Derivative Income
Derivative income is an advanced trading technique you can use to generate passive income from stocks and ETF’s you already hold in your brokerage account. But what you might not know is there are closed funds and ETFs that specialized in this trading technique which can make this much easier to execute. All while providing excellent monthly income for you!
My good friend Dissecting the Markets has been teaching me over the last week just how we can take advantage of the derivative income market in amazingly simple and easy to execute ways.
I’m serious, these things can give you an income stream of 10-12% APY on your invested capital and pay you monthly!
Let’s not delay and let’s get into it!
Tell us a bit about yourself!
I’m a college senior at UC Santa Barbara studying Economics & Accounting. I’ve interned at one of the Big 4 in the audit department, and I look forward to going back and working with them after graduation and after completing most of my CPA exams. In my spare time, I do graphic design for fun and hope to sell them as NFTs down the line. Occasionally, if I find something interesting in business news, I will write about it on Vocal.
What are your financial goals?
Short term, I’m building up my emergency savings (which I’ve recently completed) and I’m looking to grow my dividend income to the point where I’m essentially earning $1 a day.
Long term, I’m hoping to generate more portfolio income so that I have enough cash flow to comfortably invest in growth stocks. Also, I’m looking to grow my net worth to a point where I’ll be able to either invest in private startups or even have a lot of money to gamble on a business idea.
What does your portfolio look like?
Both the closed-end funds and the covered call ETFs make money by holding a basket of securities and write covered calls on them. For the covered call ETFs, they focus on the indices while closed-end funds can either be broad (like US equities or international equities) or specific like commodities or oil & gas.
Equities
As for the equities, most of them are the famous monthly paying dividend stocks like Realty Income or Stag Industrial and others are quarterly paying dividend stocks that few talk about like Ethan Allen (which I was lucky enough to buy while it had a 7% dividend before the pandemic), Juniper Networks (bought it because it started paying dividend a few years ago and felt the need to invest in dividend initiators), the SPDR Energy Sector ETF (bought it on the day that WTI Crude went negative), and Macerich (bought it before the pandemic because I loved how they were focused on building high-class malls and had a pipeline that would essentially double their profits by 2025 *pre-pandemic estimates).
Macerich
For Macerich, I’m still holding onto it because it still has a bright future. The company has made many improvements with its tenant concentration, their properties are still some of the most desirable properties out there, and they’re leasing more space to fast growing companies like Tesla, Peloton, Lucid, and more.
Overall, the focus of the portfolio is on dividend payers. While I’ve gotten burned off Macerich, at least I’ve locked in higher yields with the rest of the dividend payers. As an FYI, most of my investments are in monthly paying stocks, ETFs, and closed-end funds. Also, the closed-end funds are bought when their net asset value is negative (meaning that I bought them below book value).
Are these in a tax-sheltered 401k or Roth?
I don’t hold them in a 401K or a Roth/Traditional IRA. I hold them primarily in a normal brokerage account because I want to be able to access my money with little hassle.
How can someone get started?
The first thing you should do is have the money. With Robinhood or any other platform that offers fractional shares, if you have more than $1, you can get started. The more money you have, the better. Make sure the money you’re investing is money you can afford to lose (example: if the markets go down tomorrow, you won’t be like “I’ll have sleep for dinner”). I prefer to go with platforms that deal with fractional shares but if you want a more seamless money transfer process from checking account/savings account to brokerage account, then preferably get a brokerage account with your own bank.
Within the process of getting the money and opening the brokerage account, do your own research or talk to a financial advisor on which stocks to own. Learn the basic terminology and apply it to your own research.
What has been your biggest lesson?
The biggest lesson is to not be super active with the markets. I learned this lesson after selling Apple (the very first stock I bought) during the trade war fears of late 2018. When I’d go on Twitter and follow the traders or watch CNBC daily, I grew anxious about the trade wars to where I thought we’d experience a recession because of it. That anxiety prompted me to sell my Apple shares. In the process, I bought some REITs like Realty Income and Stag Industrial. Looking back, if I stuck with Apple, I would’ve had more money “market-value wise” but less dividend income.
On Twitter, whenever there’s a market crash and people would make fun of the panic sellers, I sometimes say “if you have a life outside of the markets, then it’s easy to not panic sell.” Thankfully, life got better after high school and once the pandemic came, I was so busy with other things that I didn’t have the urge to panic sell.
Circle back to those closed-end Mutual funds
Closed-end mutual funds are mutual funds that has a fixed number of shares. They’re actively managed by professionals and usually come with higher fees. Unlike open-end mutual funds, which trade only one time per trading day and can change the number of shares available at any point in time, closed-end funds fluctuate in price daily and the amount of shares the fund can have been fixed.
Closed-end funds would usually employ leverage to supersize returns. Some will take debt while others will write covered calls on the assets they hold.
To get started, make sure you have a brokerage account that can let you buy & sell closed-end funds because closed-end funds trade on the secondary market.
This is how I got into closed-end mutual funds:
In the beginning, I wanted to invest in closed-end mutual funds because I wanted to learn more about them. I’ve heard about them as a way to buy blue chips and other great companies at a discount and at one point, I even saw a video from one of those investment webinars (the ones that have this long video that is made to sell you a book filled with “mystery stocks”) and in that video, it said that the wealthy invested in closed-end funds during the Great Depression to continue receiving income amid bad times.
As I started shopping around iShares for closed end funds, I noticed that these funds had dividend yields that were a lot higher than that of an ETF (for any sector or for any type of investments) and to my surprise, many paid dividends monthly. Most dividend ETFs (except for the covered call ETFs by Global X) pay dividends every month. SoFi came out with 2 weekly-paying dividend ETFs and while that’s awesome, the dividend yield is quite low compared to that of closed-end funds. Some closed end fund providers pay dividends quarterly, so check when they do distributions before buying them. Because they usually traded for discounts compared to book value and held companies that we know and love (like Verizon, Broadcom, Apple, etc.), I knew that I was getting a great deal on stocks that I want to invest in without having to wait for a dip in their individual share prices.
Which funds do you hold?
I get all of my closed-end funds from Blackrock because they have a high reputation and I am familiar with the company. Here are funds that I own:
Energy and Resources Trust (ticker: BGR) Yield 4.46%
Enhanced Equity Dividend Trust (ticker: BDJ) Yield 5.81%
Enhanced Global Dividend Trust (ticker: BOE) Yield 6.16%
Enhanced International Dividend Trust (ticker: BGY) Yield 6.42%
Resources & Commodities Strategy Trust (ticker: BCX) Yield 5.09%
You can learn about closed-end mutual funds here.
Tell us more about the covered call ETFs
Covered call ETFs take the practice of covered calls and implement them into a basket of assets. Since they’re actively managed, a fund manager can write call options onto the stocks it holds and reap the premium (aka, the cash you receive from writing an option) once it’s written. Usually, the premium generated from writing call options will be used to fund the month’s dividend payments. During times of rising stock prices, when the stock price goes above the strike price of the option that the fund manager has written, the fund reaps the premium and later reaps a profit (if the stock price remains at or above the strike price).
When writing covered calls, time can be your friend and enemy. It can be a friend because with more time, the option will have more value. As time goes on, the value of the option declines (hence, why they call it time decay) and if the stock price remains below the option’s strike price (aka “out of the money”), the option becomes worthless on expiration and the options writer can move on to his next option.
Writing covered calls is like extracting an extra dividend from your stocks because the option premium you receive adds more cash to your brokerage account. Like dividend investing, writing covered calls puts you in a position to win either way. For dividend investors, they get the dividend. For covered call writers, they receive the dividends that their stocks pay while reaping more money from the option premium they reap. If it’s a bull market and the stock price is above the option strike price (aka “in the money”), then you get to sell your stocks for a profit at that strike price and move on to your next trade/investment.
Covered Call ETFs
Nasdaq 100 Covered Call ETF (Ticker: QYLD) Yield 11.87%
S&P 500 Covered Call ETF (Ticker: XYLD) Yield 9.52%
Russell 2000 Covered Call ETF (Ticker: RYLD) Yield 11.97%
Conclusion
Thank-you Dissecting the Markets for all this terrific information and actionable ideas on how to generate passive income from these derivative income based investments!
1 comment
I like how you tried to get 10-12% APY returns instead of massive 100% in a single day returns like WSB. A 10-12% annual return is projected to beat the markets over the long term and it goes to show just how much that is enough in order to do well in the markets.
Slow and steady stream of income brings a steady flow of happiness.
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