Welcome to my new “Low Risk Income” blog which is dedicated to discussing low risk strategies for generating income. I have written an e-book about a low risk income strategy which I have used in my self-managed super fund in the last three years. To help readers understand how the income strategy described in my e-book works in real life, I have created a model portfolio based on real trades that I am doing. I will provide a weekly update of this model portfolio and explain in detail any new trades that I put on and how I manage open trades. Please note that the purpose of this model portfolio is for education only and the trades shown here are NOT trade recommendations as I am not a licensed investment adviser.
As my goal is to show how it is possible to have financial security and a comfortable retirement with a small nest egg, my muse is Jane, a 55 year old lady who is planning to retire in a few years. She is a conservative investor who has $500,000 in retirement savings. At her age, a sound asset allocation for a conservative investor might be 60% in defensive assets and 40% in growth assets such as shares. We will invest her 40% allocation to shares using our income strategy so our model portfolio will be based on a $200,000 capital. This capital will be invested in a diversified portfolio of 6-8 blue chip Australian stocks which Jane is happy to hold long-term. She understands that the price of shares can fluctuate and she is not concerned if there are unrealised capital losses in her shares from time to time.
Our target income return for this model portfolio is 15% per year. The income will be come from a number of sources – dividends, franking credits, option premiums, and interest from cash which is set aside to purchase shares at a future date. Any realised capital gains (and losses) from shares sold will also be added (or subtracted) from the portfolio income.
If we can achieve the target return, Jane will receive income of $30,000 from this $200,000 portfolio every year. Assuming her other $300,000 is invested in a diversified fixed interest portfolio; she would receive another $19,500 based on a long-term average benchmark return of 6.5%. Jane’s total investment income for the year would be $49,500 which should provide her with a comfortable lifestyle according to the ASFA Retirement Standard, even if she does not have other sources of income.
Let’s assume we started this model portfolio on 1 April 2012 and Jane deposited her $200,000 in a CommSec Cash Investment account that pays 4.75% interest. The first trade that we will make is to sell put options on National Australia Bank (NAB). NAB is a fundamentally sound stock that Jane is happy to own long term. NAB has mainly been trading between $22 to $26 in the past year as shown in the chart below. Today it is trading at around $24.42 and Jane would be happy to own NAB shares at $24 or less per share.
NAB also pays fully franked dividends that have been increasing in the past 3 years as shown in the table below. As NAB will be going ex-dividend in early June, we decided to sell May puts so that if our put options get exercised, we will own the shares when they go ex-dividend. If NAB declares a similar dividend to the previous year in June, we will collect another $0.84 dividend in July and $0.36 in franking credits when we file our tax return at the end of the financial year.
Today we decided to sell 12 contracts of May $24.50 put options on NAB. We need to set aside $29,400 to buy the 1200 NAB shares should our puts get exercised. As our plan is to hold a diversified portfolio of 6-8 stocks, we can allocate roughly $30,000 for each stock position. As you can see from the options chain below, we collected $0.62 of premium per share which means that we would be buying NAB shares at $23.88 per share ($24.50 strike – $0.62 premium), if our put options are exercised on May 24, when the option expires.
If the price of NAB shares goes above $24.50 when the options expire on May 24, our puts will expire worthless and we simply get to keep the $0.62 of option premium which is a 2.5% return in less than two months or an annualised return of 21%. While we wait for our options to expire, the $29,400 we set aside to buy NAB shares can be earning interest for us. (Note: As we currently do not own any shares that can be used as collateral for covering the margin required for our NAB puts, some cash will be deducted from our account to cover the margin required by our broker. However, if we do have other shares in our portfolio which are considered acceptable collateral, we will not need to provide any cash to cover the margins for selling these put option contracts.)
Our open positions as of 11 April 2012 are:
I will be providing a weekly update on this model portfolio on this blog. If you are intrigued by our income strategy but have trouble following the discussions in this post, you will need to first download and read our e-book in order to understand the strategy and do some basic options education (found on our Resources page) to familiarise yourself with option terminology.
Disclaimer: This post is for educational purpose only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any reader interested in this strategy should do their own research and seek investment advice if required.