We have just completed the second month of this model portfolio. A summary of the income we have received to date in shown in the table below (click to enlarge).

Income Tracker as at 31 May 2012 – Click on image to enlarge

In May, we have made future commitments to buy 2 new stocks (NCM and ILU) by selling put option contracts. As you can see, the option premiums for these puts are very high (annualised return of more than 20%) compared to what we received for the put options we sold in April. Option premiums go up when the markets fall. This is why we can still generate a high income return even in bear markets, using this income strategy. Our NAB $24.50 put options contracts expired this month and because the stock price was below our strike price on expiry day, our options were exercised and we were assigned 1200 NAB shares. After we received our shares, we sold some covered calls to generate more income on top of the dividends that we will be collecting from our NAB shares.

We received a total of $3,010 in premiums for the option contracts that we sold this month. We had to use $29,400 of our cash to purchase the NAB shares. With 0.5% rate cut announced by the RBA in early May, the interest rate of our Cash Investment account has been reduced from 4.75% to 4.25%. At the end of the month, we would have received interest of $595.93 for our remaining $170,600 of cash, giving us a total income of $3505.93 or a 1.8% return this month on our capital of $200,000. The higher option premiums have helped to compensate for the fall in income from interest. This is why this income strategy can help us generate consistent income in all economic conditions. All the option premiums we received is ours to keep, just like the interest we received for our cash. We can choose to spend it our reinvest it. For simplicity, we shall assume that the income in our model portfolio is not re-invested.

At any point in time, we may have unrealised capital gains or losses on the stocks that we own. As stock prices fluctuate from day to day, we will not include any unrealised capital gains or losses in our calculations for returns. However, if any stocks are sold, we will include the capital loss or gains in our returns that month. Using this income strategy, stocks are typically sold when our call options get exercised. There is currently some unrealised capital loss in our NAB shares but we will not take this into account unless the shares get called away in September when our NAB calls expire. If the shares get called away, we will realise a small capital loss from our NAB shares because the strike price of the call options we sold is below the purchase price of our NAB shares.

Next month, we will continue to sell put options on other stocks. If our put options get exercised, we will use some of our cash to buy the stocks. Our WES $29.50 put option contracts will expire in June and if the price of WES is below our strike price on expiry day, we will buy WES shares. When we own the stocks, we can sell covered calls on these stocks (just as we did on our NAB shares) and we will also get income from dividends and franking credits.

Our target return for this model portfolio is 15% per year in income received (see Model Portfolio Set Up). If we can get a 1.5% return per month, our annualised return would be 18%. So far we have not factored in brokerage and fees in our income tracker. After deducting the expenses, we should still be able to achieve our target return of 15% per year.

I will be providing weekly and monthly 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.

Stay tuned!

Disclaimer: This post is for educational purposes 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 readers interested in this strategy should do their own research and seek investment advice if required.

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