Category: Derivatives

Passive income through option writing: Part 2

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Last week we made the case for generating passive income through option writing. A quick recap of last week: buying puts to secure the downside of your equity investment is a bit like casino gambling: pay a wager (put option premium) for the prospect of winning a big prize (unlimited equity upside potential). Unfortunately, the average expected returns are also quite poor, just like when you gamble in the casino or buy lottery tickets.

Since we can’t beat the casino, let’s be the casino!

Being the casino means we act as the seller of put options. Let’s see how we implement this: Continue reading “Passive income through option writing: Part 2” →

Passive income through option writing: Part 1

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On the path to early retirement (and most likely in early retirement as well), the ERN family will be writing options to generate passive income (in addition to equity and real estate investments, of course). This may be something that people either haven’t heard before or even if they did, they might be turned off by the involvement of derivatives. After we got over our initial aversion against trading exotic instruments like options we found that it’s actually a reliable and profitable strategy to generate passive income. We mentioned this strategy already in a previous post on trading derivatives on the path to FIRE and thought that others might find this interesting too.

Today, in Part 1, we will do a quick intro to cover mostly the conceptual aspects of this strategy. Part 2 will go into how we actually implement our strategy. As a warm up, though, let’s start with a …

Pop Quiz:

Since 2000, the SPY ETF (S&P500 index fund from iShares) returned about 101% (Dec 1999 to August 2016, dividends reinvested), or about 4.3% p.a. What would the return have been if we had participated only when the market went up, i.e., if we had avoided every single down month and received a 0% return during that time?

A: 386% total, 10.0% annualized

B: 1,039% total, 15.7% annualized

C: 2,497% total, 21.6% annualized

D: 3,891% total, 24.8% annualized

Continue reading “Passive income through option writing: Part 1” →

Trading derivatives on the path to Financial Independence and Early Retirement

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Derivatives and FIRE (Financial Independence and Early Retirement) sound like two things that don’t mix. Like oil and water. Financial derivatives (options, futures, etc.) have the aura of opaque and highly risky investments. On the way to Financial Independence, most people are either oblivious to derivatives or avoid them like they carry communicable diseases. Probably derivatives are also traded in some smoke-filled backroom or an illegal gambling joint, right?

Let’s look at the myths vs. facts! Continue reading “Trading derivatives on the path to Financial Independence and Early Retirement” →

The Great Bond Diversification Myth

Update: If you’re coming over to this article from Mr. French’s article over at RetirementResearcher, please note the last few paragraphs below where I shoot down his shockingly sloppy analysis.

Bonds diversify your equity portfolio risk. Everybody knows that, right? Well, how much diversification potential is there, really? Much less than we thought! (For full disclosure, though, bonds still serve a purpose, but it has nothing to do with diversification!)

Pop Quiz: Over the last 10 years, a portfolio of 80% stocks (U.S. Broad Equity Market) and 20% bonds (U.S. Aggregate Bond Market) had what correlation with the stock market?

A: 0.998

B: 0.857

C: 0.800

D: 0.683

The correct answer is A: the correlation was +0.998, so an 80/20 Stock/Bond portfolio would have been extremely highly correlated with the stock market. We might as well round it up all the way to 1.0 because from a statistical, financial and economic perspective that’s pretty much a perfect correlation. This correlation coefficient is for a broad U.S. stock market ETF (use Vanguard’s US Total Market VTI) vs. a portfolio made up of 80% Vanguard’s VTI and 20% Barclays Aggregate bond index (we used the iShares AGG total returns). Monthly returns are from 07/2006 to 07/2016. Continue reading “The Great Bond Diversification Myth” →

Lower risk through leverage

You heard that right! You can use leverage the smart way and reduce risk, all the while keeping the expected returns the same as in an unleveraged portfolio. Leverage has gotten a bad reputation, sometimes for a good reason, think Global Financial Crisis in 2008/9 or the LTCM debacle that almost sank the financial system in 1998. But every force can be used for good or bad, think Star Wars. So how do we change leverage from a Darth Vader to a Luke Skywalker? Continue reading “Lower risk through leverage” →

How to create a no-limit Synthetic Roth IRA in a taxable account

Tired of contributing a paltry $5,500 per year ($11,000 for couples) to your Roth? If you like to contribute more than that, why not find a way to generate returns in a taxable account that mimic those of a Roth IRA? Impossible, you say? Under very specific conditions it is possible to generate after-tax returns in a taxable account that replicate those of a Roth IRA. We call it the Synthetic Roth IRA. Continue reading “How to create a no-limit Synthetic Roth IRA in a taxable account” →