It’s a big day here at Rising Returns – today I sold my first option contract. I sold a call option on Flowers Foods (FLO). A typical contract is for 100 shares and since I own in excess of 100 shares of FLO, this is referred to as a covered call. Selling a covered call is a fairly typical way to experiment with options trading, due to the fact that as long as I hold my shares through the contract’s expiration date any obligation I may have on that date is already covered.
If you find yourself wondering what that all means, fear not. Here’s a high-level explanation.
As I mentioned above, sold a call option on shares of FLO that I already own. What is a call option? Well, I have agreed to sell shares in FLO to a counter party on an agreed upon date at an agreed upon price. In this case, I’ve agreed to sell 100 shares of FLO to a counter party on April 21, 2017 for $17.50 share. The counter party (the person who bought the contract) is under no obligation to exercise the contract. On April 21, 2017, if shares in FLO are trading below $17.50, the contract will most likely expire worthless and I will get to keep my shares. If FLO is trading above $17.50/share on that date, the contract will likely be exercised and I will sell my shares at $17.50 and the new owner will lock in an instant profit.
So, why would I do this? Simply put, I wanted to experiment. I’ve been interested in covered call trading for a long time and have never taken the plunge and sold a contract. So I decided to try it out. When anyone sells a call they collect an option premium, which must be paid by the counter party as the cost of buying the right to purchase shares at a given price on a given date. Here are the numbers for my specific situation:
100 shares of FLO at a cost basis of $15.26/share or $1,526 total.
Option premium collected: $.40/share, or $40, less $6.95 transaction fee and $.75/contract fee. Net option premium of $32.30.
If my shares are called away and I have to sell them at $17.50/share, I will make a profit of $2.24/share, or $224, plus the premium of $32.30, plus another $32 (a little more because of reinvestment, but $32 is close enough) in dividends collected between now and April for a total profit of $288.30 on an investment of $1,526 which equals an 18.89% return. I bought the shares in August 2015 so that roughly works out to a 28.6% annualized return. Someone check my math on that, but that’s not too bad.
If my shares are not called away, then I’ll still collect the $32.30 option premium and $32 in dividends and go on my way a happy man.
This strategy really works if you are planning to hold on to the shares throughout the contract period and would not have otherwise sold them. The downside is that you are giving up potential excess capital gains by putting your shares at risk of being called away, but if the strike price is fair then why not collect a little extra juice instead of just sitting on shares?
Have any of you experimented with this strategy? Obviously this trade was pretty small potatoes, but that’s ok. It’s a good way to gain some experience with the strategy.
Every once in a while someone will ask me about personal finance or how to get ahead or how to save money or some other similar question. So I’ve been thinking about how to answer those types of questions. And I think that I have boiled down all of the options and variables into one easy to remember top key to financial success.
Oh man this is so simple, you’re gonna hate me. Oh well, here goes.
The number one top key to financial success that I can recommend is……automation.
Automation is the top key to financial success.
Stay with me — I know that wasn’t very exciting. It’s certainly not as sexy as something like “put all your money into pork belly futures”. Although, that wouldn’t have been a terrible move a few years ago, given the recent bacon craze. But anyway. Automation.
In my life, automating as much of my finances as possible has made things so easy and really paved the road to success.
Let me explain.
Let’s say you have a goal of saving $1,000 over the course of the next year. In order to meet that goal, you’ve got to break it down into a series of easily manageable and achievable mini-goals. For me, it’s helpful to break down larger goals into smaller steps that can be easily repeated without too much effort or thought. I tend to perform best when I have the least chance of getting in the way or screwing something up.
Which leads us to automation. Think back to our example goal of setting aside $1,000 during the course of a year. The first thing I would do is break that down into some more tangible, real-to-me goals. I mean, if I say I will do something in one year’s time, chances are it’s not going to happen. So let’s break it down.
One year is 52 weeks. Using weeks as our measure of time for our mini-goals is helpful because one week is an easy time frame in which to gauge success. Did I do what I set out to do this week, or did I not achieve my goal?
So if we are going to save $1,000 over 52 weeks, that breaks out to just a hair over $19.23 each week. Let’s call it $20. Save $20/week for a year and you’ll have $1,040 at the end of the year.
Isn’t $20/week much easier to think about than $1,000/year? I think so. The problem here is that even with a goal of $20/week, you still have to think about it. What are the mechanics of saving that money? How does it happen?
Well, you could take $20 in cash and every week for a year you could put that cash into a jar – that’s one way. Or, you could log into your bank account each week and transfer $20 from your checking account to your savings account. If you’re old-fashioned you might go into a branch office of your bank and direct the teller to make the transfer. That’s another way.
The problem with both of those options is that you still have to remember to take action each week. If you’re anything like me, that gives you 52 opportunities to come up with an excuse not to save the money, or to forget to do it. This is why I say automation is the top key to financial success.
In my opinion, we should work to remove as many barriers as possible that exist between us and our goals. By automating the process of saving $20 every week, I’ve effectively removed the most prominent barrier: my inertia when it comes to taking action and my difficulty with remembering to do something consistently each week.
The mechanics of this are really simple. If I were you, I’d log in to my bank account online, set up an automatic weekly transfer between my checking account and my savings account to occur each Friday for $20. Boom, you’re done. In one year you’ll be a thousandaire.
Obviously, automation is applicable to get more than just saving $1,000. I have the vast majority of my bills set to auto-pay. I have automatic transfers into savings accounts, investment accounts, etc. Anything that I can set up so that I don’t have to actively remember it, I set it up that way. By doing this I reduce my role to more of an overseer. I’ll log in to my accounts to make sure that everything is flowing as I have planned, but unless I’m making an adjustment to my plan there’s ok real need for me to be physically transferring money between accounts most of the time. It’s beautiful.
This is why I think automation is the top key to financial success. Once it’s set up, it guarantees you will meet your goals. And it frees up your time to focus on other, more important things. Like breakfast.
In my earlier post about building your cash reserves, I talked a lot about why it was a good idea to have cash reserves and gave a couple of tips for building up those cash reserves.
Today I’d like to talk a little bit about how you can arrive at a number that represents a healthy emergency fund for you in your specific situation. I’ll walk you through my thought process about how I arrived at my emergency fund number.
Let’s start by defining the term “emergency fund”. It’s pretty simple: it’s a fund that we use in case of emergencies. If I lose my job and can’t buy groceries – that’s an emergency. In that situation, I would use my emergency fund to pay for my groceries and other bills instead of using some other source of financing (credit card, loan, etc.).
Since an emergency fund is intended for use in only a true emergency, when calculating an emergency fund amount I like to only think about the bills that I would have to pay in an emergency.
Here’s a rough breakdown of my emergency bills:
-groceries, gas, other necessities
Why do I include those items in my emergency fund calculation? Well, the mortgage and utilities are fairly obvious. I want to keep my house and I want to turn the lights on and have heat. It would have to be a truly dire emergency for me to not pay the electric bill. Groceries are another obvious one – no matter what happens, you still need to eat. Gas and other necessities could be debatable. I like to count these items because even in an emergency situation, I’m going to need to drive places and I’m going to need to do other normal things. Additionally, by including items that could be considered frivolous in an emergency, I am effectively building in an extra layer of reserve. If I had to, I could cut back on something in an emergency and stretch my money even further.
I include insurance and debts here, as well. Many people might not, and that’s ok. My thinking is that insurance is not something you ever really want to be without if you can help it at all. The same logic goes for paying down debts. If you can help it at all, don’t ever get behind on a debt. With that in mind, I like to include those numbers when calculating my emergency fund.
Hopefully, you’ve been doing some financial benchmarking and you have a pretty good idea of what you typically pay for each of these items in a typical month. Let’s throw out some generic numbers, just for our example:
Groceries, Gas, Etc.: $600
Total minimum outlay for one month: $2,150
So now that we have our minimum expenses for one month, we can start playing around with different factors in order to arrive at our final emergency fund number. At this point it is important to remember that there is no perfect number that will apply to everyone. I’m going to mention some general guidelines, but they are flexible for different people and different situations.
In my post on building your cash reserves, I mentioned that I think $1,000 is a great starting goal for someone that has no emergency fund. If you are in the situation of having next to zero emergency savings, I definitely recommend setting $1,000 as your initial target.
If you have $1,000 set aside already and are ready for the next level, aim for one month’s worth of expenses. In our example situation, you would be aiming to set aside an additional $1,150 for a total of $2,150.
If you already have one month of expenses set aside, I think that the next reasonable goes is to go for one month of expenses for each person in your household. If you are single, you’re already there. If you are a married couple, then your next goal is to save up one more month’s worth of expenses. If you have a kid, save a month for the little one.
The general guideline for your total emergency fund that I like to live by is that you should really have two months of expenses set aside for each dependent member of your household. In my situation, I am married with no kids right now. That means I need to have four months of expenses put away, according to my guideline. Once you reach this point, you really have some options regarding your extra cash.
I’m a little more conservative and have decided to keep 6 months of expenses stashed aside for emergencies. Now that I have that emergency fund built up though, what do I do with extra cash? That’s a topic for another day.
There are lots of different opinions about the emergency fund. Many people will say that 6 months is way too much money to be holding in cash – that money could be working much harder for me somewhere other than a savings account. I admit – I think the same thing about once a month. The bottom line and most important lesson to take away is that you need to have money set aside strictly for emergencies. This money shouldn’t be touched for anything else. Getting a sufficient emergency fund built up is not an easy task and can take quite some time, but when you do get there it’s totally worth it.