Since I earned over $1000 with blogging in December, I thought I would try to pay off some principal on a rental house and eliminate private mortgage insurance (PMI) since I had read that once you had paid off the loan to 78% of the purchase price, you could do so. I called the company that services the mortgage and found out some things that I did not know.
First, I found out that my mortgage was owned by Freddie Mac. That was somewhat disappointing given all of the bad press in recent years on the quasi-governmental institutions that have been bailed out. But then again, I don’t know what else I should have been expecting, so for all practical purposes, it is neither here nor there.
I also found out that I need to pay down the loan to a much greater extent with a rental than I would with a primary residence. That makes sense since investment property is considered more risky and demands a higher interest rate for the mortgage as well. Make sure you compare mortgage rates to get the best deal. However, I was somewhat shocked that the requirements for Freddie Mac are a 65% loan-to-value. The bottom line is that I don’t have $15,000 lying around to simply eliminate PMI. I would save $66 per month or $792 on a $15,000 investment giving me a yield of just over 5%. Certainly not the best use of funds even if I did have them.
Going With Plan B
Or should I say, “Back to the original plan”? The original plan was to pay off a business credit line with an 18% interest rate. At the time, the balance was about $1000 with a most recent monthly payment of $68. Over the next year, then my cash on cash return would be $816 saved in payments for a $1000 investment which does wonders for the monthly spending plan.
So, that is exactly what I did. I paid off the business credit line and will next start working on paying off the Discover Card as I had mentioned previously. I won’t be making any significant progress on that credit card balance this month since I haven’t quite earned $1000 yet and will be spending some of my blogging income on paying authors for the new blog and for funding my recent contest.
However, I hope to make a decent dent in the Discover Card balance in February since I have little anticipated blogging expenses other than paying authors and hope to make close to $1000 in that month as well. It has been a rough few weeks from a revenue standpoint, but I think that I can expect blogging income to be variable with some ups and downs.
Paying More Than the Minimum
I am already paying more than the minimum. Since I have been doing my best not to add to my overall credit card balances, as the minimum required payments on some of the other cards decreased, I shifted the difference to the Discover Card so that I am still making a decent sized payment each and every month without adding any of the blogging income. Now that I have paid off a business credit card and a business line of credit, I should be able to make more rapid progress on the Discover Card.
Then it will become a matter of figuring out the next debt to tackle and so on and so forth. I can only hope to maintain the intensity (which I think I will do) and avoid any of those nasty financial surprises that can derail even the best of plans.
Wish me luck!
Recently, Joe over at Retireby40.org discussed his options for a $50,000 emergency fund, and I must confess that I thought they were rather poor. Not that Joe is making poor decisions, but his options for investing this money are pathetic. A 5 year CD paying 2.25%? That is a guaranteed loss of purchasing power because you know that after taxes and inflation are taken into consideration, the value will be down!
Now Joe has certain requirements, and I am not trying to change his mind regarding them. But he did ask the question posed in the title and since my answer was going to be longer than could be held in a comment, I thought I would write a post about it.
How I Would Manage $50,000
I have to assume that Joe is debt free (with the possible exception of a mortgage) so I would make sure that I am debt free as well. I also have to assume that there is some savings in Joe’s budget so that he might be adding to this fund at a rate of $500-$1000 per month. You don’t want to be quitting a job with a budget that is tight.
I also have to assume that the likelihood of needing all $50,000 within one month is incredibly slim. What emergency costs that much? You should have other insurance to cover major medical or disabilities or liabilities so needing the whole sum at one time would be unexpected. So having access to half the money rather quickly seems reasonable to me.
Invest in Stocks
So, I would invest in stocks. Now I know it doesn’t meet Joe’s requirements but hear me out. Investing in a margin account would allow you to access half of the equity rather quickly (within one week). The interest rate on that at ETrade is 8.44% which is likely better than a credit card. Again, how much will be needed at one time?
But there is the concern about loss of principal. Now I am just as concerned about loss of money as much as the next guy and possibly even more so as I get older. This is why I use protective puts. I would look for large company stocks that pay dividends but might be slightly volatile so that they pay a good premium on covered calls. Then I would buy some puts, sell some calls, and collect the dividend. I would probably split the money in two portions and invest in one energy and one tech stock.
For example, I might choose to purchase 1000 shares Intel stock (INTC) at $26.38 and purchase the January 2013 $22.50 strike put option at $1.47 per share. I am choosing the longer term put because the cost per month of protection is relatively low. Thus my total cost is $27.85 plus commissions or $27,850.
I would then sell the April 2012 $28 strike calls for 42 cents per share lowering my basis to $27.43. Now if the stock heads above that price by April and stays there so it gets called out, then I have made 57 cents in profit plus the 21 cents quarterly dividend or $0.78 on my $27.43 investment. The yield is 2.8% over 3 months which is much better than a five year CD. But let’s not forget that the put option has an additional 9 months of time value left which can be sold for additional profit.
Rising Tides Are Easy
So it is easy to make money when your stock increases in price, but the real problem is the risk involved. What if the stock drops like a rock? The most money that is at risk is the difference between the basis of $27.43 and the put strike price of $22.50. That is $4.93 which represents an almost 18% loss of capital! That sounds too risky. But we will collect 84 cents in dividends over the next year so we would only lose 15% instead. But still losing 15% of an emergency fund is not fun.
However, this is where it is important to be able to add to the fund. If you are adding $1000 to the fund each month, then an additional 100 shares could be purchased in 2.5 months. If purchased at a lower price, then the basis will decline and additional calls could be sold after April. Eleven contracts could be sold at that point. The strike may end up being the $27 strike so this may help cushion the loss. Additional shares also means additional dividends which can be reinvested.
Now if the stock ends up $15 in January 2013, that is OK. The puts will be exercised at $22.50 giving the investor $22,500 which can then be used to purchase 1500 shares. If this is all that happened between now and then our original basis in the stock is $27.43 minus the 84 cents in dividends. The new purchase drops the basis even farther to $17.73 which would make selling a $17.50 call option a possibility.
The bigger risk is a slow grind down to $22.51 where the investor has difficulty managing the covered calls from April to the following January. That is where some experience helps as well as being able to purchase additional shares during the year to bring the overall cost of the position downward as the stock declines.
The bottom line is that I would be putting 15% of my capital at risk in order to earn about 5% over 3 months. To me, that is reasonable which is why personal finance is personal. You would never catch me investing in a CD in a negative real interest rate environmental. Again, a personal decision. But, since the question was asked, I answered it.
Feel free to ask questions and discuss in the comments and consider subscribing to my RSS feed as well as sharing this article if you liked it.
With having been in South Carolina on a golf trip over the past week, I hadn’t really done any round up or link posts, but I do want to highlight those carnivals CFM has been in these past two weeks. Be sure to check them out. A big thank you to all the sponsors.
How appropriate is it that we should wrap up our discussion of covered call time premium for the week on the day before option expiration? Even though options expire tomorrow on Saturday, today is the last day that they could trade. So for all practical purposes, I consider the third Friday of the month as the more important day when it comes to trading options.
Additional Factors Affecting Options Prices
We have already discussed a couple of the factors that influence the premium that one might receive for selling a covered call and will summarize those at the end, but another important factor that can influence the price of an option contract is the volatility of the underlying stock.
This should make sense since the way to profit with an option is by having a significant change in the price of the underlying stock. If a stock only typically moves $5 in a month, you can bet that options priced $10 away from the market price have very little value. However, if the stock is highly volatile and will move $20 up or down in a month’s time, then that same contract would be worth a lot more.
Finally, one needs to consider the impact of interest rates and dividends on the premium of a call option. In a higher interest rate environment, the call premiums tend to be higher since the cost to purchase shares of stock outright with borrowed money is more. This makes a call option a viable alternative as a form of leverage and so the price increases somewhat. Of course, this will benefit those selling covered calls.
On the other hand, a stock that pays a dividend will tend to have a lower premium since the stock should be losing value when it goes ex-dividend. On a side note, dividend paying companies tend to be less volatile.
Five Factors that Influence Call Option Premiums
To summarize, there are five main factors that work together to determine the ultimate price of a covered call:
- Relationship between the stock price and the strike price
- Time until expiration
- Volatility of the underlying stock
- Prevailing interest rates
- Dividends paid by the underlying stock
That concludes this week discussing covered calls and premiums. Feel free to ask any questions or suggest topics for the future.
Don’t Forget the Cash Giveaway
There are only 5 days left (ends January 25th) in the cash giveaway celebrating my 100th post here on CFM! Be sure to enter!