I’ll get right to the point: I think there’s a better and faster way to grow passive income in order to achieve financial independence! We are committed dividend stock investors looking to build wealth through stock market investments. But I’ve been learning/studying for the past two years and implementing a new investment strategy the past nine months and the results are promising. Let me run this income producing investment strategy by you and help me figure out if this is sustainable or just a short term phenomenon that can’t be maintained to and through retirement from full time employment.
Path To Financial Freedom
We’re not much different from your average FI enthusiasts. My wife and I live below our means, have eliminated all debt except the home mortgage, have a six month emergency fund and invest aggressively, including in retirement and taxable accounts, to develop long term wealth. We have set aside money for our last child’s college fund (two are already out of the house) and we invest in our Health Savings Account for current and future medical expenses. In terms of investments, we are deeply invested in dividend producing stocks and our account is equally dividend between stable, high dividend yield stocks and faster growing dividend growth stocks. Our stocks produce an average 2.8% annual dividend yield, growing about 11.5% annually. All in all, our stock portfolio has averaged a total annual return of 18% including dividends and appreciation over the past eight years. Everything mentioned so far is pretty straightforward and consistent with most FI practices.
Also consistent with standard FI practices, my wife and I have been planning to develop wealth that is 33 times our expenses (assuming a 3% annual drawdown in retirement to be conservative). While we are well on our way to meet that goal, a new (to us) passive income path presented itself a couple years ago that I have studied and now implemented for the past nine months with incredible (to me) results. The results have been so good that we are re-thinking our FI goals, amounts and timeframes. In addition, the new (fairly) passive income stream seems to be sustainable into retirement.
Conservative Options Trading As A Significant Passive Income Source
Hear me out. Monthly dividends are and have been a consistent income source. If we didn’t invest another dollar in the stock market and retired in a couple years from now, dividends would produce one third of our income needs in retirement. But its not enough to be safe as the rest of our financial needs would need to come from asset (stock) appreciation and sales. So two years ago we started studying option trading, focusing on a fairly conservative approach to produce additional monthly income. Then, nine months ago, we implemented the following monthly options trading plan:
- Each month, we sell out of the money (OTM) puts on premiere dividend and dividend growth stocks to produce immediate income and give us the chance to buy well researched, desired stocks at a discount. If the option expires OTM, then we keep the premium. If the stock price falls and the option is in the money (ITM) then we get the premium and we “get to” purchase a dividend producing stock on sale. Both are wins to us. (In general, we target to earn 1% or more on the monthly option premium each month and use an OTM strike price that is at least 5% lower than the stock price.)
- Each month, after much research and analysis, sell OTM covered call options on the dividend stocks we own at strike prices that meet or exceed our researched sell price target. If the option expires out of the money, we keep the premium as income. If the strike price is met, we get the premium AND a nice profit from the sale of the stock. All proceeds from the sale of stock are then reinvested in more dividend producing stocks. (In general, we target to earn .5% or more on the monthly option premium each month and use an OTM strike price that is at least 10% higher than the current stock price.)
That’s it. Each option has a one month duration. If the option expires OTM, the money is then reinvested in options for the next month. Some call that “Stock Option Rinse and Repeat”.
The Results, So Far
Thus far, the options trading income nearly quadruples the monthly dividend income. Take a look at these results:
- We are averaging a monthly return of 1.79% (or over 21% annually) on the sale of put options. We have made over 250 put option trades in the nine months, with 236 expiring out of the money and 14 put options being assigned. We have purchased great dividend champion and dividend growth stocks on sale, such as ABBV, LOW, QCOM and CSCO.
- We are averaging a monthly return of .99% (almost 12% annually) on the premiums of covered call options! We have made over 100 covered call option trades in the nine months, with 94 expiring out of the money and 6 call options being assigned. We have sold some great dividend stocks but got a large premium for the sale, at least 10% higher than our target sales price. Usually these sales result because of a higher than normal run up of the stock price. So our covered calls allow us to cash in profits on unusual spikes in price. Then all proceeds from the sales of stocks are reinvested into other dividend stocks. Sales have included stock in CSCO, STX, SBUX and ETP.
Summing up the performance of this income strategy over the past nine months we find that the total income return by adding the monthly option trading premiums to the monthly dividends equals 18.15% on our entire stock portfolio not including stock appreciation. (The stock appreciation during that timeframe was 19.1%) After taxes, fees and other costs, the net return on trading and dividends, or net income, was slightly over 12%.
So, Working Backwards, Doesn’t That Mean…
Let’s take that 12% net annual income return and reduce it by a small safety factor to 10% to be conservative. And let’s assume we do not want to spend any of the stock assets nor any of the stock appreciation. Just keep letting that build. Let’s also ignore social security and any other side income. Where does that leave us? I think that leaves us needing an investment base of 10 times expenses to meet our total retirement needs. Let’s take a look at some actual numbers to this situation: If we need $7,000/month to live comfortably in retirement, or $84,000 a year, doesn’t that mean we will need $840,000 of investable assets to produce that income ($840,000 X 10% = $84,000)?
But let’s continue to make the case more conservatively. Let’s assume that you trade options on only a portion of your investments, say only half of your investments. So, for option and dividend income to cover $84,000 in annual expenses, you would need roughly $1.2M of investable assets (This assumes dividends from all of the investments but options trading on only half of the investments).
The net result: I don’t think we necessarily need an investment account that is 33 times expenses to retire comfortably. I think with conservative options trading in conjunction with a stock portfolio of dividend and dividend growth stocks, that a couple could retire with an investment account that is only 15 times expenses.
Fact or fallacy ? Set me straight…
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