Foreword
In which I come up with a possibly crazy idea….
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Capital Stack
As discussed before in Capital Stack, there are different ways that a company can finance itself. In particular, bonds (i.e. debt) are generally structured such that as long as the company makes periodic payments to the bond holder (and possibly making a balloon payment at maturity), the bonds remain as bonds. However, if the company fails to make payments, in most cases, the equity holders are generally wiped out (or at least lose a substantial portion of their investment), while the bond holders now become the equity holders, while the bonds themselves are generally canceled.
In a sense, bonds are just “safer equity”, or equity with a deductible — as long as the deductible is not met (the company does not do too poorly), you remain a bond holder. But once the deductible is met (the company does so poorly it cannot afford its periodic bond payments), then bond holders become equity holders.
Trading Bonds
Now, the problem with trading bonds, is that trading bonds are hard. And annoying. Unlike shares, where every share (of the same class) is identical, companies tend to issue different “series” of bonds, and each series tend to have its own slightly different rules. As a result, the number of “identical” bonds tend to be fairly large, compared to the number of types of shares, and as a further result, corporate bonds tend to have fairly poor liquidity.
Which is to say, trading corporate bonds is hard and annoying. Especially if you are not splashing 10’s of millions in a single trade… at least.
Cash
For those who follow me on StockClubs (which I have invested in), you’ll notice that pretty much since Sep 1, 2021, the portfolio I share on StockClubs is almost entirely in cash. While this is just 1 of 10+ brokerage accounts I hold, it is pretty representative of my entire stocks portfolio (1).
Instead of buying stocks, I have bought money market funds, which have been yielding from 3-5% (pretax) in the past year or so. As noted in Safest Money, right now, money market funds are one of the safest way to hold US dollars, and they provide an almost decent yield.
Puts
At the same time as holding a lot of cash (via money market funds), I’ve also been selling puts on a few select stocks that I am interested in. These are generally stocks that I feel will do well during inflationary periods.
If the stock price falls below the strike price of the put, then I will have to buy the stock at the strike price. But if the stock price is above the strike price at expiry, then the premium I collect is mine to keep with no other consequences (other than taxes, always the taxes…). If you think about it, this is, in a hand-wavy way, sort of like a bond. A synthetic bond based on the stock price instead of company cash flows, sure, but since stock price tends to follow performance, it’s close enough for me.
If I happen to get assigned, then I will just switch to selling calls against the stock position, effectively creating a synthetic put. Yes, a synthetic put that I’m using as a synthetic bond. We must go deeper!
Now, to be clear — I don’t generally oversell puts. In fact, I generally undersell puts, i.e. if the puts are assigned, I have more than enough cash to pay for the stocks — I simply have to sell off some of the money market funds. Overselling puts is equivalent, somewhat, to using leverage, but selling cash secured puts is not.
All together now
Put together, this setup means that:
- I get a steady stream of income from the money market fund.
- Every month or two, I sell puts/calls with expiry in the next 1-2 months on stocks I like.
The money market fund yields me 3-5% a year, while options play yields between 6-8% annualized (depends on the stock, the expiry and the strike, but I generally aim for about 5-10% out of the money).
The plan is to continue doing this, until the market makes up its mind whether it wants to go up or down, and then revisit the decision. While this strategy limits my upside (I can’t earn more than the option premiums + money market fund yields), I have almost the full downside of owning stocks outright — if the stock prices drop far enough I’ll be holding the shares at potentially large unrealized losses.
But if my guess is right — that stocks will mostly not go anywhere for a while, then there’s no upside in owning stocks outright anyway, but I still get to keep the yields from the fund and the option premiums.
Fingers crossed, let’s see where this leads us.
Footnotes
- To be clear, this is just representative of my stocks portfolio. I also have a real estate portfolio which is entirely in… real estate. Duh.
Janky Thoughts 