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Investing for Income

Posted on the 09 April 2011 by Phil's Stock World @philstockworld

My intention is to test-drive a virtual portfolio of $500,000 and see how it performs over time, our goal is going to be collecting $4,000 a month, nearly 10% without touching the principal and we’ll see how it performs over time.  Of course we will be favoring dividend stocks but a little option selling also allows us to make our own dividends.  We’ll do our best to account for margin requirements as well.  

I don’t want this to be a high-touch portfolio, that would not fit in well with the kind of investing we’re looking at.  However, unlike building a long-term portfolio early on in life, we won’t be scaling in as much because – if someone just collected a $500,000 life insurance policy but needs $4,000 a month to live on, then if they wait two years to build up a portfolio properly they will likely have eaten into 10% of the principal.  Of course – over-investing can cause just as much damage and I REALLY wish the market wasn’t so toppy but my Dad just died and my Mom has to deal with this now and her friends have issues now – they don’t all have the luxury of waiting for better market conditions.  

Investing for IncomeBack in October, we had thought the market may be toppy but we also wanted to add some bullish positions so I put up a Portfolio Titled "Defending Your Portfolio With Dividends."  I won’t spend time here trying to re-sell the idea of going with dividend stocks – you can read the logic in that post and the chart on the right says it all.  Things are tricky now as we have to worry about both keeping an income flowing AND keeping up with inflation, which remains a concern.  

Also, I want to be clear about this – in no way, shape or form is it a good idea to use your savings for income unless you absolutely have to.  Over the long haul, it is STUNNING how much damage you do to your future with every dollar you pull out of even a modest growth fund.  If you have $500,000 saved up and you still have the ability to work to support yourself – it is very foolish not to do so.  After just 10 years, $500,000 invested at 6% becomes $895,000 at 10% it’s $1.3M – so choosing NOT to work and earn $50,000 for 10 years costs you $800,000 at the end of those 10 years – is that smart?    

If you are 55 or even 65 – always consider the great benefit you would have by not tapping into your retirement savings early.  In case one, you are 55 with $500,000 and you draw $50,000 a year (best case, by the way) in income and any time the market dips you get less or, in a crash like 2008, you can lose half your savings and income.  When you are using your principal for income, you have nothing to reinvest in a crash.  On the other hand, if you work those 10 years to support yourself and your reinvested money makes 10% a year compounding – then you have $1.3M (best case) and, even if it’s cut in half $650,000 – quite a bit better off than the early retirement would have left you.  

Investing for IncomeOf course this is general advice, I’m not a financial adviser and you need to consult one who takes your whole financial position into account – including the tax ramifications of various investments.  What we’re trying to do here is explore an investment strategy that may be a good fit for people who do need to tap their nest egg.  

We are, of course, going to be revisiting some of our favorite dividend payers so consider this a continuation, somewhat, of the prior portfolio but, as I said, here our primary goal is to generate an income with as little fuss as possible.  We will be looking for quarterly money, not monthly as dividends pay, usually in quarters.  Feel free to add ideas in comments under this post, after reading the trade ideas below, I’m sure you’ll have some of your own…

NLY is a REIT that pays out their profits as dividends.  REITs are very scary in that they move up and down with the economy and they typically carry huge amounts of debt so you need to be very careful with them but this one pays a .62 quarterly dividend on a $17.23 stock price works out to 14% a year.  Before you sell your house and mortgage your kids to buy NLY though, keep in mind that they paid .68 in 2002, .60 in 2003, .50 in 2004 and .11 in 2005.  The dividends are PROFITS and, sometimes – there just aren’t any.  

3,000 shares of NLY are $51,690 and we can risk getting called away by selling 30 2013 $12.50 calls for $4.95 ($14,850) and risk buying 1,500 more shares of the stock again by selling the 2013 $15 puts for $2.05 ($3,075).  The put selling is good in an ordinary account.  Think or swim says the net margin on the sale is $1,585 so that’s a great return on margin and $3,075 is 27% of the $11,250 margin that buying 1,500 more shares would cost (at 50% pm) so this is simply a long-form method of scaling in – taking our cash in advance.  

Initial proceeds generated: $17,925.  Cash used $33,765.  Margin tied up: $30,505.  Dividends expected $13,020  Cash returned: $37,500.  Caller’s premium (risk of being called away): .27.  Cash removed – None.       

Investing for IncomeSee that wasn’t hard, was it?  We’ve already got $17,925, which is more than we need for our first three months.  Now you know why I threw all those idiot financial advisers out of my Mom’s house!  Now, let’s talk about what can go wrong and what is misleading.   First of all, we are buying the stock for $17.23 and selling it for $12.50.  That’s not very smart is it?  But we’re not really buying it for $17.23, we are buying it for $17.23 LESS the $4.95 we’re selling the calls for and less the $1.02 per long we are selling the puts for.  That’s net $11.26.  While getting called away at $12.50 is not sexy, what we have is very good downside protection.  We’re also not touching the money for now, we’ll get that elsewhere.  

Unfortunately, when a company pays a big dividend, like NLY, it’s very possible that you will get called away on deep calls just ahead of the dividend.  From the caller’s perspective, they are paying $4.95 to keep a tab on the stock, tying up very little capital between dividends.  On dividend day, they exercise the option, hold the stock for 24 hours to collect the dividend (.62 is 12.5% if $4.95!), then sell the stock and buy more long calls to do it again.  If you have a hedge fund and you are very organized, this is a great way to play but too annoying to track here.  No, our "danger" in this set-up is that we will get called away in June ahead of dividends with "just" a .27 profit but that is still $1.08 a year on our net $12.28 entry, which is 9% so I’d rather have very good coverage to start and risk only getting 9% instead of 14%.  As the position matures, we can lighten up on the coverage but, for early entries, safer is better.  

So, aside from the danger that the stock will go down or they will not pay their dividend (or both) or that tax regulations will change to make dividend income less attractive (very possible) we have the additional "danger" of being called away with a smaller gain than expected.  That is why it is CRITICAL that you sell calls for as much as possible and the BEST thing that can happen to you is the stock goes down after you sell the calls because that will make the caller less likely to execute and take the loss.  

Investing for IncomeGetting the stock called away is not a big deal at all, you keep the $4.95 plus the caller has to give you $12.50 of cash for the stock – but then you have to rebuy the stock (if it seems worthwhile).  The nice thing about selling the puts along with the trade is that, if the stock goes up so much that it does not seem worth buying back, then logically the puts should be going well in your favor and you will make money there.  Also, typically stocks drop on dividends and, if you are lucky, you can get back in cheaper than the $17.45 cash you have to spend.  If not, the trade needs to be re-evaluated each quarter as if it’s a new one.  

We also, of course, have the risk of assignment if the stock goes very low.  That we treat just like any other short put play and we either take our loss, wait it out or roll but keep in mind that the margin requirement on the short put goes up as the stock drops so we never want to over-commit on those.  These issues are a concern on every position – hopefully this gives you an idea of what I’m summarizing above.  The bottom line on this one is we lay out net $33,765 and we expect to resell the stock for $37,500 (at $12.50 or better, which is 27.5% below the current price) – a profit of 11% in 19 months.  We HOPE to collect a quarterly dividend of .62 ($1,860) although we may get called away with just a .27 profit ($810), which is still 9.5% (annualized) of $33,765.  

This stuff is not supposed to be sexy – we are going for conservative plays that hopefully outperform "regular" conservative investment strategies and leave ourselves with potential bonus upside when we can.  We do far more aggressive plays all the time in Member Chat – these are not them!  

AGNC is another REIT I like.  They don’t really own buildings though.  AGNC nvests in agency pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by a U.S. Government agency or a U.S. Government sponsored entities.  I think they sold off on fears of a Government shutdown (now averted) and I’m inclined to play this one a little more aggressively.  Their quarterly dividend is $1.40 but was .30 in June of 2008 – as with everything, it works until it doesn’t.    

2,000 shares of AGNC at $28.31 ($57,020), selling June $28 calls for $1.10 ($2,200) is over the current net price, of course.  Still a danger of being called away as the dividend is more than the option but perhaps we roll the caller ahead of June if the ex-dividend date comes sooner than options expiration (ah, and you thought there would not be homework!).

Initial proceeds generated: $2,200. Cash used $54,820. Margin tied up: $28,510. Dividends expected $2,800 Cash returned (if called away): $56,000. Caller’s premium (risk of being called away): .79. Cash removed – $2,200.   

Investing for IncomeNow we have $100,000 worth of real estate investments.  Maybe it’s time for a hedge.  There are several ways to hedge but we’ll concentrate on hedging for income here.  IYR is the Dow Jones Real Estate Index and it’s filled with REITs.  In fact, NLY is 3.5% of the holdings.  A way to hedge a major crash in the IYR (it fell from $60 to $20 between September and November of 2008) AND draw an income is to buy 200 Jan $50 puts for $2.20 ($44,000) and sell 100 May $57 puts for $1 ($10,000).  The plan is, of course, to sell $10,000 worth of puts 4 times to get free (almost) long puts by January.  The danger is IYT goes much higher so, at $60, we would have to sell 150 $60 puts to cover.  

These do have to be actively managed but they are delta neutral with the short puts at .35 and the long puts at .23 x 2 (.46), which means we lose net .11 per $1 per option on a move up so a rise in IYT from $58.45 to $60 will cost us approximately .17 on 200 contracts ($3,400) while a fall of $1.50 would only net us $3,400 of profits.  So not great coverage on a big move that comes soon but it gets much better over time (hopefully!).  If IYR really collapses, we have a $7 disadvantage through $50 but then we make 2x below that so break-even in a collapse is $47.50 and, below that, we pick up $2,000 per $1 drop in the index so a ride all the way back to $20 would net us about $50,000 on the hedge (and, of course, we don’t expect our longs to go to zero). 

Initial proceeds generated: $10,000. Cash used $34,000. Margin tied up: $7,000 (spread on the 100 short puts). Dividends expected: N/A Cash returned (if called away): N/A. Putter’s premium (risk of being called away): $2.45. Cash removed – None.

Now that we have that settled, we can look at some more basic trades aimed at generating income:

FTR is a long-time favorite of ours and a 9% dividend payer at .18 per quarter.  There’s a nice buy-out possibility here so we can call it 3,000 shares at $7.99 ($23,970), selling 2013 $7.50 calls for $1 ($3,000) and the 2013 $7.50 puts for $1.30 ($3,900, margin $7,200).

Initial proceeds generated: $6,900. Cash used $17,070. Margin tied up: $19,185. Dividends expected $3,870:  Cash returned (if called away): $22,500 Caller’s premium (risk of being called away): 0.50. Cash removed – $1,800.        

Investing for IncomeWhy $1,800?  Because we took $2,200 from AGNC so that makes $4,000, which is our goal for one month.  In THEORY, this trade will generate a $5,430 profit when called away in Jan 2013 plus another $3,870 in dividends.  When we take the money is arbitrary, of course and our goal each quarter is to simply make sure we have plenty to work with.  I’m being a little aggressive with FTR because they MIGHT get bought out and then we collect early (although we’d miss out on the dividends).  

GLW had a nice sell-off but does face real, possible supply issues from Japan that will not affect them directly but affect the companies they, in turn supply.  So, here’s a slightly complicated trade but the money is worth it so let’s give it a quarter.  

  • Buy 20 2013 $25 calls for $1.65 ($3,300)
  • Sell 20 2013 $17.50 puts for $2.40 ($4,800, margin $8,500)
  • Sell 20 Aug $20 calls for $1.30 ($2,600, margin $10,000)

The trick with this play is you must BUY the stock if GLW goes over $20 (now $19.58) so $40K needs to be kept on the side.  If the stock goes down – it’s a non-issue, we would net in for $15.10 off the 2013 puts less whatever profit on the call spread.  The net entry is a $4,100 credit and we can extract 1/2 of the August sale for this quarter.  

Initial proceeds generated: $4,100. Cash used $3,300. Margin tied up: $18,500. Dividends expected None: Cash returned (if called away): -$5,200 Caller’s premium (risk of being called away): $1.72. Cash removed – $2,050.

That’s going to be plenty for now as we’ve collected $6,050 after putting $142,955 of cash to work with a total margin requirement of $103,700.  With any portfolio, it’s good to take it out for a test drive and see how it balances before hitting the highway so we’ll follow up in a couple of weeks and add some more trades and adjust these if we have to.  Meanwhile, we’re sitting on $357,045 of virtual cash and about $900K of margin and that’s just wasteful so let’s sell a couple of puts while we wait in things we might want to buy if they go on sale.  

  • Investing for IncomeSell 10 KO May $65 puts for .65 ($650) – net margin $11,189
  • Sell 20 INTC May $20 puts for .75 ($1,500) – net margin $3,975
  • Sell 20 PFE May $20 puts for .47 ($940) – net margin $3,632
  • Sell 10 T May $30 puts at .45 ($450) – net margin $5,422
  • Sell 10 KFT Jan $30 puts at $1.60 ($1,600) – net margin $4,654
  • Sell 10 EXC Jan 437.50 puts at $2.20 ($2,200) – net margin $5,156

That’s another $7,340 collected but we won’t need to use that money until they clear.  Those are just some stocks we are very happy to buy on a dip so we may as well get paid to wait.  Here’s another tip for nervous put sellers.  If I sell 20 INTC $20 puts for $1,500, I’m netting into INTC at $19.25.  Yes, the obligation is to buy 20,000 shares for $38,500 but what if Intel does drop to $15 all of a sudden?  

Well they just dropped from $23.63 in April of 2010 to $17.32 in August so it is possible but lets’ keep in mind that A) We REALLY want to own INTC long-term and B) We can adjust.  If we had, for example, sold the April $25 puts and the stock is now $20.02, then we owe our putter $4.98 x 2000 ($9,960) less the $1,500 we collected for $8,460.  I don’t have to get assigned 2,000 shares, we can buy 1,000 shares of INTC for $20.02 ($20,200) and sell the 2013 $20 puts and calls for $5.90 ($5,900) which would be a net loss of $2,560 and, if called away at $20 in 2013, an additional loss of .02 per share ($400).  

Those are the "damages" we would have to withstand if INTC dropped 25% so fast that we could not roll the puts and got stuck with the stock.  If they do not cancel their .72 dividend, in 2 years we would recoup another $1,440.  The real loss would be having $20,020 out of circulation for two years and not working for us but, if you stick to blue chip companies you REALLY want to own when selling puts – we are not talking about outsized risks here. 

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