market share

How to (Actually) Generate Cash Flow in the Financial Markets

Introduction

Income generation has interested me for a while now.cash

At first, I thought the best place to generate income was in the financial markets.

Guys like Ed Seykota as described in the book, Market Wizards,* astounded me with their income generating success.

I read Turtle Traders,* I studied babypips.com, and I asked investment professionals about how to generate income in the financial markets.

Most of these investment pros were guys I worked with, mainly value investors.

And like any good value investor will tell you, you can’t generate income in the stock market.

The stock market is for building wealth, not cash flow.

Some of the most successful investors ever are value investors.

There’s not a doubt in my mind that value investing works when applied properly.

(It can’t not work. Value investing is buy a $1 for 80 cents.)

But value investing isn’t the only way to make money in the stock market.

In fact, it’s only one of the many strategies to increase wealth.

And this is what took me so long to understand:

In the stock market (and in life) there are wealth creation strategies and there are income generation strategies.

The two are different and easily confused.

Income Generation

90%+ of Americans (and nearly the entire global population) focus only on generating income.

Income generation is about meeting basic needs and expenses by increasing the amount of cash you bring home.

It’s about the short-term: food, water, and shelter for this week, month, and year.

Many people generate income with a day job.

You measure the success of income generation by the amount of cash generated.

This is why we calculate job salaries in dollars per year.

Income generation is about turning invested time and small(er) cash investments into cash flow.

Using a $100 investment in your own blog and turning it into a cash generating machine is (obviously) an income generating technique.

This requires little cash, and a TON of time.

Starting your own business is one of the more promising ways to generate income, but it’s not the best way to preserve and create wealth.

Wealth Preservation and Creation

Wealth preservation answers the question, “How can I put away money now so that I can access it (and more) in the long-term.”

The wealthy’s primary focus is on wealth preservation and creation, not income generation.

Why?

Because they already have enough income or have reasonable basis to believe they can continue earning that income for the next few years.

Their concern is income in 5 years, 10 years, or longer.

This is why you measure your success in creating wealth with annual returns.

And you measure your success in generating income with annual cash flow.

Many of the greatest wealth creators (stocks without dividends) don’t generate any annual cash flow.

And that’s fine as long as your goal is wealth preservation and creation.

Because as soon as you sell stock, the cash you get is earning a -3% return (or whatever the inflation rate is).

Even if the company whose stock you own is earning a “measly” 4% return a year, that’s a lot better than -3%.

In the hedge fund industry, the rule of thumb is that investors want to see at least double-digit returns.

This means that in our most optimistic models, we must be able to offer our investors annual returns of 10%+.

If we can’t, then they might as well invest in an index fund for free or nearly so and get approximately the same return for less risk and fees.

So in our example above, if you have $100 and you earn a 10% return on it annually, you’re only making another $10 a year.

This example illustrates the reality that wealth creation requires more capital than time.

The Stock Market, Wealth Creation, and Income Generation

The stock market is one of the most popular places to create wealth.

But hopefully you’re beginning to understand why it’s not the best place to generate income.

As Seth Klarman says in his classic, Margin of Safety,* there are two ways to make money in the stock market: asset appreciation and dividends.

Asset appreciation (when you own stock and the price goes up) is a fantastic way to preserve and increase wealth.

But it doesn’t generate any cash (unless you sell when it’s up. Then you’re stuck earning the -3% of cash).

Dividends are by definition, cash flow, but you need a significant amount of capital to cover yearly expenses from dividends alone.

For your reference, the average dividend yield for companies in the S&P500 (the most valuable 500 publicly traded companies in the US) is 2%.

This means that you get 2% annually in cash from your investments.

This also means you would need 50X your annual expenses invested in the market before you could count on dividends to cover your expenses.

Plus, stocks (and thus) dividends can be volatile.

Over the long-term, they average out for a good return, but in the short-term, companies fail, get acquired, and otherwise change.

This results in wide stock price fluctuations.

This volatility rewards the long-term investor focused on wealth creation.

But it can hurt the short-term investor looking to generate cash flow from the market.

What About Day Traders?

There are countless success stories of people creating serious wealth with value investing.

But there are hardly any success stories from day traders creating cash flow from the markets.

Why?

Because the financial markets are built for wealth creation, not income generation.

So to generate material cash flow in the markets, you need a significant sum of money to start.

Even the few and far between day trading success stories involve a starting sum that’s more than most focused on income generation can afford.

Take Timothy Sykes, one of the most famous day traders of our time, who turned $12,415 into $1.65 million over the course of his college career.

Of course, this is an unbelievable feat.

But he still started with over $12,000 in cash, had a lot of time to focus on the markets as a college student, and didn’t need that $12,000 to eat.

And the famous Turtle Traders who were complete novices taught by experienced traders and made millions in the markets were given $1 million to start.

You can try to sidestep this need for capital with margin (a fancy word for debt).

But using margin is an extremely risky strategy.

You could easily end up owing more money on a bad trade than you have to spare.

How to Actually Generate Income from the Financial Markets

After learning all this, I gave up on the financial markets for generating income.

Instead, I looked to entrepreneurship to make cash flow.

And I still think that entrepreneurship is one of the best ways to do this.

But what I didn’t realize until recently is that cash flow in the financial markets is still possible, just not likely in the stock market.

Of course, you can take the path of many investment professionals who realize this and sell their financial services to generate cash flow in the stock market.

For instance, hedge fund managers make their money from charging their investors fees, not exactly from their trades.

You earn more from your fees and can charge higher fees if your trades are profitable.

But ultimately, your cash flow comes from fees, not exactly from your trades.

This is how Warren Buffett initially built his wealth – charging fees as a hedge fund manager, not directly from asset appreciation or dividends.

But there’s another way to make cash flow from the markets.

Making Cash Flow in the Financial Markets with Options

One way to do this is with options.

If you’ve heard of options, you’ve probably heard they are difficult to understand and risky.

If you haven’t heard of them, don’t worry.

I’ll give you a brief explanation that (hopefully) shows you what they are and how they don’t have to be too complicated or risky.

There are two main types of options – calls and puts.

I’ll start with calls.

Let’s say Apple is set to announce their earnings next week.

You think Apple did really well this quarter so you think their earnings report will be positive.

And you want to bet that the stock will go up at least $10 per share after the earnings report publishes.

What you really want is the option to buy the stock at a later date a given price.

This option exists in the financial markets and it’s called a call option.

Call option buyers purchase the right to buy stock below what they believe to be intrinsic value.

This is so that they can turn around and sell it on the open market for the difference.

But for every call option buyer, there must be a call option seller who collects a fee known as the option premium.

And this option premium is how you can generate income in the financial markets.

Option premiums range from $10 to thousands of dollars.

Once you sell an option, you immediately receive the premium in your brokerage account.

That means you could transfer the option premium to your bank account and spend it the day you make it.

Now you don’t really know if that money is profit until the option contract expires.

But you can sell options just days before they expire.

So you can know whether that cash you received is profit very quickly.

Selling Cash Secured Puts with James Altucher

I’ve briefly explained call options.

But there’s another type of option called a put option.

This time, I’m going to let the pros at Dough Inc. explain put options.

If you watched the video you have an idea of how put options work.

When you sell a put option, you always collect an option premium just like a call option seller.

If the put purchaser’s prediction of the stock price is true, the stock will get “put to you.”

This means you have to buy the stock at the strike price.

Altucher’s strategy in his Instant Income product is to sell put options on stocks you’d like to own.

If the buyer exercises the option , you buy stock you’d like to own at a great price.

If not, the option premium is pure profit.

You can learn more about Altucher’s “instant income” product here.

But basically, Altucher’s product includes his stock picks/put option strategies in a weekly email format.

Conclusion

I’m excited to see how much cash flow I can generate selling Altucher’s picks of put options.

And I’ll be sure to report my earnings and losses here on the blog!