My first year selling stock options….33% returns

As I tally up the results of my investing activity over the past year, one asset class stands out Above the rest – selling stock options.

For many of you that may think of options as overly speculative and risky, let me point out that some of the most revered investors in the world including Warren Buffett do a variation of the strategy that I have used.

It’s called selling put options, which fundamentally is selling insurance against a large drop in a stock portfolio – and there are a ready pool of investors willing to buy it.  And like any other viable insurance business, the model works if the amount of premium paid can cover the expense and anticipated frequency of the insured event.  When you sell a put option you incur the obligation to buy a counter parties stock only if it drops to a certain agreed-upon price below where it is currently trading.  The obligation can be purchased for a wide spectrum of time horizons ranging from weekly contracts to several months. If the equity drops to the agreed-upon price level called the strike price, the option is exercised with a transfer of ownership.  If it does not  reach the strike price, the option expires worthless and a new contract can be written with more premium taken in by the put seller.  The exact same strategy can be executed for strike prices above the current price and these options are referred to as calls. Conceptually, it’s fairly straightforward although there are a number of variables that need to be understood related to volatility strike price selection and timing that allow you to tailor the strategy for your risk tolerance.   In Buffet’s case, he has often sold millions of dollars of long term put premium as a way to lower his cost basis on positions he wanted to own anyway like Coca Cola and Burlington Railroad.  Apparently options were excluded from his famous derivatives as weapons of mass financial destruction credo as he has also been quoted as saying,  “Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies”.

While I did an extensive amount of reading, in the end, I ultimately wound up hiring a “coach” to walk me through my first several months of trading.  My coach as it turns out was not a professional trader but actually a second generation CPA who has been conservatively trading options for the past 15 years.  This brings up another interesting point. When you peruse the retail options blogosphere (ie non-finance professionals) you will see that there is an over representation of engineers, pilots, accountants and other professions where a high degree of technical and or mathematical competence is required.  Perhaps my physics background and the very quantitative nature of radiation oncology practice lends itself to this sort of investing, although you certainly don’t need a PhD in math to master the concepts.

How does this strategy compare to simply investing passively in a broadly diversified low-cost mutual fund?  With the S&P index returning 19-21% (depending on dividend reinvestment) for the calendar year 2017, the strategy outperformed it by a comfortable double-digit margin.  This was enhanced by the unusual fact that we didn’t have a 10% market correction the entire year.  In discussions with my coach, in a typical year where we do have a correction, the strategy would produce a return in the low 20% range .  Particularly noteworthy is that the strategy can produce these returns in a number of market conditions ranging from side ways to slowly downward drifting. Conversely, during a more severe market correction ala 2008; the losses will be more severe than if you had simply held the equity positions. Nonetheless, the option premiums are priced sufficiently to still yield a net positive return over time and makes this a viable long-term strategy.

Here are a few other factors I consider to be positives about implementing a conservative options trading strategy.

  1.   While of course I enjoy experiencing the capital appreciation of my equity positions, the steady inflow of options premium satisfies my cashflow oriented background as an income property investor.     
  2.   The particular strategy I employ is not very time-intensive. The mechanics of putting a position on or taking one off is very straightforward and takes 5 to 10 minutes.   Because our positions have such a low probability of being breached, they require little monitoring or adjusting.
  3.  If the strategy is implemented on the major indices like the S&P  as opposed to individual stocks or ETFs there is also a tax advantage.    Under IRS rule 1256, 60% of your Index options profit is taxed at the long-term capital gains rate even if was earned in less than a year.  For   this reason, I have thus far limited my trading activities to these instruments.

Certainly there are trading cost to consider, but they continue to go down over time. Recently the popular stock market app Robinhood introduced commission free options trading on its platform which will surely apply further downward pressure throughout the industry.  And while there are certainly more options specific platforms, many of the mainstream brokerage houses like E-Trade, Fidelity, etc. allow for some basic option strategies. If you already have an account with them, this provides extra leverage to negotiate your options commissions in my experience.   

I should also note that it is possible to implement a variety of conservative options strategies in retirement accounts although usually it requires additional paperwork, permissions, and disclosures.  With the exception of my coach, the people I have met that are actively doing this are retirees looking to generate additional cash flow from their nest egg.

If you’re interested in learning more about options, one resource I found particularly helpful was the TastyTrade YouTube channel. Run by a former professional trader who has a proprietary trading platform; there are plenty of easy to follow along visual illustrations of how options trading works.  Equally compelling is his interview series with mostly people from a non-financial background who have had a measure of sustained success as retail traders using a variety of approaches.  OptionAlpha.com is also another incredible free resource that covers the full spectrum of options strategies.  (By the way I have no financial relationships with either company)

When you browse the options education blogosphere you will see many people making hyperbolic claims. Additionally it’s quite easy to cherry pick and highlight your best trades while ignoring your losers.  In the spirit of transparency, I’m happy to show the details of my actual trades if you would like to reach out at www.AlternativeFinancialMedicine.com.  

Option trading, even when done conservatively is certainly not a substitute for long-term buy-and-hold investing. The the majority of my stock portfolio is in a retirement account invested in a index fund with minimal expenses.  Nonetheless when done correctly, options can be a reliable way to augment your returns long-term.

 

 

Long Term Turnkey: More Landlord or Investor?

I distinctly remember perusing the BiggerPockets Forum a couple of years ago (my go-to site for real estate investing) and there was a topic asking people to elaborate on their long-term experiences owning TurnKey rentals. At the time the number of responses was low and the few people that did chime in had only owned their properties for a short amount of time. Likewise, I owned two properties at the time for barely a year and didn’t feel qualified to weigh in. A couple of years and a few properties later (8 total) I feel that I can provide some meaningful input.

First off, as a full-time practicing physician, I wanted to own income property in the least time-intensive way recognizing that I would sacrifice some degree of returns compared to a full-time real estate pro sourcing their own deals. After thoroughly researching the concept of TurnKey rentals I decided to take the plunge. As anyone that has followed this category of real estate investing can attest, your mileage may vary significantly depending on the provider, property condition, and location just to name a few key factors. I think the intrigue of turnkeys is the promise to turn the landlord experience into more of a passive investment. This is particularly appealing to the time-starved high-income professional like me.

With that being said I thought it would be an interesting exercise to show the email correspondences with my TurnKey provider for this calendar year dealing with any issue above and beyond the occasional late payment.

The first details a routine tenant turnover. Fortunately, we’ve averaged nearly two years of occupancy for my units so this has been a relatively infrequent occurrence. The expenses are in line with what I had been told to expect. As a testament to the quality of our units relative to the marketplace, we are able to bump up the rent and have had strong interest from rigorously screened applicants which result in a vacant period of just about 1 month.

I reviewed this email for approximately 5 minutes in between patients and responded in the affirmative to go ahead with the process. I honestly didn’t think very much about it until later in the month when reviewing the rent roll and noting the less than usual amount. A little over 4 weeks later and things were back to normal followed by several uneventful months until late August when the second email came through detailing issues at two separate properties.

In the first instance, the tenant, unfortunately, lost his job and fell behind on the rent. He had been rock solid for 18 months before his payment history began to get sporadic and ultimately stopped. The property management team attempted to find alternative lodging for him including exploring various social programs and charitable organizations. I think that in recognition of this he ultimately decided to make it easier on us and move out rather than trying to squeeze out more occupancy time through the eviction process. There was no undue damage to the property and this resulted in another routine turnover.

The 2nd half of the e-mail details a small section of the kitchen ceiling falling to the floor secondary to water damage from a roof leak. The leak was caused by squirrels damaging a roof vent boot ultimately resulting in a $700 repair bill. In my 3-1/2 years of ownership, this was the only instance that resulted in any sort of after-hours call in order to get authorization to move ahead with the repair as soon as possible.

So as we were coming to the end of the calendar year 2017 I would characterize the preceding emails as typical of both the frequency and scope of issues I have been confirmed with as a turnkey owner with an excellent provider. The communications are concise but detailed enough to take executive action and a thorough digital trail is documented via a robust online owner portal. And just for completeness sake, I received an additional 7 emails detailing either slight delays in rent payment or automatic authorization for minor (< $150) repairs.

While it is impossible to expect to be able to own income property as after effortlessly as a paper asset, with a good turnkey provider it can come pretty darn close. My experiences thus far have reassured my decision to slowly build my portfolio with the confidence that it will not be a significant time hindrance as I continue to enjoy practicing medicine full-time.

What has been your long-term experience owning Turn-Key rentals?

Hurricane Irma: The Importance of Reserves

I live in southeastern Georgia on the coast and we were certainly impacted by Hurricane Irma. This included a mandatory evacuation, temporary work closure, and scrambling for portable food and available hotel rooms. During the week-long ordeal, the constant barrage of images of torrential rain, flooding and downed trees created a sense of gloom of what I would find upon finally returning home. Likewise, I had similar concerns for the tenants and properties of my rental portfolio in Jacksonville Florida – further southward and therefore more exposed to the effects of the hurricane.

I feel very fortunate to report that, relatively speaking, we came out of this ordeal with manageable damage both to my own home and my rentals. I define manageable as no significant flooding, no direct hits from trees, and no need to file insurance claims. Nonetheless, the following communication from my TurnKey provider/ property manager attests to the fact that I will be facing some unusual financial challenges over the next couple of months and prompted me to write this blog.

When we screen our tenants we are very strict on verifying that their monthly income is three times the rent. With an average rental rate of approximately $1,000, this translates to a minimum requirement of $36,000 gross annually. In most cases, our tenant’s household income is in line with the national median household rate of approximately $57,000. Their jobs include bus drivers, dietician, and retirees working part-time. Good salt of the earth people, but also not the profile of someone easily able to withstand a significant short-term cash flow crunch.
When you factor in that many of the tenants have missed 5 days of work or more, and have extra hotel and food expenses, it can quickly exhaust their savings.

So not only am I faced with the dilemma of half of the tenants or more having payment issues over the next 2 months, but I also have elevated expenses related to tree pick up, and minor structural damages. Combining this with my debt service and this is likely to be the first time in over 3 years of ownership that I will have to feed my portfolio as opposed to receiving its usual cash flow. Given the relatively measured pace of my property acquisition and prudent use of leverage; it is a position I never thought that I would be in.

This underscores the often repeated mantra that I have read on this site and heard on the podcast: If you’re going to be in the landlord business and survive long term, you need to have adequate cash reserves. Roofs wear out, HVAC die, pipes burst, and yes…hurricanes happen.

The exact amount of reserves is a matter of debate as I have heard amounts advocated ranging from as little as $500 up to $10,000 per property. Personally, I allocate $1,000 per property which has always been more than sufficient in the past but will be tested during this whole ordeal. Obviously, I am hopeful that the disaster relief rent program will eventually help, but I certainly can’t count on it happening in a timely manner if at all.

How much in reserves do you set aside?

Has anyone had their rental portfolio affected by Irma or other natural disasters in a significant way?

Hear my story on Bigger Pockets podcast episode 219

More User Questions…..We Love Them!

user question

I continue to get great engagement from readers and listeners. Andy recently finished reading Alternative Financial Medicine: High Yield Investing in a Low Yield World and had a few follow up questions in this thoughtful and appreciated email he left on the site. The reason I share it is because there may be some of you with the same concerns and hopefully you can benefit from my insights to help you be a better investor.

Message: Hi Doctor Meadows,

I just finished your book and wanted to thank you for writing it! You give some great direction to those of us who have been floundering. It’s comforting to hear someone else’s views on some of the things that I’ve been considering and looking for feedback on. I invest in PPR and was glad to hear that there’s another option out there. Realtyshares has been another consideration, and I’m curious now, do you prefer it over Realty Mogul, or others? Also, I just saw a troubling article in Business Insider about Lending Club, do you still look favorably at them? Here is the link: http://www.businessinsider.com/lending-club-may-have-hit-a-dead-end-2017-5

On turn-key investing, wow, right here near me in Phoenix, there are a number of companies offering opportunities! So, now the daunting task of sorting them all out!

Are you familiar with The Note Factory? I just pulled the trigger with them and really like their business model a lot. You might want to take a look. They don’t advertise and are strictly word-of-mouth.

So, thanks again for the great book. It was very timely for me finding it when I did since the decision process was well underway.

Kind Regards,
Andy

Andy,

Tons of points you bring up!

Realtyshares is my number one crowdfunding site in terms of money and number of projects. This is due to me getting to know the CEO to a degree through multiple conversations over the past few years including meeting him in person at an industry event. They seem to be very committed to maintaining strict underwriting standards which is the real key to long term success.

If you have not seen it, I would highly recommend you check out my video interview with the CEO HERE.

Full disclosure, I have a teensy position in the company having been invited to invest in one of their equity rounds of fundraising.

I have been on Lending Club for about 3 years now and have seen everything from extreme optimism to much more pessimistic articles like the one you pointed out. Around the time of their IPO in December 2014 there was talk they could emerge as a real rival to traditional banks and then they went through some turmoil and scandal with impropriety with their CEO.

Lending Club

It seems like things have been shaky both for the company and the industry overall since then. Personally, I have maintained my account, which is only a modest portion of my overall portfolio. From the beginning I have been a relatively conservative investor preferring “A” and “B” loans with a target return of about 7% which I have been able to achieve. I have not noticed a spike in defaults sticking to these types of notes despite the occasional bad news for the industry.

On the rental property front, I haven’t found any shortcuts to vetting a turnkey rental provider. The things I used included podcasts, reading forums, calling up current investors and some on the ground site visits. I would particularly focus on talking to the investors and finding out their experience in terms of actual rents/expenses vs the always rosy numbers on the proforma. Also ask how responsive the property management aspect of things has been. In the end, it took several weeks for me to get comfortable with a provider but it has paid off significantly as I have experienced great customer service and expected financial performance on my now multiple purchases.

Can’t say that I have heard of the Note Factory. I have been pretty pleased with PPR as my exposure to the world of distressed real estate notes but I will check out Note Factory as well. I like PPR’s fund structure as it greatly diminishes the default risk associated with holding individual mortgages.

Thanks for picking up the book and if you haven’t, please leave a review on Amazon and tell your friends!

To your Wealth,

Doc