Blog | Paper Assets

Investing for Cash Flow With Stocks

Stock investing isn't at odds with the Rich Dad philosophy of investing for cash flow.

Summary

• Most people think that stock investing is at odds with the Rich Dad philosophy of investing for cash flow

• However, an educated investor knows how to strategically generate cash flow using the stock market

• There are two ways to generate cash flow using the stock market - read below to learn how

---

One of the things that makes The Rich Dad Company so different from other financial educators is that we do not tell you what to buy or what to invest in. Instead, we teach why an opportunity is good and we show you how many different things there are to invest in.

Real estate may be a good fit for many investors, but it’s not a great fit for all investors. Stocks may make a lot of sense to most people but certainly not all. A good investment vehicle (stocks, real estate, business, commodities) needs to fit with your lifestyle, your personality, and your philosophies. There is no investment vehicle that is one size fits all.

Stock investing and the Rich Dad philosophy of investing for cash flow

Most people believe that stock investing is at odds with the Rich Dad philosophy of investing for cash flow. The reason people believe this is because they think stocks are simply buying low and selling high—a capital gains investment.

We teach that cash flow is better than capital gains for three reasons:

1. It is resilient from market swings and market chaos

2. It brings money into your pocket on a regular basis (not imaginary “paper wealth” such as net worth)

3. It is generally taxed at a lower rate than other forms of income, including capital gains

So it makes sense that if you think stock investing is only capital gains investing, and you subscribe to Rich Dad’s philosophy of investing for cash flow, that you’d think we’re telling you not to invest in stocks. But we’re not.

Because an educated stock investor knows how to cash flow with the stock market, not just invest for capital gains.

In this post, you’ll be introduced to two ways that you can invest in stocks and follow the Rich Dad philosophy of investing for cash flow.

The first method of dividends is pretty direct. The second method of covered calls requires quite a bit more financial education.

Investing for cash flow with stock dividends

The NASDAQ website says this about dividends:

At its core, a dividend is your share in the profits of a company you own. In return for purchasing stock, or investing in a company, you are given two basic rights. First, you have the right to participate in electing a board of directors to run the company, and second you have the right to be paid a share of the company’s profits, at the discretion of that board. This is paid in the form of a dividend. When the board of directors releases company results at the end of each quarter, they will also announce the amount of dividend (if any) to be paid per share. Thus, if a company declares a $0.50 dividend for a given quarter and you own 100 shares, you will receive $50.

Read more: http://www.nasdaq.com/article/what-is-a-dividend-

So if you were to buy stocks that pay regular dividends, then you are purchasing assets that add to your cash flow. With enough assets like this, you can eventually have the income to do whatever you like, right now or in retirement.

There is one caveat, however. Dividends are at the sole discretion of the board of directors, so you have no control over them. You also have no control over the company you buy stocks in, so you can’t influence the performance of that company each quarter. So while investing in stocks with dividends is a cash flow investing, it takes a low level of financial intelligence. So the returns are low too.

Investing for cash flow with the covered call strategy

The covered call strategy requires a high level of financial intelligence. But as a result the potential for returns are also high. This is going to get a bit crazy. But once you get it, it’s very exciting! Now, let’s explain cash flowing a covered call (a stock option).

A stock option is a promise by someone to sell a certain stock at an agreed-upon price until a certain date. In return for this promise, he receives a premium as income. This premium is not just based on the movement of the stock price, but on the movement of time.

Stock options can be confusing so let’s use an example as it relates to real estate.

Let’s suppose that you are a landlord who owns a house. You find a family to buy the house, but they don’t want to buy it outright today. Instead, they decide to lease the house for three years with the option to purchase the house at an agreed-upon price at the end of the lease term.

While you are waiting for the lease to expire, you are earning money on the movement of time (rent).

As the owner of a lease-to-own house, you will make money no matter what happens. It doesn’t matter if the value of the house increases or decreases. If the house increases in value beyond the agreed-upon price, the family got a good deal but you still got what you wanted since you set the price.

If the house goes down in value, the family will likely not buy the house at the end of the lease and you get to keep the house.

Now you can go out and lease-to-own the house again. Rinse. Repeat.

While not exactly the same (you don’t receive payments during the term of the option contract), you now have a general idea of how a stock option works:

1. You own Stock XYZ

2. You sell an Option to buy Stock XYZ after a predetermined amount of time at an agreed-upon price

3. At the expiration of the term, you receive the option premium.

4. You either sell Stock XYZ at the agreed price or you retain ownership

5. Repeat.

Now let’s shift from real estate examples into actual ways we can use this cash-flow strategy to make real money with options in the markets. This is especially useful in difficult markets where buy-and-hold investors are suffering from crazy up-and-down conditions.

Let’s have Rich Dad Advisor on stocks, Andy Tanner, explain a covered call option:

“…an option is a promise by someone to sell a certain stock at an agreed-upon price until a certain date. In return for this promise, he receives a premium as income. This premium is not just based on the movement of the stock price, but on the movement of time.

As a teacher, I’ve seen how hard it is for many people to grasp the ideas of time decay and cash flow in the stock market. I know it certainly took some time for the light to come on for me. So a few years ago I made a small trade just for the purpose of teaching. I chose to hold a stock for a long time regardless of the fluctuation in its value, just as many real estate investors hold their rental property regardless of fluctuations in the price.

To show my students the similarities between stock investors selling options and real estate investors collecting rent, I bought an Exchange Traded Fund (ETF) and held it for a year. It’s not my usual practice to hold stocks that long, let alone buy anything that is heading down. But my goal was to prove that it is possible for a falling stock to generate income just as a house that is declining in value can still generate rent. This is not hypothetical. This is an actual series of very small trades I did during the subprime meltdown of 2008.

My first step was to buy 500 shares in an exchange-traded fund called the Spyder Trust (SPY), which mimics the S&P 500. This was very important because the SPY simply mimics the S&P 500. I was going to hold it for a year, come what may. After buying it, I watched it closely to see if it was going up, down, or sideways.

Since I owned the shares, I was positioned to be the seller of an option instead of the option buyer.

After buying 500 shares of the SPY exchange traded fund, I then sold five, one-month call option contracts on SPY at a premium of $2.15. I promised the buyer that he could buy the Spy for $154 (which was more than I paid for the SPY) at any time before the expiration date.

The stock could now go in one of three directions:

1. If the stock went up and he wanted to buy at $154, I would have made money since I bought it at a lower price.

2. If the stock went sideways and stayed below $154, the option would expire worthless, and I would have kept my $2.15 (multiplied by 500) premium in cash flow. This is just like a house where the value remains the same. I would still be getting that rent as income.

3. If the stock went down, the option would expire worthless, and I would keep my $2.15 premium (multiplied by 500).

You can see that I have set up a scenario where no matter what happened, I would generate income from an asset I had purchased. To me, this was a very attractive way to generate my own income. I bought 500 shares and then I sold those options. That’s five one-month contracts of 100 shares, each at a premium of $2.15. When you do the math, you’ll see that I created an income of $1,075, less the brokerage fee, so I received a net $1,061.

This shows you how to own stock assets and generate an income from them.

Even though the stock was falling in value, I continued to sell options on my shares of the SPY month in and month out for a whole year. Why? Because I am not much different than a real estate investor who sees the value of his rental house decline for a season. He is receiving his rent each month and I am also receiving my income every month from options. This income flows in even as we both wait for the underlying value of the assets to bounce back. I get to keep the stock while the time decay is bringing in cash.”

True cash-flow investing is when the underlying asset, whether it’s a house or a stock, can go down but cash flow stays fairly consistent.

As we said earlier, most people think that stock investing is at odds with the Rich Dad philosophy of investing for cash flow.

If they’re thinking of most people’s idea of stock investing – buy, hold, and pray – then yes. However, an educated stock investor knows how to cash flow with the stock market and knows the rewards of cash flowing the stock market.