Passive Income

Almost everyone knows about the power of compound interest. The earlier you start investing the better. Kiplinger’s provides three steps to harness the power of compound interest.

1. Start Early
2. Remember that a little bit goes a long way
3. Leave it alone

This is great for those of you who were smart enough to start when they were young. It would be better even still if you were still young. But what about those of us who are slightly older? Did we miss the compound interest train?

Absolutely not! We may just have to rethink or time frame a bit.

If you went to any website that had a savings calculator, Kiplinger for example, you could calculate that if you were to earn 5% a year on an investment of $10,000 you would have approximately $16,289 after ten years. But what would happen if you could make 4% a month? What would your results look like then?

Time Account Value
Start 10,000
Year 1 16,010
Year 2 25,633
Year 3 41,039
Year 4 65,705
Year 5 105,196
Year 6 168,423
Year 7 269,650
Year 8 431,718
Year 9 691,195
Year 10 1,106,626

As you can see, in just over 10 years you would have a sizable portfolio. But is this type of return possible? The experts would tell you no. The reality is that the big money has been using this technique for years and years, continually increasing their net worth.

I have been selling covered calls to generate consistent monthly income for about 6 months now. From my experience, I can tell you that this strategy can work. We have been in a TERRIBLE market lately. If it can work now, it would be magic in a bull market.

I wish I would have known about this in college. My life sure would be different. But, I know about it now and I am actively using this technique. Starting in April, I will post my transactions so that you can follow along.

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Many investors are interested in selling covered calls but really do not know how to begin. This is actually my favorite investing strategy, and as such, I will be allocating a great number of posts to this topic.

Introduction
An option is a financial instrument representing a real contract. It gives the holder the right, but not the obligation, to buy or sell the underlying asset at a certain price up to a certain date (expiration date). Until the expiration date, the holder has the right to buy or sell the underlying stock if the transaction is to his or her benefit. After the expiration date, your option is worthless.

Buying and selling calls and puts is an extremely risky form of investing. These speculators risk their entire investment on a guess of which direction their stocks are heading. Myself, I prefer to sell covered calls which generates consistent monthly income for my portfolio.

The covered call technique involves utilizing “call” options only. Options trade on the stock market just like stocks do. This fact allows us to generate monthly income by selling calls to speculators. Let’s look at a quick example:

Crocs, Inc (CROX)
Current Price – $17.18
Near Month Option – April 2008
Closest Strike Price – $17.50 premium of $1.30

For this example, you would buy 100 shares of CROX at $17.18 and immediately sell 1 April ‘08 $17.50 call for $1.30. My broker, thinkorswim, gives you the ability to do both at the same time. I like this feature because I am only charged one commission of $5, instead of 2 if I did them separately.

The 100 shares would cost you $1,723, but this would be offset slightly by the $130 of income you received from selling the call. Now all you have to do is sit back and wait until the third Friday of April (the expiration date). In this simplistic example, two possible outcomes exist:

1. The stock closes below $17.50 on expiration date and you are not called out. For this transaction, you “earned” a one month return of 7.5%. You earned this money by selling the call to the speculator (who lost all of his money). You now have 100 shares of CROX with no open calls against it. You are free to sell another call or sell the stock.
2. The stock closes above $17.50. In this case, you will get called out of your stock. Don’t worry, it happens automatically and there is nothing you need to do further to make it happen. For this transaction, you earned a one month return of 9.1% [((17.50-17.23)+1.30)/17.23]. Not a bad one month return if you ask me.

Like I said above, this is my favorite investing strategy. It is a powerful way to increase your wealth because you are continually generating cash flow from your stock investments, while simultaneously lowering your cost basis in the stock. It does, however, have its drawbacks. As this post was meant to be an introduction to selling covered calls, I will create a future post describing the challenges of this technique.

Are you selling covered calls? Have you ever wanted to try it? I would love to hear of your experiences selling covered calls.

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I hate getting a tax refund. Each year, I try to be as close to tax-neutral as possible. Basically, since I am a salaried employee, I try and determine the exact exemptions I need to take to end the calendar year “all square”. Most financial planners, bankers, brokers and advisers will tell you that this is the best approach to take.

If you get a tax refund each year you are simply giving the government an interest-free loan. As of March, the average refund received was approximately $2,700 (mine is actually larger than that). Best practices suggest that you reduce the amount of money that is withheld from your paycheck and invest this amount in an interest-bearing account.

That last part always makes me laugh. I am puzzled how the experts determine what amount you should invest. Most Americans, myself included, have an extremely hard time NOT spending every dime that hits their wallets. My wife and I have a financial plan, and we are pretty consistent in following it to within 10 – 15%. The problem always occurs when our friend “Life” shows up.

Last month, “Life” decided that both cars needed to break down (-$300). “Life” also decided that both of our dogs would get sick – the Scotty’s bill came to $80 while the Silky’s bill came to over $300. Life’s friend “Heartache”, decided that our frig had lived long enough, so we had to replace that as well. Luckily we purchase “home warranty insurance” each year so they were able to get us a brand new frig for around $300. Most people say that Home Warranty Insurance is a waste of money, but we have saved hundreds, if not thousands, of dollars over the past three years with it.

The total damage of Life’s little adventure last month was close to $1,000. This really put a damper on our savings account. Then along comes tax season. I do have a pretty strong financial and accounting background. I have passed the CPA exam and should be getting my license very soon. Each year, my refund ranges from $17 to around $250, which I consider to be pretty good management. In the middle of 2007, I switched jobs and really forgot to inform our payroll department to withhold less from each paycheck. I was so busy trying to lead the company, I forgot to follow up with my deductions.

As a result, this year, I will get a refund of approximately $3,200. Additionally, I will get $1500 for simply filing my taxes this year. While I know this is not NORMALLY a good thing, this year, due to Life’s Slap in the Face, I am pretty happy I gave the government a loan. Now just give me my money back!

How much are you getting back this year? How do you plan your taxes each year? I would love to hear from you.

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