low risk income strategy v3.0

A Low Risk IncomeStrategy for AllEconomic Conditions

w w w . L o w R i s k I n c o m e . n e t

Christina McDonald

Learn how to safely generate consistent income from your

portfolio in all market conditions.

A Low Risk Income Strategy For All Economic Conditions

© 2012 Christina McDonald www.LowRiskIncome.net Page 1 of 20

© 2012 Christina McDonald

First Published in April 2012Last Updated in October 2012

What You Can Do With This e-Book.

You are welcome to share this e-book with anyone, reprint portions of it on your blog or website, and basically do anythingexcept sell it for profit.

If you do reprint or reuse any content from this e-book or make any reference to content from this e-book, we wouldappreciate an attribution link to http://www.LowRiskIncome.net

Disclaimer

The information contained in this e-book is not intended to be taken or relied upon as specific investment or financialadvice. The authors shall not be liable in respect of any claim arising out of any reliance on the information in this e-book.At the time of writing all information, including prices and interest rates, is, as far as the authors can ascertain, correct.Readers should always obtain independent or professional advice before acting on any information in this e-book.

Low Risk Income Strategy V3.0

http://www.lowriskincome.net/



Table of Contents

A Low Risk Income Strategy for All Economic Conditions........................................................................... 3

Introduction......................................................................................................................................................3

About Me..........................................................................................................................................................3

Understanding the Concept...................................................................................................................... 5

Introduction to the Income Strategy....................................................................................................... 10

An Example Trade.......................................................................................................................................... 10

Example Trade Using Options Terminology .................................................................................................. 11

Selling Cash Secured Puts.............................................................................................................................. 12

Selling Covered Calls...................................................................................................................................... 14

Putting It All Together ............................................................................................................................ 16

Maximising Your Return ................................................................................................................................ 16

Does It Really Work? ..................................................................................................................................... 17

Next Steps...................................................................................................................................................... 18

Some Frequently Asked Questions ......................................................................................................... 19



A Low Risk Income Strategy for All Economic Conditions

IntroductionIncome from traditional sources such as bank deposits or fixed income securities, dividends or even rental

properties, is great when there is a booming economy. Interest rates are up as more borrowers compete for

funds, dividends are up because people are spending and therefore company profits are up, and rentals are

up because more people will rent if they have well-paying jobs.

Economies tend to do 1 of 3 things - expand, contract or trend sideways. As suggested above, an expanding

economy is great for your income. What happens though, if the economy contracts or trends sideways? In

the past few years we have seen all of these events. A strong economy plunged into a contracting economy,

due to the Global Financial Crisis, followed by our current sideways trending economy.

During the GFC, the central bank cut interest rates, dividends fell in line with falling company profits, and

people cut their spending when they lost their jobs. If you had a high dependency on some or all of these

sources of income, as my parents do in their retirement, times suddenly got financially tighter and definitely

more stressful.

Similarly, the good life experienced during an expanding economy, seems a distant memory, now that we

are in a sideways trending economy. Our share market index is trading at the same level as where it was in

2004. Things are not in a state of disarray; however, there is definitely more caution and people are chasing

that extra 0.1% yield.

Would it not be nice to be able to have an income stream that is not heavily impacted by economic

conditions, and that was low risk and something that you could easily manage?

If you are open to new concepts, then the answer to the above question is YES.

About MeHi! My name is Christina McDonald and I have been a self-directed investor for over 8 years. I have been

trading full-time with my own capital since 2004, as well as managing our retirement (SMSF) fund since

March 2007.

My husband and I have very specific goals for our retirement fund; one of our investment objectives is to “To

maintain the real value of the investments at 5% above the inflation rate after allowing for costs and taxes”.

Given that this is our retirement fund, we wanted a conservative, low risk approach to achieve moderate but

consistent returns. I have been applying this income strategy in our SMSF since 2008 and have maintained a

consistent income return of greater than 10% in the past 4 financial years.

Although the current tax laws make almost any investment strategy more tax effective in an SMSF, you do

not need an SMSF to execute this strategy to obtain good results.

The biggest challenge I have found in investing for our retirement is getting consistent income from our

capital. We all need income to live, whether it is in retirement or in addition to one’s salary, and we generally

need the same amount of income every year regardless of economic conditions. For SMSFs in pension

phase, there is a minimum amount (e.g. 4% of your fund balance) that must be withdrawn every year. If the

income produced by your fund is less than this amount, you may have to sell assets, often at the worst

possible time to comply with the SMSF withdrawal requirements.



What happens if we encounter another GFC? Many people had to delay their retirement after their

retirement fund shrank considerably. What happened to those who had already retired and counted on the

income streams that have since diminished? How will we be able to ensure we can get enough income to

meet our living expenses if that happens?

Hopefully this e-book will give you an insight into a new way of generating income, one that you may have

never considered, one that you may have heard about but thought it would be too hard or one that other

people said was only for professional investors.

The primary goal of this strategy is consistent income. The strategy is not new and has been used for years

by savvy investors in the US and what I have done is to adapt it to fit the Australian market. This is a

long-term strategy and understanding and mastering the strategy is a new skill that can help you generate

lifelong income.

The reality is that, with an open mind and a clear understanding of the concepts, what you will see is a

straight forward, manageable, and low risk strategy that generates consistent income in all market

conditions.

I hope that after you read this, like me, the light bulb in your head will turn on brightly and you will clearly

see the benefits of this strategy and that you too will want to achieve the results I achieve.


© 2

Understanding the Concept

My favourite way of explaining the concept of the strategy is by using property, or I could use art or any

other asset for which the buyer and seller tend to negotiate a deal.

Jim sees a house selling for $900,000 which he thinks would be a good investment at the right price. Jim is an

investor looking for a good deal and, after doing his homework, he thinks that if he can buy the house for

$800,000, then this would be a great deal!

Jane, the owner, originally bought the house for $500,000 and would prefer to sell at a higher price.

However, the housing market is a little soft and because she does not have a better offer in hand, she would

be interested in Jim’s offer if no better offer presented itself.

Let’s see what the negotiation between Jane (the owner) and Jim (the buyer) may look like.

Jan

rig

At

Let

I would like $900,000 for my house.

I will promise to buy the house from you for$800,000 and I will wait up to 3 months foryour decision.

m
Jane
012 Christina McDonald www.LowRiskIncome.net Page 5

e has now secured a guaranteed price of $800,000 for her property which, if she exercises her contr

ht within the time period, Jim will have to pay (even if the market price for the house drops to $700,0

the end of the 3 months, two things can happen:

1) Jane (the owner) manages to find another buyer who is willing to pay a higher price than $800,

so she chooses not to take up Jim’s offer, or

2) Jane (the owner) could not find another buyer so she takes up Jim’s offer to buy her house for

$800,000.

’s see how this would look:

As I would be tied into a contract (mypromise to buy), I would like compensation.

Given that I will have a legal commitmentfrom you to buy the house from me for$800,000 should I ask you to do so in thenext 3 months, I will give you $24,000 (1%per month) to lock in the deal.

Deal !

Ji

of 20

actual

00).

000


© 2

Scenario 1 - Jane (the Owner) manages to find another buyer who is willing to pay a higher price than

$800,000 so she chooses not to take up Jim’s offer:

Sce

the

No

giv

Let

ho

Jim

Pe

pro

to

$2

Jim, I wanted to let you know Iwas able to get a better offer.

Good for you! Nice doing business with youand thanks for the $24,000. m
Jane

Note: Jim can now look for another Seller to do a similar deal and repeat the process.

nario 2 - Jane (the Owner) could not find another buyer who would offer more than $800,000, and

refore takes up Jim’s contractual offer:

Note: Jim could put the $24,000 he received to seal the deal 3 months earlier towards the cost

the purchase, meaning that the real cost to Jim is $776,000 ($800,000 - $24,000). Not only did

buy the house at a price he was willing to pay, he also bought it at a 3% discount, paying only

$776,000 out of his own pocket.

matter what happens, Jim gets to keep the $24,000 that Jane paid him when the deal was struck for

ing her the option to sell to another buyer within the 3 month period.

’s continue this example on the assumption that Jane exercised the contract, and Jim purchased the

use for $800,000. As an investor, Jim is looking to maximise his investments.

relists the house for sale at $800,000 (remember he only paid $776,000 out of his own pocket), and

ter, is very interested in buying the house but wants some time to think about it as he believes the pr

perty may fall a little further and he may be able to get a better deal later. Jim tells Peter he is prep

wait 3 months for Peter’s answer but he must be compensated for waiting. Peter agrees to pay Jim

4,000 for the right to walk away from the deal if he so chooses within the next 3 months.

Jim, I would like to exercise thecontract for you to buy myhouse for $800,000.

Sure! I will deposit the $800,000 into yourbank account and have the propertytransferred into my name.

Thanks! Nice doing business

with you.

Ji

m
Jane Ji
of 20

of

Jim

ice of

ared


© 2

Let’s see what the negotiation between Jim (the owner) and Peter (the buyer) may look like.

Pe

his

up

At

Let

I would like $800,000 for my house.

I am interested but I think the price ofproperty may fall.

m
Ji

ter has now secured a guaranteed purchase price of $800,000 for the property for which, if he exerci

contractual right within the time period, Jim will have to sell (even if the market price for the house

to $900,000).

the end of the 3 months, two things can happen:

1) Property prices go up and Peter (the buyer) decides to proceed with the deal, exercising the co

and buying Jim’s house for $800,000, or

2) Property prices go down and Peter decides not to proceed with the deal.

’s see how this would look:

Why don’t I hold the property exclusively foryou for the next 3 months and, at any timeduring the 3 months, I guarantee I will sell itto you for $800,000?

Given that I have your legal commitment foryou to sell the house to me for $800,000should I ask you to do so in the next 3months, I will give you $24,000 (1% permonth to lock in the deal).

As you are tying me to a contract (mypromise to sell), I would like compensation.

Deal!

Peter

of 20

ses

went

ntract


© 2012 Christina McDonald www.LowRiskIncome.net Page 8

Scenario 1 - Property prices go up and Peter (the buyer) decides to proceed with the deal, exercising the

contract and taking up Jim’s offer:

Note: Jim can now start looking for another property to buy and repeat the process he used wi

Jane.

Scenario 2 - Property prices go down and Peter (the buyer) decides not to proceed with the deal:

Note: As a result of the deal not going through, Jim still owns the house. He can relist the house

sale and repeat the deal process (again collecting another $24,000 for doing the deal) he used w

Peter.

Note: Remember Jim put the $24,000 he received from Jane to seal the deal (6 months earlier), toward

cost of the purchase. Meaning that the real cost to Jim was $776,000 ($800,000 - $24,000). Given his

transaction with Peter, Jim has received another $24,000. His cost basis is now only $752,000 ($776,00

$24,000).

Sure! Deposit the $800,000 into mybank account and I will have theproperty transferred into your name.

Jim, I would like to exercise the contract foryou to sell me the house for $800,000.

Jim, I wanted to let you know that I will not beexercising the contract and buying the housefrom you.

No problem! Nice doing businesswith you and thanks for the $24,000.

m

m

Great! Nice doing business with you.

Peter

th

Peter

Ji

Ji

of 20

for

ith

s the

0 -



You can see that in the 6 month period Jim has collected $48,000 ($24,000 from Jane and $24,000 from

Peter). This equates to a return of:

This income has come about by Jim selling contracts to either buy or sell property that gives somebody else

the option to exercise the contract at a given time in the future. These are known as option contracts, and

this method of selling option contracts to owners and buyers, is the concept behind this income strategy.

The purpose of the example above is to lay out the concept that having an option to sell or buy an

investment at an agreed price within an agreed period of time can be valuable. While it is not a common

practice to use these types of contracts in selling or buying real estate, it is a very common practice for

selling or buying shares. In fact, it is such a common practice that options contracts are listed and traded on

a regulated exchange, just like shares. While option buyers (or takers) are predominantly investors (or

speculators) who hope to make money from capital gains of the underlying asset i.e. shares, option sellers

(or writers) are income investors who do not mind holding their capital in the form of either cash or shares.

Exchange Traded Options are available on most blue chip shares on the ASX.

Frequently it is possible to collect an income of 0.5 to 1% per month from selling options to

buy shares you would like to own or

sell shares you already own.

$ 48,000

$800,000= 6% (in 6 months) x 2 = 12% p.a.



Introduction to the Income Strategy

This income strategy is based on having an investment portfolio comprising of cash and blue chip Australian

stocks. What I do differently from most other income investors is that I use exchange traded options to

generate additional income from our portfolio on top of the interest and dividends that we receive.

At the time of writing, the interest rate on bank deposits is between 4 to 6% and the average dividend yield

from stocks is also around 4 to 6%. By including the use of options into your portfolio, you can look to

increase your income by another 6 to 12% per year. My target annual return from this income strategy is 10

to 15% of capital and I have been successful in achieving this target over the past four financial years where

we have had very diverse market conditions ranging from bear market (FY2009), bull market (FY2010) to

sideways market (FY2011 and FY2012).

An Example TradeLet’s walk through an example using Wesfarmers (WES) shares. As an income investor, you like WES because

it is in a reasonably recession proof industry and pays a generous fully franked dividend which has been

steadily increasing in the last two years. Today the stock is trading at $31 per share which you think is a fair

price as the stock has mainly been trading in the range between $30 and $34 over the past 2 years. You

want to make an offer to buy 1,000 shares at $30, which is slightly below the current market price. Your

offer is only good for 3 months because you want to own the shares before the next dividend payment

which is in 4 months.

Joe is a share trader who bought 1,000 WES shares at $30. He believes WES will continue to go up in the next

few months. However, he wants to protect his capital if he is wrong, so he is happy to take up your offer to

buy his 1,000 shares at $30 in 3 months while giving him the option to sell his shares at a higher price if he

can.

He pays you compensation of 60 cents per share, or $600, for your offer. While waiting for your offer to

expire, you put the $30,000 you set aside to buy the shares, into your broker’s cash investment account

which pays 5% interest p.a. At the end of 3 months one of two things can happen:

1) The share price of WES stays above $30 so Joe decides not to take up your offer to buy his shares for

$30 as he can sell them for a better price.

2) The share price of WES falls below $30 so Joe will take up your offer to buy his shares for $30 per

share. You have to pay Joe $30,000 and take ownership of his 1,000 shares.

Let’s say the share price when your offer expired after 3 months is $29 so you pay Joe $30,000 to buy his

1,000 shares. You immediately make another 3 month offer to sell your 1,000 shares at $30 per share.

Sue, a share speculator, thinks WES shares at $29 are very cheap and will go up rapidly in the next few

months. She decides to take up your offer to sell her your 1,000 shares at $30 per share while giving her an

option to back out of the deal if she is wrong. She pays you compensation of 50 cents per share, or $500, for

your offer.

In the next month, WES announces that they will pay a dividend of 70 cents per share. As you are still the

owner of the shares, you will get the dividend, not Sue. You get a dividend cheque of $700 from WES the

next month. At the end of the 3 months two things can happen:



1) The share price of WES goes up above $30 so Sue will take you up on your offer to sell her your

shares at $30. She will pay you $30,000 for your 1,000 shares.

2) The share price of WES remains below $30 so Sue decides not to proceed with buying your shares at

$30 per share.

Let’s say the share price, when your offer expired after 3 months, is $34. Sue happily takes up the offer to

buy your shares at $30 as she can sell them at a higher price and make a profit. She pays you $30,000 for

your 1,000 shares. Although you bought and sold WES shares at $30 per share, (hence you have not made

any capital gains), the following is what you have earned as income in the 6 months period:

1) $600 from Joe for giving him a 3 month option to sell his shares to you at $30

2) $375 which is 3 months of interest from your cash investment account for the $30,000 you had to

set aside to buy Joe’s shares if he chose to sell them to you at $30

3) $500 from Sue for giving her a 3 month option to buy your shares at $30

4) $700 dividend payment from WES

5) $300 in franking credit rebates as WES dividends are fully franked.

This is a total of $2,475 or an 8.25% return on your capital of $30,000 in 6 months, or an annualised return of

16.5%.

This example is quite typical of what I do to generate a 10 to 15% return on our capital using this income

strategy. I hope that you can see that this is a logical process and is actually quite straight-forward. Again I

would like you to focus on the concept and how the examples tie this together before moving on. If needed,

walk through this a couple of times and draw out the transaction on paper to help clarify this for yourself.

Example Trade Using Options TerminologyStay with me now, as I take this WES example and run through it again using options terminology. Don’t be

concerned if you don’t grasp all the terminology; remember it is the concept that is important here.

There are two types of exchange traded options:

1) Put Options

When we agree to give Joe the option to sell us his 1,000 WES shares for $30, we are effectively selling

him 10 Put Option contracts at the strike price of $30 with an expiry date of 3 months. During this

period, he has the right to sell his shares to us and we have the obligation to buy his shares at the

agreed strike price of $30 if he chooses to exercise his put option contracts.

Definition: The buyer (taker) of a put option contract has the right to SELL 100 shares of stock at an

agreed strike price by a certain expiry date. The seller (writer) has the obligation to buy the stock at

the agreed strike price, if the buyer chooses to exercise their right to sell the stocks



2) Call Options

When we agree to give Sue the option to buy our 1,000 WES shares for $30, we are effectively selling

her 10 Call Option contracts at the strike price of $30 with an expiry date of 3 months. During this

period, she has the right to buy our shares from us and we have the obligation to sell our shares at the

agreed strike price of $30 if she chooses to exercise her options.

As you can see, the option buyer enjoys all the rights but normally has to pay compensation to the option

seller for those rights. In options terminology, this compensation is called the option premium. The key

things you need to understand about options are:

1) There are two types of options - put options (or puts) and call options (or calls),

2) Each option has a fixed strike price,

3) Each option has an expiry date, and

4) The buyer has to pay a premium to the seller for the option.

The above is all you need to know about options in order to understand the two option strategies I use

which are also commonly known as:

1) Selling cash secured puts

2) Selling covered calls

Selling Cash Secured PutsThis is an income and a stock acquisition strategy. I sell put options on stocks I would like to own at the price

I would like to buy them for. I receive a premium when I sell the put options which provide us with an

income. As I may be obligated to buy the shares later if the buyers of the put options decide to exercise their

put options, I need to set aside the cash to buy the shares, if required. In the meantime, the cash can be

earning interest in a high interest bank account. As in our example trade:

The market price for WES shares was $31

Instead of buying shares at the market price, I sold put options at a below market strike price of $30

with a 3 month expiry date for a premium of $0.60 per share and kept the cash in a high interest

bank account

Over the next 3 months, the market price of WES will either 1) remain above the strike price or 2) fall below

the strike price.

Scenario 1 – Share price remains above strike price

A put option at the strike price of $30 gives the buyer the right to sell his shares at $30. If the price of WES

remains above $30, there is no reason for the buyer of the put options to exercise the put options as he

Definition: The buyer (taker) of a call option contract has the right to BUY 100 shares of stock at an

agreed strike price by a certain expiry date. The seller (writer) has the obligation to sell the stock at

the agreed strike price, if buyer chooses to exercise his right to buy the stocks.



would be selling his shares at below the market price. If the share price remains above $30 by the expiry

date, the put options will expire worthless and the seller keeps the option premium. The realised profit

under this scenario is $0.60 from the option premium or a 2% return in 3 months. The return is even higher

when you include the interest earned from cash. If the bank interest rate is 5%, the pro-rated interest for 3

months is 1.25% giving you an overall return of 3.25% in 3 months. If you can do this 4 times a year, you can

get a 13% return without owning any stocks!

Scenario 2 – Share price falls below strike price

If the share price of WES falls below the strike price of $30, it is very likely that the buyer of the put option

will exercise his right to sell his shares at $30. As the option seller, you will be obligated to buy the shares at

$30 per share. Since you have already received $0.60 of option premium, you only need to use $29.40 of

your own capital to buy the shares. Hence, you are effectively buying the shares at a $1.60 discount

compared to buying the shares outright when they were trading at $31 at the time of selling the put options.

Of course, you may suffer some unrealised capital loss if the market price of the share is below $29.40. This

is why it is important that you only sell options over shares of fundamentally sound companies that you do

not mind holding long-term. You should NEVER sell put options on shares you are not happy to own.

Hopefully you can see from the above example, that there is no additional risk in the cash secured put

strategy, compared with simply buying and holding the stock. In fact, you are buying the stock at a discount

and the option premium received will help to offset some of the capital loss if the share price falls. However,

it does limit the reward that you can get if the share price goes up as you do not own the shares and will not

receive any benefit should the stock move above the strike price. Below is the payoff diagram for selling cash

secured puts compared with owning stocks.

Payoff Diagram for a Cash Secured Put



Selling Covered CallsThe covered call strategy involves selling call options over stocks that you already own. As an option seller,

you will receive a premium from the buyer. The typical set up for this strategy involves buying a stock and

then selling an option at a strike price that is higher than what it cost you to buy the stock. As in our example

trade:

We bought our WES at $30 per share but the real cost to us is $29.40 after we deduct the premium

we received for our put options

We sell call options at the strike price of $30 with a 3 month expiry date for a premium of $0.50 per

share

Over the next 3 months, the market price of WES will either 1) go above the strike price or 2) remain below

the strike price.

Scenario 1 – Share price goes above strike price

If the price of WES goes above the strike price of $30, the buyer of the call option is likely to exercise her

right to buy WES at $30 as this is lower than the market price. The buyer can then sell the stock at market

price for a profit. Call option buyers are typically speculators who believe that the stock price will go up and

use options for leverage as they can buy a lot more call options than shares with the same amount of capital.

If the call options get exercised, the covered call seller will have to sell his shares at the strike price. Our

profit under this scenario would include:

Realised capital gains – as the shares were purchased at $30 and sold for $30 in our example trade,

there is no resulting capital gain. If we had sold the call option at a higher strike price e.g. $31, we

would realise a capital gain of $1.00.

Option premium – you received premium of $0.50 when you sold the call option.

Dividends – as you are still the owner of the shares, you received a dividend of $0.70

Franking credits – as WES dividends are fully franked, you will receive another $0.30 in franking

credit rebate after you file in your tax return for the financial year.

The total income received is $1.50. As the cost per share is $30.00, this is a 5% return in 3 months. As your

WES shares are now sold, you will receive cash of $30,000 and you can sell cash secured puts on WES or

other stocks using this capital.

Scenario 2 – Share price remains below strike price

If the price of WES remains below $30, there is no reason for the buyer to exercise the call option as she

would be paying more than the market price for the shares. If the share price remains below $30 at the

expiry date, the option will expire worthless and the seller keeps the option premium. The realised profit

under this scenario is still $1.50 or 5% return in 3 months. Of course there would be some unrealised capital

loss if the share price is below the purchase price of $30 but you can sell another call option to generate

income while waiting for the next dividend payout from WES.

Hopefully you can see from the above example that there is no additional risk in the covered call strategy

compared with simply buying and holding the stock. In fact the option premium received will help to offset

some of the capital loss if the share price falls. However, it does limit the reward that you can get as you will

miss out on the capital gains if share price goes above $30. The choice of stocks for doing this strategy is

important and ideally you want a stock that is not too volatile and pays good dividends. Below is the payoff

diagram for covered calls compared with owning stocks.



Payoff Diagram for a Covered Call



Putting It All Together

Maximising Your ReturnWhile each option strategy by itself can easily provide a good annual return, it is even more powerful if used

strategically with dividends and franking credits. For most Australian stocks, dividends are paid twice a year.

To qualify to receive the dividends and franking credits, you need to own the stocks before the ex-dividend

date, and hold the stocks for the required minimum holding period, which is 45 days at the time of writing

(check the Australian Tax Office website for “holding period rule” details), so the covered call strategy may

be better during the dividend payment periods because you own the stocks. In between dividend payments,

the stock does not produce any income so it may be better to sell put options and let the cash earn interest

in the bank. The following is a typical cycle of what I do with each of my favourite dividend stocks:

First 3 months Next 3 months Next 3 months Next 3 months

Sell put options

Receive income from- option premium- bank interest

Sell covered calls

Receive income from- option premium- dividends

Sell put options

Receive income from- option premium- bank interest

Sell covered calls

Receive income from- option premium- dividends

Instead of just receiving income from dividends twice a year, you could also be getting income from selling

options four times a year. At the end of each financial year, we also receive income from franking credits for

our franked dividends after we submit our tax return.

Income from options is also a natural hedge for income from interest and dividends. During bear markets,

interest and dividends tend to fall, whereas option premiums rise with volatility. During bull markets,

interest and dividends tend to rise while option premiums fall. Hence, I am able to continue to make a good

return with these strategies even during bear markets, such as the one that occurred in FY2009.

Below is the table of my returns from FY2009 to FY2012 for our retirement fund:

Financial Interest Dividends Franking Option Stock Gains / Loss Gross Capital Rate of

Year Credits Gains / Loss Realised Unrealised Income1

Return

FY 2009 $3,612 $676 $290 $16,200 -$705 $0 $20,073 $120,000 16.7%

FY 2010 $3,426 $2,106 $715 $10,060 5094 -$3,669 $21,401 $120,000 17.8%

FY 2011 $983 $5,955 $2,232 $4,801 $40 -$6,940 $14,011 $120,000 11.7%

FY 2012 $2,137 $19,470 $6,886 $13,455 -$17,515 -$6,670 $24,433 $150,000 16.3%

Note 1: Gross Income includes interest, dividends, franking credits, realised capital gains/loss from stocks and options



Does It Really Work?The concept that it is possible to make money when your stock price is falling is one that many people find

hard to believe. To demonstrate how this is possible, I have provided an example of actual trades I did on

BHP in 2008-09 when the stock price was falling. Do not get too concerned about the terms; what is more

important is to understand the concepts at work, based on a real life example. The chart shows the price

movement of BHP and my trades are explained in the commentary below.

Month BHP Price Cash Flow Commentary

Sep 36.00 $1.50 Sold a Put option and was paid $1.50 per share to wait up to 2 months to buyBHP at $33.00

Oct 26.00 -$33.00 The Put option contract was exercised and I had to buy BHP shares at $33.00,even though the market price was $26.00. [I now OWNED BHP stock]

Nov 29.00 $1.25 Sold a Call option and was paid $1.25 per share to wait up to 1 month to sellmy BHP shares at $32.00. Note: This contract expired in Dec and I did not haveto sell my shares as BHP was trading below the strike price.

Dec 28.50 $1.60 Sold a Call option and was paid $1.60 per share to wait up to 2 months to sellmy BHP shares at $32.00. Note: This contract expired in Feb and I did not haveto sell my shares as BHP was trading below the strike price.

Feb $0.93 Received BHP dividends of $0.93

Mar 27.00 $1.40 Sold a Call option and was paid $1.40 per share to wait up to 1 month to sellmy BHP shares at $30.00

Apr 33.00 $30.00 The Call option contract was exercised and I had to sell my BHP shares at$30.00, even though the market price was $33.00. [ I SOLD my BHP stock]

$3.68 Total Cash Flow

$33.00 Total Capital Employed (used to buy the shares)

11.15% Return (3.68 / 33.00) over an 8 month period (Sep – Apr)

Even though BHP shares fell in value between September 2008 and April 2009, our fund still generated an

income of $3.68 or a return of 11.15% during that period.



Next StepsThe purpose of this document is simply to show how this income strategy works and why it is not a high risk

strategy even though it involves the use of exchange traded options. If you have read this e-book because

you are keen to generate income using a low risk strategy for all economic conditions, then there are a few

options depending on how you would like to move forward.

Head over to the low risk income web site at www.LowRiskIncome.net for more details about these

packages.

http://www.lowriskincome.net/



Some Frequently Asked Questions

Q1. Aren’t options risky?

Options are powerful tools which can be used in a variety of ways and the risk is very dependent on how

they are used. Just as cars are powerful tools that can get you from point A to point B faster than just

walking, they are generally quite safe if you follow the road rules. However, if you decide to break these

rules and drive outside the speed limit, run through red lights, drink and drive etc, then you are likely to get

yourself into trouble.

Q2. What do mean when you say that the strategy is low risk?

In August 2012, the ASX published a landmark research paper called “An Encyclopaedia of Australian Buy-

Write Returns (April 2005-December 2011)” which clearly showed that covered calls can reduce risk and

improve returns on a stock portfolio. This paper can be found on the Resources page of our website.

Selling put options has lower risk compared with buying shares outright because you are buying shares at

below market price and thus immediately managing risk. For example, if you decided to buy BHP shares

when they were trading at $35, then you will lose money if BHP falls below $35. However, if you sell a put

option to buy BHP shares at $33 and were paid a premium of 50 cents for your option, you will not lose

money unless BHP falls below $32.50. Hence, you have an extra margin of safety compared to simply buying

shares. The safety buffer you have in this example is $2.50.

Q3. Are these proven strategies?

Yes, this strategy has been around for years. It has mainly been used by professional investors initially but is

slowly gaining popularity with retail investors, especially in the US market. Well known investors like Jim

Rogers, George Soros and even Warren Buffet use these options strategies.

Q4. Why does this strategy work?

It works because the probability of success is in your favour. You can make money if the stock price goes up,

down or stay the same. Using the BHP example in Q2, you will make money if the price of BHP goes up, stays

at $35 or fall to $32.50. The probability that BHP will stay above $32.50 is higher than the probability of BHP

staying above $35. These probabilities can be mathematically calculated but it is quite easy to see that it is

greater than 50%. This is similar to how casinos make money. The rules of the game usually provide the

house with a slightly higher probability for winning compared to the player. In the long run, the house

always wins.

Q5. How much income can I expect from this strategy?

I have been able to obtain an income return of more than 10% per year ever since I started using this

strategy in 2008. The income comes from option premiums, interest, dividends, franking credit and realised

capital gains from selling stocks when the call options that I sell get exercised. Individual returns may vary

and depend on a lot of factors such as amount of brokerage paid, account size, frequency of trades, trading

skills, etc.



Q6. Why does this income strategy work in all market conditions?

Option premiums tend to move inversely with market trends. In bull markets, option premiums are lower

but you tend to get higher dividends from your stocks and higher interest from your cash. In bear markets,

option premiums tend to be higher and can make up for reduced income from dividends and interest.

Q7. Why should I learn this strategy?

Learning to sell options is a skill that can help you earn a second income for life with only a little bit of effort.

You can significantly increase the income from your stock portfolio and reduce your risk with options.

Q8. What are the advantages of using Australian vs US options?

There are many reasons to trade US options. For starters, there are many more US stocks (1600+) compared

to Australian stocks (70+) that have options. You can build a more diversified portfolio if you include US

stocks as some sectors (e.g. Technology, Healthcare) are simply not available on the ASX. The main reasons

why we prefer to use Australian options (where possible) are:

1) There is no currency risk. If we live in Australia, our living expenses are in Australian dollars (AUD) so

our income should be in the same currency. However, this is becoming less of an issue with trading

platforms such as the Halifax Trader Work Station (TWS) which do provide facilities to manage

currency risk.

2) Most Australian stocks pay higher dividends than US stocks which is good for the income investor. A

lot of the dividends are fully franked and franking credits can be another source of income for

investors who are in low tax brackets.

3) Most Australian investors already invest in blue chip Australian stocks. Selling options over these

stocks is a natural extension of their current stock investment strategy.

Q9. What are some of the difficulties in doing this strategy?

Conceptually this strategy is quite simple and most people can understand it after reading this e-book. Most

of the challenges lie in the execution. Some of the biggest challenges faced by new investors are:

1) Opening an option trading account - Applying for an option trading account with an Australian

broker can be a daunting process. There are pages of forms to fill and you need to take special tests

to qualify to sell options. Halifax Investment Services (our preferred broker) currently has the

quickest and simplest account opening process. An account can normally be opened in 1-2 days.

2) Option terminology - There are many new terms used in describing options and many new investors

are confused by the terminology. Learning to trade options involves learning a new language.

3) High minimum commissions - The minimum commissions charged by Australian option brokers are

quite high at $30 - $45 per trade. Hence you need to trade these strategies with adequate capital

(minimum of AUD 30,000 recommended) to make correctly sized trades to justify the commissions.

If all this is too hard, you can always opt for a full service brokerage package and have a professional broker

trade your account for you.

low risk income strategy v3.0

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