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Income Trading, For Traders With Small Accounts

Income Trading, For Traders With Small Accounts

Income investing is a popular strategy. Over the past few years, it has become one of the best sources of income. Low interest rates have really left investors with few alternatives to stocks.

Income investors have traditionally focused on fixed income investments. These include bonds, Treasury bills, certificates of deposit and even money market funds. Investors in these investments exchanged upside potential for steady income.

It really wasn’t that long ago when investors could earn significant income from fixed income investments. For example, as the chart below shows, the interest rate on the 3-month Treasury bills was as high as 5% as recently as 2007.

The 3-month Treasury would generally be the floor for fixed income investments. Bonds would yield more than that, and yields of 8% to 10% were common as little as ten years ago. These yields were available on relatively safe instruments.

The Financial Crisis Forced Investors Into Stocks

In 2008, the global financial system faced an unprecedented crisis. Of course, each crisis can be called unprecedented. What was different in 2008 was that the global credit system almost came to a standstill. Many firms were excessively leveraged and overnight lending became too risky.

Businesses were unable to obtain money to finance short term operations. This included Wall Street firms like Lehman Brothers and large industrial firms like General Electric (NYSE: GE) and General Motors (NYSE: GM).

The nature of the crisis required immediate action. The Federal Reserve was forced to take actions that were, in a sense, experimental. The Fed cut interests quickly as the chart above shows. They pushed rates towards zero and they flooded the financial system with liquidity.

Arguably, the Fed’s emergency measures prevented the crisis from becoming worse. The financial system was able to function and provide liquidity to businesses. Some businesses, including Lehman, didn’t survive the crisis. But, the system survived.

However, the system has been slow to recover. The Fed has been unable to raise interest rates back to the level economists would consider to be normal. A normal level of interest rate would be welcome for many investors who are faced with low rates and almost no income from traditional portfolios.

In this environment, investors have been forced to reach for yield, taking on more risk than they would under normal market conditions in able to maintain a minimum level of income.

Nontraditional Income Investors Turn to Stocks

Some investors have responded to low yields by turning to the stock market. Dividend stocks have always been a part of a conservative portfolio. But, these investments were usually held in addition to fixed income investments. Income stocks were one part of a diversification strategy.

Now, income stocks have replaced fixed income investments for many investors. Unable to meet their investment objectives with short term interest rates near zero, investors have bought stocks that offer stability and steady income.

Income stocks have usually been large stocks that have stable business operations, pay dividends and are perceived to have low risk. Of course, this has always been the definition of income stocks. In the bear market that began in 2008, some of these stocks suffered large losses.

In some cases, companies that were considered stable lost all of their value and entered bankruptcy. This was the case with Lehman Brothers, a stock once prized for stability and income that ended up without any value at all.

Conservative investors have learned from this experience. Now, in addition to considering income, they consider the safety of the stock and they consider how much debt the company carries. Combining safety with income is one way to reduce the risks that the investment will be destroyed in the next bear market.

This will usually mean sacrificing some income for safety. Higher yields in stocks are often associated with higher risks. The balancing act for income investors requires finding income that is consistent with risk.

A Conservative Income Stock

Among the safest income stocks are the ones that have long histories of operation and safe financial statements. One if the companies that fits that description is AT&T Inc. (NYSE: T), a company that traces its roots back to 1875.

In the past seven years, AT&T has adapted to changes in the marketplace. The company has turned from landlines to cellular service. It’s become a broadband service provider and bought a satellite television service to provide bundles of services to clients.

The results can be seen in the company’s financial statements. Revenue has increased in each of the past seven years. We also see steady gains in cash flow from operations and dividends. When evaluating an income stock, these two metrics can be more meaningful than earnings per share (EPS).

EPS are largely determined by the accounting department. There will be assumptions about revenue and costs, impairment expenses as the company discards slow growing divisions and expenses associated with growth. These charges have a large impact on EPS.

Cash flow from operations, however, is almost free of assumptions. It provides a clearer picture of how the company is generating and using cash. This is important because cash is used to pay dividends. Strong cash flow has allowed the company to grow its dividend.

AT&T now offers investors an annual dividend of $1.96 per share. At the current price, an investor is earning a yield of 5.2%.

An Income Strategy for Smaller Investors

Many investors may find they don’t have enough capital to make a large investment in AT&T, or any other income stock. An options strategy known as an iron condor could be useful for these investors.

To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.

In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.

The risks and potential rewards of the strategy are shown in the diagram below.

Source: The Options Industry Council

The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.

Opening an Iron Condor

For AT&T, the trade can be opened using the following four options contracts:

  • Sell T Oct 20 $39 Call at $0.16
  • Buy T Oct 20 $40 Call at $0.05
  • Sell T Oct 20 $36 Put at $0.42
  • Buy T Oct 20 $35 Put at $0.22

Notice that all of the options expire on the same day. The difference in the exercise prices of the calls or puts is equal to $1. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.

Selling the options will generate $0.58 in credits ($0.16 from the call and $0.42 from the put). Buying the options will result in a debit in the amount of $0.27 ($0.05 for the call and $0.22 for the put). This means opening the trade will result in a credit of $0.31, or $31 for each contract since each contract covers 100 shares. That is before commissions are considered but commissions should be small at a deep discount broker.

The maximum risk on the trade is $0.69, or $69 since each contract covers 100 shares. This is the difference between the strike prices ($100) and the credit to open the trade ($31). Most brokers will require a margin deposit equal to the amount of risk. That means this trade will require just $69 in capital.

The potential reward on the trade ($31) is 44% of the amount risked, a high potential return on investment.

This trade could be repeated once a quarter to generate $120 a year in income. This could be done with less than $100 in capital. Generating this much income from AT&T shares would require owning more than $60 shares and investing more than $1,900.