by Andy Tanner
Collecting premiums from selling calls or puts is a primary way to generate income using time decay. As you continue along the Education Continuum, you will discover that there are many ways to position yourself to collect premiums from selling options in the stock market.
The important thing here is to realize that you don’t have to be Warren Buffett to take advantage of strategies that allow you to collect premiums for cash flow. You can use the same strategies he uses because the same educational opportunities are open to you.
Constant Ongoing Source for Income
There are many people who wish they could own a business, but have struggled to come up with a product to sell. In addition, they haven’t received the proper education or experience to run a large business well. Others dream of being a large real estate investor but haven’t yet learned how to raise capital and do not yet have sufficient real estate education to get involved without getting themselves into trouble.
I love learning more about all of the asset classes. But what sticks out in my mind in relationship to the stocks and options market is the exciting concept that there is always an opportunity to collect premiums month in and month out.
I realized very quickly that the stock and options markets were liquid and that there are always buyers and sellers every single month, year in and year out. One of the reasons I want to get better and better at selling options is because this is an ongoing income opportunity that anyone can tap into after receiving some education.
My biggest hope at this point in this book is that you’ve come to the realization that there is such a thing as stock market cash flow. I hope that you realize that you don’t have to ride the ups and downs of the stock market as a mutual fund investor in order to be a participant in the market.
When most people first learn about options they usually get very excited. And rightly so. Buying and selling options is exciting. But be careful. This is the point at which a little education can be dangerous. Option premium is also influenced by volatility in addition to time decay and changes in the stock price. And education in these areas and how they work is vital. Earning cash flow with options is for investors who first want to educate themselves.
This book is written for the beginner investor and is designed to help as they progress along the Education Continuum™. I highly recommend that you refer to the Education Continuum™ often as you study any topic—especially investing. That’s because in everyone’s financial education are points where people learn just enough to be dangerous. You’ve probably hit that point here.
Learning to develop streams of income from stock market cash flow can give you huge benefits because most of these techniques are free from the boilerplate investment advice doled out by the mutual fund and the 401(k) industries. Please don’t think that this is an easy path that can be taken casually. Quite the contrary: No matter what investment class you may invest in, it is an environment where many people fail. When I’ve failed, it’s usually been because of my own ignorance or arrogance or lack of discipline to follow the rules. The more time I spend on my journey as a serious student, the more convinced I am that I want to continue to learn and that more education will always pay off.
These chapters have helped you move along the Education Continuum by improving your awareness of how cash flow can be generated from basic option trades. Now we’re ready to look, in more depth, at what kinds of risks we face as cash flow investors and how to manage those risks to protect ourselves as much as possible. Because no matter how smart you may be as an investor, if you cannot effectively manage and even eliminate your risk, then you can get yourself into big trouble.
Risk management is about taking control of your investing. As you learn how to take control, you will be in a position to maximize your cash flow and returns.
Chapter Summary
Let’s review some of the important points of Chapter Six:
1.Fundamental and technical analysis helps you in the first phase of investing to gain more information. Cash flow and risk management strategies help you in the second phase where you will determine how to position yourself in the market.
By learning different positioning strategies, you are no longer required to hope for bull markets all the time.
2.An investment in the stock or options market can serve any one or more of three purposes: a capital gain, cash flow, or protection of your assets with a hedge.
3.Rate of return is (money out – money in) / (money in).
4.Infinite return is achieved when an investor receives a return from an investment that requires none of his own money be invested in the deal.
5.There are two ways to go for bigger returns: try to get lucky and find a ten bagger or reduce your initial investment.
6.An option contract is an agreement where one party has a choice and the other party makes a promise.
Another word for the word choice is option. Options are a way to take control of the stock without having to purchase the stock.
7.Some options have intrinsic value.
Intrinsic value is the difference between the price at which you can buy or sell, and what the market will pay for shares of that stock.
8.Three important parts of an option contract are the strike price, the expiration date, and the option premium.
The strike price is the fixed price agreed upon in the option contract for which the stock shares can be bought or sold. The expiration date is the date on which the contract is no longer valid. The premium is the amount of money that is paid for an option contract.
9.One difference between buying shares of stock and buying an option contract is that the option contract expires.
Many investors consider options to be more risky because it is certain that they will expire and, at that point, become worthless. Some investors might feel good about holding stock when the price goes down because there’s always a chance the stock will go back up as long as the company doesn’t go bankrupt. However, with an option contract the stock must go in the desired direction before its expiration date to become valuable.
10.Time is money. The more time you want before your option expires, the more it will cost you. This is known as time value.
There are many factors that go into determining time value of an option, including the volatility of the stock, interest rates, the distance of the option’s strike price from the current price of the stock, as well the amount of time in the option before expiration.
11.Option premium includes the option’s intrinsic value and time value. An investor who is purchasing an option should identify how much of the premium is intrinsic value and how much of the premium is time value. As expiration draws near, the time value of an option decays.
12.With a call option contract, the buyer of the option has the choice to buy at the strike price and the seller of the option makes a promise to sell the stock at the strike price. With a put option, the contract buyer of the option has the choice to sell the stock at the strike price and the seller of the option makes a promise to buy the stock at the strike price.
Understanding both call options and put options is the beginning of expanding the many different ways an investor can position himself or herself in the market.
Chapter Seven
Pillar 4: Risk Management
Basic risk management is the fourth, final, and most important of the Four Pillars. Have you ever heard of the World Championship of Trading? It’s an annual competition where traders from around the world test their skills against each other and the market. Many of them enter the competition with fancy computer programs and all sorts of strategies to earn huge profits and take home the title. Typically, though, it’s not these high-flying futures traders that win the trophy. Instead, it’s the traders who know how to manage risk. It is the traders that know how to avoid a large loss—versus those that try to go for big gains.
Because I speak to so many groups of investors, I inevitably meet a lot of people who like to toot
their own horns about their stock-picking skills: “I bought this stock and it went sky high.” I just smile and congratulate them, even though what they are telling me may be no different than the person who had a lucky night at the tables in Vegas. Anyone can get lucky and have a stock shoot up to make some profits. But a few fortunate picks doesn’t make them an all-star investor.
What impresses me is the investor who can say, “I was in this investment and the thing tanked, and this is how I minimized my losses.” Why is this a better position as an investor? Because minimizing losses proves that you are in control of your investment. You aren’t just hoping and praying for the best. You have actively taken actions that put you in control of the situation.
If you buy a stock and hope it will go up, you are out of control. That’s why investors who have their life savings in 401(k) plans and mutual funds have virtually no control of their future. They believe the financial industry’s sales pitch about the safety of their money, but the truth is they are just hoping and praying that the market will go higher so they can survive in retirement. No wonder so many people are so stressed out all the time. I don’t like having something as important as my financial future out of my control.
Now that we have discussed some of the basics of analyzing a possible investment and how to position for generating cash flow, let’s look at some powerful ways to manage our risk. For any type of investor, keeping a tight leash on risk is perhaps the most important skill you can have.
By studying more about the Risk Management Pillar, you will:
•Learn how to identify several kinds of common risk
•Understand the truth about risk and control
•Discover some powerful risk management techniques
•See when investment diversification can actually be dangerous
•Uncover the vital link between risk and education
•Learn how you can actually enter an order in the market that will minimize your risk
When we decide to put our money in the stock market, there is one rule we should remember: Always expect the unexpected.
That’s why we should take the time to learn about the different potential risks we might face when we put our money into an investment. There are many different risks we need to manage. Most people have no idea how risky it can be in the market. If they don’t know how to identify and neutralize those risks, it might be just a matter of time until they get pummeled by them.
One of the activities I am involved with is working as a Boy Scout leader. Other Scout leaders and I take the scouts to the shooting range and show them how to manage risk, and sometimes we will show them how to shoot a firearm. How do we manage the risk? Massive, intense, unbreakable rules. If there were ever an accident, it would be because someone broke those rules. It would not be because the risk was unmanageable. It would be because someone decided not to manage it.
When you think about it, we all manage a wide variety of risks in our everyday lives. Driving a car on the freeway could be life threatening if we don’t follow the rules that are designed to help us manage that risk. That’s why we manage the risks of driving at high speeds by keeping our eyes open, driving defensively, wearing seat belts, and keeping our speed within reasonable boundaries.
Putting a 747 airplane in the air has a lot of obvious risks. It weighs a million pounds, carries a lot of people…yet we trust it to fly us safely at 40,000 feet traveling 500 miles per hour. Why do we trust stepping onto a plane like that? Because we know the government has strict safety requirements and the pilots have intense education and experience. All those risks and more have been considered and proactively managed.
So we can see that it’s not necessary to avoid risk to keep ourselves safe. It’s also not necessary to just throw caution to the wind and hope for the best. Instead, we need to understand the risks before us and learn how to manage them. That’s the key to prospering with any type of investing activity.
Let’s walk through the most common types of risks facing investors so you’ll know what they are and how you can control them in your own investing.
Non-Systemic Risk
Non-systemic risks are the things that can happen to affect the price of an individual stock without impacting the overall market.
For example, when British Petroleum (BP) caused a big oil spill in the Gulf of Mexico, it had a fast and harsh impact on its stock price. BP stock went—very quickly—from $60 to $30 a share. But the overall market felt very little negative impact from this event. The spill didn’t impact the entire system.
When a company manufactures products, those products can have defects. Should there be a recall on brake pads for your car, or a particular toy, or some other product, it will likely affect the price of that company’s stock. But there’s no reason for investors to think the company’s problem will bring down the entire market. Not even a company as big as BP, not even with an event as big as that spill. That is a non-systemic risk.
Financial advisors will often tell their clients to protect themselves against non-systemic risk by diversifying. This type of diversification will help an investor absorb the impact of an individual stock that may go down if some kind of non-systemic event should occur. This isn’t necessarily a bad approach. But it does concern me when investors use this approach of diversification and are satisfied because they think they have managed all their risks.
The truth is, they have only addressed one type of risk. And by diversifying across other stocks in various sectors, they are actually exposing themselves to risk from another source: systemic risk.
Systemic Risk
As we just discussed, most investors think that diversifying across multiple stocks protects their risk exposure. If one stock goes down, the others can help prop up the losses.
There’s just one problem with only focusing on non-systemic risk. What happens when the entire market drops? How does diversification help your retirement account when nearly every single stock takes a plunge.
This isn’t just a theoretical possibility. This is the reality we have been living with over the past few years. Take a look at the following chart to see the difference between non-systemic and systemic risk:
On the left is the example of British Petroleum we talked about earlier. We can see that after the oil spill in the Gulf of Mexico, the stock price rapidly lost half of its value.
On the right is a different chart that shows the broader market (represented by the S&P 500) dropping due to the sub-prime meltdown. This market drop was the result of factors that hurt the overall market. Here’s the short version: The Federal Reserve lowered interest rates so people could borrow money more easily. As a result, people did indeed borrow money at rapid rates and invested that money in houses and others things. This buying frenzy quickly drove up the prices of real estate to levels that weren’t realistic. It didn’t take long for this demand to drop as investors realized things had gotten out of hand. Suddenly, people weren’t able to make their mortgage payments and they weren’t able to sell the properties for anywhere near what they paid. That’s when the real estate bubble popped, and the resulting mortgage meltdown brought the entire stock market and most of the economy down with it.
In the chart on the right, we can see that the S&P went from over 1,400 down to 700. In less than two years, half the value of the market disappeared into thin air. Many investors lost 50 percent of their account values. The same thing happened in 2000 when the dot-com bubble burst. It brought the whole system down with it.
That’s why it’s called systemic risk. Something happens beyond an investor’s control and it affects the entire market system. If you were invested in the market during this time, it doesn’t matter how diversified you were; it’s likely that most of your stocks lost much of their value.
As a reminder, this is why we focused earlier in the book on carefully doing our fundamental analysis. Analyzing fundamentals is one of our best tools for recognizing the degree of systemic risk w
e can expect. When we see the government printing money or the condition of a government’s financial statement, we can use that information to help us measure the amount of risk we would face when investing in stocks tied to that system. Remember, even quality stocks can be vulnerable to systemic risks.
In Japan, the Nikkei lost 14 percent from 1984 to 2012. Even with big-name companies such as Toyota, Sony, and others, the Japanese system has been losing money for nearly 30 years. That isn’t good news for Japanese investors who have had their retirement accounts in the market and are hoping for good returns.
European countries are struggling with debt loads and austerity measures in an attempt to get their economies back under control. In the United States, the debt/GDP ratio is getting out of control. The risk of investing in those systems is going up. And because we’re looking at systemic risk, we as investors need to be aware of it so we can control our exposure. We don’t want to lose money.
Purchase Risk
Purchase risk is a simple concept tied to the currency of your specific country. If the value of your currency is dropping, what risks do you face by hanging onto your money?
What if you put one dollar into the bank today, and a year from now the value is still at one dollar? At face value you might be disappointed that you didn’t earn anything in interest, but you might not care too much because you still have your dollar. But consider this in the face of rising prices of goods you might have purchased during the same time period.
For example, if a gallon of gasoline was one dollar at the beginning of the same period, but increased to ten dollars per gallon a year later, what does that mean for your money? You have actually lost a lot of buying power during that time. This is what we call purchase risk.
When considering the state of the economy, do we see the value of our currency falling? Is our money best held in cash or in another investment that will better hold its value?
