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Usually when people talk about making money in the stock market they don´t think about how to generate passive income, instead they think about capital gains. However, today I want to write about how to generate passive income in the stock market in a easy and effective way.
The approach is a little bit different but what we want to do is basically to create passive ongoing incomes in the same time as we make our capital gains and even to offset losses if that’s the case.
Capital gains/ Generate passive income
Capital gains are dependent on a price increase in the stocks that you buy. For example if you bought a stock at 100€ and then the prize went up to 110€ you have now made a 10% capital gain, great!
The problem with capital gains investing in all markets and assets is that it is dependent on a price increase in the underlying asset to make money. A price increase (or fall) can never be predicted with certainty, even if you get really good at analyzing and back testing in the end anything can happen that makes the price move in one direction or another. With that said you can of course put the odds in your favor by learning to use some of the technical analysis tools available out there.
If your analysis tells you that the stock price should go down you might want to “short” the stock, meaning that you will make a capital gain if the price of the stock goes down. Practically it means that you borrow stocks and sell those borrowed stocks at today’s price, then when the price is lower you buy the stocks, give them back where they were borrowed and keep the price difference. This all works out automatically on the trading platform.
For example if you see some stock priced at 100€ today and you think the price will go to 50€. If you want to short the stock you first sell it at 100€ then when the price has gone down you buy it at the lower price and keep the price difference. If the stock price would go up instead the loss potential is unlimited since there are no limit to how high a stock price can go, that makes shorting very risky.
How to generate passive income is a bit different. Passive income can be generated in some different ways in the stock market. The most common and well known way to generate passive income in the stock market is through dividend payouts from the company that you own stock in. The dividend payouts are based on how well it´s going for the company during the year and may vary a lot between different companies. The range is usually between 1-10% or so per year. But what most people don’t know is how to generate passive income from your stocks from day one with something called options.
Options contracts are exactly what the name tells us, an options contract gives the buyer the option but not the obligation to buy or sell a stock at a predefined price within a predefined time period.
So why would you want to do that?
Let’s say you bought a stock at 35€ and then it went to 50€, now there´s an earnings announcement around the corner and you worry that there might be some bad news coming but you don’t want to sell the stock. What you can do then is to buy a put options contract that would give you the right to sell the stock for maybe 45€ anytime during the coming 30 days, no matter what happens the seller of the option has to buy your stocks for 45€, even if it would go to zero. For this “insurance” you pay a premium.
Puts and Calls
Put options gives the buyer the right but not the obligation to sell the underlying stock at a predefined price within a predefined time period.
Call options gives the buyer the right but not the obligation to buy the underlying stock at a predefined price within a predefined time period.
How to generate passive income with options
There are two simple ways to generate passive income from selling options.
Let´s say you buy a hundred shares in some company at 100€ because you made your analysis and it tells you that the price is likely to go up. After that you can you can sell a one month call option with the 110€ strike price. This means that you will give the buyer the option to buy your shares from you within a month for 110€. For this you will get paid a premium of maybe 5€ per share, total 500€.
After this 3 things can happen:
The stock price goes up over 110€ and you have to sell the stock to him for 110€ and get to keep the 5€ premium. You just made a total gain of 15% in a month, that’s pretty good.
The stock price stays the same under 110€. You keep the stocks and keep the 500€ premium and can do the same thing again the next month.
The stock price goes down. You keep the stocks and the 500€ premium and can do the same thing the next month.
As you can see, with this strategy we can generate passive incomes no matter what direction the stock price is going. Of course we would like to do this if we believe the stock price will stay the same or go up in the coming time period, but we will make money in any case.
Another way to generate passive income is the way Warren Buffet did in 1993 with options on Coca Cola:
In April 1993, with Coca Cola stock hovering around $39 per share, Warren Buffett determined that he would be interested in buying more shares if the price fell below $35.
But instead of waiting for the price to fall, he simply sold 5 million ‘put’ options with a $35 strike price. If Coke stock were to fall below $35, the option buyers would sell their shares to him, which would have meant Mr. Buffett would be forced to buy the stock at $35. This was perfectly fine because he wanted to buy at that price anyway.
But if Coke rose instead, Mr. Buffett would be happy enough, since he collected a $1.50 option premium ($7.5 million). In other words, Mr. Buffett wins on both sides. If the price falls, he gets the stocks at the price he wanted. If it goes up, he makes $7.5 million.
So to sum it up Warren Buffet got $7.5 million in passive income and didn’t even buy the stock.
He is still using both these strategies successfully and makes a lot of money from it.
If you would like to learn how to generate passive income from the stock market, Andy Tanner´s book – Stock market cash flow is a really great way to start educating yourself. Options trading is like everything that is worth doing in life. It´s not easy, it takes some education, practice and effort but it´s another way to create passive income, and it works. I am currently taking an online course to learn more in depth about options trading and different more advanced strategies to use. I will evaluate the course at a later moment, so far it’s really great.
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