Cashflow Report – Paper Income during August 2011

Welcome to my cashflow report for August 2011!

Every month, I create a “cashflow report” to review the paper income I’ve created from trading covered calls. Every investor and trader should review their trades on a regular basis, and I use my reviews to do the following:

  1. To help me track my progress towards financial independence
  2. To maintain my focus on increasing paper income and meeting my goals each month
  3. To provide an example of creating an income from investing/trading
  4. To get your perspective


August 2011

I feel like I wrote the last cashflow report ages ago. The October 2010 DRN uptrend was still intact, with a price that was range bound between the mid-60’s and mid-80’s. EDC was in a short-term downtrend, but remained range-bound between the mid-30’s and mid-40’s. TMF gaped up at the end of the month and pierced the $40 level. And FAS was headed south.

So many events roiled the markets in August that it is hard to know where to begin. You can take your pick between the S&P downgrade, US debt ceiling debate, Europe’s banking crisis, and the sputtering US economy.

But as an option trader, these events are actually GOOD things. More uncertainty creates more volatility, which in turn creates higher premiums.

What I learned in August

The major “duh” last month came in the form of higher premiums.  I traded more often (mentioned here and here), so my commissions and fees were higher.

As for “ah-ha’s”, anytime I have a loss, I know there is an opportunity to learn. And since I had some large losses in August, I know there are some large lessons to be learned.

First and foremost, August served as another example for the importance of having trading money management rules. Had I been “all in” on DRN, EDC, or FAS, my losses would have been staggering. Not that my position sizes in DRN or EDC were ideal, but I am glad that I limited my position in FAS (instead of buying as much as I could in order to chase option premiums). I get to live to trade another day!

Secondly, having the ability to trade naked options is extremely important for capital preservation and loss avoidance (mentioned here).

Quick Primer:
A “covered” call is a call option on shares of an investment instrument that you own.

  • If I own 100 shares of DRN, and sell a call, I have sold a “covered” call.

A “naked” call is a call option without any shares.

  • If I own 0 shares of DRN, and sell a call, I have sold a “naked” call.

Trading covered calls on an underlying positions is great when the markets are moving sideways. When the markets a rising, covered calls aren’t bad either. But when markets fall, watching the value of your underlying position fall isn’t pleasant. This is especially true when you know you should have sold because you use a mechanical trading system that TELLS you when you’re supposed to buy and sell. Since markets rise geometrically and fall exponentially, losing money happens much faster than gaining money.

Going back to the example above, to protect against a loss I would need sell my 100 shares of DRN as soon as I got a sell signal from my mechanical trading system, and then hold the “naked” call (or buy it back if the cost is low enough). Sitting on the money from the sale of my 100 DRN shares, the DRN call would be still be covered by the cash in my account, rather than shares of DRN. The problem is with my brokerage firm. Naked calls are not allowed in accounts with a balance lower than $100,000. Lesson learned – lower my risk percentage per trade until I have the ability to hold naked calls.

Finally, there is one more major lesson to be learned, but it won’t be fully realized until the current market correction/economic recession is complete. Let’s revisit a subject I touched on in July’s income report:

For example, I haven’t created the process or mechanisms in place to really live off investments. Profits are recycled back into the trading account for the time being. There are still some topics that need to be addressed before I can start weaning myself off of a paycheck…

In August, my covered call account suffered a ~15% draw-down. I still have enough capital to continue meeting my cashflow goals. But this statement is misleading, because I have not made withdrawals from my trading account each month. If I were truly “living” off my option trades, the losses would have been closer to 25% and generating $3,600 in September would have challenging.

The lesson to be learned here relates to minimum account size needed to supply $3,600 cashflow during a market correction. On the bright side, higher option premiums make my task a little bit easier.

Cashflow Report – Paper Income During August 2011 – Breakdown:

DRN-Direxion Daily Real Estate Bull 3X (ETF)

Premiums = $2250.00
Dividends = $0.00
Commissions/Fees = ($20.96)

EDC-Direxion Daily Emerging Markets Bull 3X (ETF)

Premiums = $1855.00
Dividends = $0.00
Commissions/Fees = ($34.22)

TMF-Direxion Daily 20+ Yr Trsy Bull 3X Shares (ETF)

Premiums = $0.00
Dividends = $0.00
Commissions/Fees = ($0.00)

FAS-Direxion Daily Financial Bull 3X Shares(ETF)

Premiums = $434.00
Dividends = $0.00
Commissions/Fees = ($31.53)

Net Cashflow – August 2011 = $4452.29


Paper Income from Covered Calls
GOAL: Create cashflow greater than or equal to $3,600 USD per month for 3 months straight by executing my covered call strategy.

Well, I did it. I reached my goal of $3,600/month for 3 months. Tack on my previous goal ($3,000/month for 3 months), and that is 6 straight months of steady cashflow. Not too shabby.

The Road Ahead

From here, there are several directions I could head (in terms of goals). As mentioned earlier, there is the need to get my account past the $100,000 mark. I have actually achieved three of my longer term goals this year (in terms of cashflow/month), so I could go for the 4th watermark at $6,000/month for 3 months. Given my money management rules, these two goals tie together nicely assuming an average option premium of 6%.

But my mission here is to gain financial independence. I proved to myself that creating consistent cashflow is possible. So achieving a higher cashflow each month is about having more money in my account. Sure, there will be additional money management challenges, but I think most will be mental.

I haven’t proved that I can withdrawal money from my trading account each month and still hit cashflow targets. So I think the cashflow level of $3,600 will remain where it is for the next three months…but what I do with the money will be different.

NEW GOAL: Create cashflow greater than $3,600 USD per month, and withdrawal $3,600 USD per month, for 3 months straight by executing my covered call strategy.

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About T. Knight
Blogging about my journey to financial independence via investing for cashflow.

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