12 Apr Stock Market Cash flow Strategies you can adopt for Retirement
When it comes to stock market retirement strategies, there are a multitude that you can adopt. But there are two key things all investors want: to limit Risk and to make Money.
Returns are created either through Capital Growth or through Cash flow. And the performance in either correlates directly with the level of Risk you are willing to adopt. The lower the Risk, the lower the potential in growth or cash flow. And vice versa; the higher the Risk, the higher the potential in growth or cash flow.
If you’re managing your own stock market investment portfolio, then finding the balance that is right for you is absolutely critical. There are many factors to consider, such as how much capital you are using, are you shifting towards retirement or already in retirement, the diversification of your assets (property, 401k, IRA, direct investments), and what your expectations of returns or needs for cash flow are.
In this article, I will discuss a Cash flow strategy for retirees (and upcoming retirees), who are looking to reduce their Risk in the stock market, but at the same time don’t want to inhibit their rate of return.
Creating regular cash flow from stocks
Typically, cash flow from stocks is derived from Dividends: a share of a company’s profits distributed to its shareholders. This is different from an increase in capital value, which is dependent on many factors such as economic performance, company decisions, broad investor sentiment, industry strengths etc.
US companies are not known for being high dividend payers. Their philosophy is that the company can reinvest its profits more successfully than you, the investor, can.
Compare that to a country such as Australia, where Blue Chip companies incentivise investors by paying regular dividends. Average figures can exceed 4.5% per annum, although individual companies regularly pay much higher.
For decades, however, investors have been adopting a strategy known as the Covered Call, to create an Income approach that provides consistency in cash flow. The strategy uses stock positions, and overlays Options (Exchange Traded Options or ETO’s) to create the position.
If you’re put off by the fact that Options are used, don’t be afraid!
This is a simplistic strategy.
If you’re not familiar with what Options are, then you can watch this quick video to help explain: <CLICK HERE>.
I’ll explain how the option fits into the strategy shortly.
The “Cash flow” aspect of the strategy is derived by selling the Call option against the stock position. You are receiving the premium of the option. If you were to do this on a regular basis, it would create a consistent return.
Now, there are numerous variations to how you can manage the strategy, and there is a little more to understand about the strategy. But the absolute basics are that selling the option contract creates a cash position that you would otherwise not have had by just holding the stock on its own.
As someone who has managed funds and private portfolios with this strategy for more than a decade, I have my preferred methods. But it pays to have an understanding of the most basic approach first, before considering alternatives.
How is the Covered Call created?
The Covered Call strategy is where you purchase shares, and sell the equivalent number of Call options against that stock position. You need to use your own capital to purchase the shares, but you receive the premium of the sold call options.
Adopting this strategy, the first rule of thumb is that you are not intending to hold shares for the long term. Your expectations are that you will sell your shares. And if you sell your shares, this will have been in a profitable position.
What we are doing by selling calls is to reduce our average buy price for the position. So, for example;
If you purchased 100 shares in XYZ at $30.00 per share, and sold 1 call option and received $0.60 per share in premium, your average price for the position would be $30.00 minus $0.60 = $29.40.
The benefit of entering this strategy, first and foremost, is that you reduce your average purchase price. The share price is then going to do one of three things: go up, go down, or go sideways.
- Should the share price fall, you are $0.60 better off than the person who merely bought the stock. And you will still hold your shares.
- Should the share price remain sideways, you have still received the premium and have a lower purchase price (as above). You may still be in a profit (depending on where the stock price is). Whereas, the investor has made or lost nothing.
- If the share price rises, then you will be “Called Away”, or Exercised, on the sold option. You will sell your 100 shares in XYZ. This is the nature of the strategy, and one of the reasons why a long-term investor shy’s away from the strategy.
If you would like to watch a quick video on how the Covered Call strategy works, CLICK HERE
Is this a Strategy that you can adopt yourself?
Many private investors are attracted to this strategy because of its simplicity.
Accessibility through online broker platforms, and the fact that it utilises stocks for the underlying position, makes this more tangible than other strategies that adopt higher Risk.
Like all strategies, it has its strengths and weaknesses. And by no means is this a strategy that is suited for everybody. Which, in my opinion, is one of the biggest problems for investors – they adopt a strategy they are not familiar with or understand completely. Hence, when it is not successful for them, they have a negative association that might deter others from considering.
So what sort of investor profile would suit this strategy?
- First and foremost, an investor wanting to reduce Risk of their investment capital. In particular, during periods of declining or stagnant market activity (in individual stocks or the broader stock market environment)
- Who is willing to implement a little more effort into the evaluation and management of positions/portfolio
- If unfamiliar with Options, willing to take the time to learn (at least the basics)
- Using available capital to purchase stocks, but willing to sell those stocks if Called Away. Or, if using existing stock positions, also willing to sell those stocks.
- Looking for consistency in results, not volatility
- Wanting to create some certainty from their investment capital whilst maintaining exposure to the stock market.
Considerations that might not suit all investors:
- The basic approach to the strategy will not outperform strong bullish (upward) market activity. It is not a Growth strategy.
- It is not a set and forget approach. You will need to adopt a strategy approach that best suits your needs.
The Covered Call strategy is not designed to beat the markets!
It is a strategy developed to provide an income approach, and by doing so, you are locking in a certain amount of return in exchange for an uncertain market/underlying outcome.
Your needs, your money!
For many investors, having more control of their investment capital, and having it work for them is an absolute priority. Fact is, the uncertainty of the markets for investors heading towards (or already in) retirement, means lower Risk strategies quite often provide lower rates of return.
The Covered Call strategy is one that provides better rates of return than low risk investment approaches, and at the same time reduces the Risk of stock market investment.
If that is an approach that you think might suit your needs, then I recommend investigating as much as possible.