Using Options for Income

One of the attractions of option trading is the opportunity to use options to generate current income. This can be an attractive proposition for investors in retirement, those who need to supplement their current cash flow, or for those who just prefer to stay mostly in cash.

In this article, I share a couple of Leveraged Investing methods of using options for high yield income.

What Is Leveraged Investing?

Leveraged Investing is simply the options-oriented method I've developed and use to acquire high quality companies for as little as possible.

Don't be put off by the word "Leveraged." The way I use it, it's not about debt or high risk or recklessness. It's about using options conservatively to lower your long term risk, not increase it. At its best, a lever is an important tool that focuses and amplifies our strength in order for us to build something we couldn't with our bare hands.

The premise of Leveraged Investing is that we can use options to lower our cost basis on our long term investments - and not just once, but repeatedly.

And the less you pay, the better your future - the more shares you can acquire, the higher your dividend yields, and greater your capital appreciation.

So if Leveraged Investing is a powerful long term investing approach to building wealth in the stock market, can the principles of Leveraged Investing be used for those who with current income preferences?

Here are a couple of ways I believe that they can . . .

Leveraged Investing Method #1:
Use as Directed

When used in conjunction with a dividend growth oriented portfolio, Leveraged Investing as I teach and promote it already is an income strategy.

In fact, it's largely based on the dividend growth model (investing in high quality dividend paying companies with a track record of increasing their dividends every year and allowing the compounding effect to eventually snowball your passive income).

It's just that Leveraged Investing seeks to significantly speed up the process.

By using options to perpetually lower the cost basis on your overall portfolio, and then using the proceeds of those returns to buy additional dividend paying and dividend growing shares, your overall dividend income is obviously going to increase much more quickly than traditional dividend growth investors will ever experience.

Leveraged Investing Income Example #1

If I invest in a hypothetical high quality company that initially pays a 3% dividend and, over time, manage to reduce my cost basis by 50%, my new yield is 6% because my adjusted cost basis (or what it actually cost me to purchase the shares) has been cut in half.

Of course, in and of itself, that does nothing to increase your actual dividend income. But when you then reinvest those "adjusted cost basis" option returns into additional shares of that company, your original investment amount hasn't actually changed - but your dividend stream has just increased by 50%.

More importantly, the dividend growth rate applies to ALL your dividend income, which has powerful income compounding implications over time.

For example, if a company increases it's dividend by 10% and your initial yield is 3%, then your new effective yield (or yield on cost) bumps up to 3.3%. If, however, you've already adjusted your cost basis so that your adjusted yield is 4.5%, then a 10% increase in the dividend means your yield moves all the way to 4.95%.

It's not just that your dividend income is compounding - the rate at which it's growing is also compounding.

So if your primary objective is income, but you consider regular yields to be too low, or if you're concerned about the time for the benefits of dividend growth investing, you might consider adding a conservative options component to your portfolio to make the dividend growth strategy a more pragmatic and useful proposition.

Leveraged Investing Method #2:
The Retained Earnings Method

Now there is a much higher yielding alternative to Method #1 above if current income REALLY trumps long term wealth.

And that's simply to retain your option income in lieu of purchasing additional dividend paying shares of quality companies.

The premise of Leveraged Investing is to customize and use certain low risk option trades that have no relationship whatsoever to the underlying operations of the business and no impact on your ownership of that investment. Side trades and deals, if you will.

As a result, Leveraged Investing tends to generate a fair amount of cash on a percentage basis. There's no rule that say you have to "reinvest" that option income into more shares, or for that matter that you have to own any shares at all.

In fact, you're free to generate the option income and issue any amount of it to yourself at any time - much like issuing yourself a large special dividend. It's your portfolio and investment account after all.

What's important, however, is that you don't be seduced by ever higher and higher potential returns so that you turn what should be low risk trades into high risk trades.

Leveraged Investing Method #2:
The Retained Earnings Method

I'll be honest - in my experience, if you can at all swing it, Method #1 is my preference and recommendation. It's not that Method #2 is inherently risky, but I find that actually owning shares grounds you in a way that being all in cash doesn't.

It also provides you the additional opportunity for returns in the form of capital appreciation that isn't available for straight Leveraged Investing income investors.

I wouldn't presume to tell you what's best for you and your portfolio - I don't believe in one-size-fits-all - and you obviously know your own financial situation and personal preferences better than I do.

But in principle, it's like investing in theory - the longer you're able to not spend what you've built up, the more it will produce in the future.

Best of luck . . .

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