The Extreme Income Portfolio

by Wes Bridel on May 27, 2011

in Stewardship

An Income Portfolio is not easy for most people to come by today, but since we’ve been discussing various portfolios for different types of people, we wanted to show you a way to create a portfolio that pays you a large income.  Meet our newest couple…

Louis & Janette need income!  They are really depressed at the sad interest rates that are being paid everywhere they look.  Before they designed this portfolio, whenever the money conversation would come up Louis would immediately start complaining “What happened to the days when we could count on 6 or even 8% income from our money?  What’s the point of even having savings if we can’t earn anything on it?”  Boy was he steamed!

But then they discovered options. Now they get paid a higher income than they ever did before and even have some chance for appreciation from time to time.  It’s important that you understand that Louis and Janette are not trying to hit a homerun with their money.  They’re willing to sacrifice the possibility that the stock market could double over the next year.  When they developed “The Extreme Income Portfolio” they understood that they wouldn’t see most of those gains if that were to happen.

They also understood that they are taking on the risk of capital losses as the value of their holdings fluctuate in a turbulent market.  Neither of these things are as important to Louis and Janette as earning a solid and dependable income on their portfolio.  And this is exactly what their portfolio does.

So How Does it Work?

Louis and Janette identify 20 companies that they would be happy to own forever and which they are willing to buy at today’s prices.  This is important because if they were to buy a company that they didn’t think would stand the test of time than they would stand a greater chance of losing their principle on that part of their allocation.  And if they pay too much for a company, it could be decades before they see their principle back.

So they scan the stock market for companies which have durable competitive advantages in the marketplace and are profitable under and market conditions.  They prefer global companies because those companies collect profits from all corners of the world and are thus more diversified against a shock to the US economy.  They also tend to favor companies which pay a high dividend up front to all owners.  Finally, they look to make sure that they are able to buy in at a low price so that they are getting a good value if they buy the stock at today’s prices.  They then plan to have 5% of their money available for each stock.

But they don’t just buy the stock.  They sell options!

You see, most people lose money when buying options.  Most options expire worthless and therefore end up being a waste of money for the person who bought them.  However, if you are the seller of an option, you almost always make money for doing nothing.  Here’s who it works…

Janette sells one put option for each 100 shares of stock that she would be willing to buy at a price a little below today’s market price.  The closer to the market price, it is, the more money the buyer will pay her to sell the option, and the more likely that she will actually be “put” the stock.  (This means she would have to buy the stock at this prearranged price.)  She tends to select options that are two to three months out in strike price.

So they have been paid money up front in exchange for their promise to buy shares of a company (that they are willing to buy at today’s price) for an agreed upon price which is less than today’s price.  It’s a can’t lose proposition since they wanted to buy the stock anyways, why not take the income first?  (Strangely, they had to really wrangle with their online broker in order to get permission to sell options, and they do have to keep money held aside for the purpose of buying the stock in case they are put the stock.  But this is not a problem since they are willing to buy the stock.  The worst thing that can happen is that the stock price goes straight through the roof and they never bought the stock that they liked because they agreed to buy it at a lower price which was never hit.  But at least they got paid for losing!

So one of two things happens with each of these stocks which they have sold put options on.  When the option expires, the option will either be “in the money” in which case, they will be put the stock and have to buy it at the agreed upon price.  Or the option will be “out of the money” in which case their agreement is over and they can sell a new put option a couple months out to repeat the process.

This is exactly what they do.  They continue to sell puts on these companies until they are finally put the stocks, all the while collecting income based upon their promise to buy the stock if the low price is reached.  Sometimes, they delay selling a new round of put options when the VIX index is low because this indicates that the premium which they will be paid for selling an option has become very low (and also the likelihood that they will be put the stock becomes higher).  So they wait until option prices rise so that they can get a bigger check to sell a new round of puts.

Once they own a stock, they change strategies and become sellers of call options.  This means that they sell a “covered call” on the lots of 100 shares that they own on each company.  If the price is at or above the agreed upon strike price on the day that the option expires, then they will have to sell the shares to the owner of the option.

One call option is sold per 100 shares.  Again, they select an expiration a couple months out, but this time they choose a price that is a little higher than the current price.  Again, the amount that they are paid increases with the likelihood that they will have their stock called away from them (in this case when a lower strike price is agreed upon.)  They are paid upfront for this promise.

So, let’s look at the two things that can happen.  The stock price can either go down or only up a little (but not to the level of the strike price) and the option will expire worthless.  Louis and Janette will keep the premium that they were paid and be able to repeat by selling new “covered call” options.  (Keep in mind the price could drop by 90% and they would be holding stocks that are now worth significantly less than what they invested into them.

The other possibility is that the price does go above the strike price and the shares will be called away.  In this case, they were paid income up front for promising to sell the shares, and they will collect the appreciation that they earned when the shares sold for more than they invested into them.  However, if the price goes up dramatically, they will not receive this appreciation (this is the upside that the option buyer was betting on and he gets to collect it.)

So Louis and Janette have a simple options strategy which allows them to collect 10-20% on their principle.  They sell puts until they are put each stock and then sell covered calls until those same shares are called away.  When this happens, they look to see whether the same company is still in their buy range or if they need to replace it with another.  With their strategy, they are not particularly concerned about their paper losses because their primary concern is the income (although those losses can be painful when the statement shows up in the mail!)  And they don’t’ worry about the fact that they’ll never see the moon shot in their portfolio because they’ve sold away the upside on each of their stocks.

But for Louis & Janette, Income is king, and their portfolio pays them more income than most anyone else in the market place receives!  And that suits them just fine.

This is the last post in a series on Real Life Examples of Portfolio Management.  You can read the previous posts at: Pt 1, Pt 2, Pt 3, Pt 4, & Pt 5, Pt 6, & Pt 7.  If you’re interested in learning more about generating income through options, you can learn more by reading the series we’re doing on this topic starting with these links: Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, & Pt 9.

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