) and has no value. Who would want to sell the stock at $50 if the stock is trading at, say, $51? (If you have any inclination to sell a stock for a $1 less than it is worth please let me know, I will be glad to accommodate you. ?)
Now you may be thinking, “That’s only $100!”
Here’s the thing, if you consider that buying 100 shares of stock would cost you $5,000 (100 x 50) then earning $100 on a $5,000 investment is a 2% return. The key is that the 2% is generated in roughly 30 days.
You could buy a 10 year note from the US government and earn less than that over an entire year!
If you could employ this strategy every 30 days, over a year, you would earn better than 20%. You be the judge: 2% over a year or 20% plus over a year?
WHAT IF THE STOCK GOES BELOW $50?
You will notice on the graph above that the blue line move from the green area (profit) to the red area (loss) at $49.
That is your break-even point. The break-even for a sold (or short) put position is the strike price minus the premium collected. Let me explain the logic.
Let’s say that the stock on expiration is trading at $49. At that point the put option is considered in-the-money (ITM) and the owner of the put will exercise his or her right to sell and you will be obligated to buy the stock at $50.
At any price below $50 you will end up owning the stock. But that is ok because you had already decided that if it dropped to that level you would want to buy it anyway.
Because owning the stock is a possibility, it’s important to have the cash available to make the purchase. Again, to buy 100 shares of a 50 stock would cost $5,000. Your broker looks at it this way: you collected $100 on the sale of the put, that is cash money that has already been added to your account, so that means you only need $4,900 in available funds to make this trade. This is why your break-even is at $49.
I cannot emphasize enough: IF YOU DO NOT HAVE SUFFICIENT FUNDS TO BUY THE STOCK, YOU SHOULD NOT MAKE THE TRADE!
This is known as a “cash covered put”, meaning you have the funds to cover the purchase of the stock should that occur. This is very important from a risk management standpoint.
You are managing your portfolio and should think about how much capital you willing to allocate to each position and still allow for diversification. I am not alone in believing that 5 stocks in 5 different sectors provides a minimum level of diversification. So, if you are to employ this strategy divide the capital you are going to allocate to the strategy into 5 equal parts.
Getting back to an assignment on your put and owning the stock. The income generation process does not end if you get assigned on your put. Once you own the stock, you can then start selling calls against that stock position, but we will get into that next time. For now, let’s just remember what is important for this part of the income strategy.
A PUT SELLER SHOULD:
- Be willing to own the stock at the strike price.
- Have the cash available to buy the stock if it goes below the strike price.
- Allocate no more than 20% of your portfolio to each trade.
- Be willing to accept some volatility. Sometimes you may end up owning the stock, sometimes you won’t.
- Enjoy the income you can generate every month.
Behind the Markets