Find Financial Freedom

I have always been fascinated by the share options, ever since I studied them during my degree in accountancy. As in most academic studies, we were taught the various methods for determining option pricing (Black Scholes springs to memory), the difference between put options and call options, and when each type should be used.

The part I never really understood, was if you buy an option to hedge your position, surely then someone else has to sell the other position, which implies they leave their position exposed. Now since then, I have gone onto do my own studying and learnt a bit more about this subject (but am by no means an expert). Principally, I was first introduced to the concept of writing options by Robert Kiyosaki’s Rich Dad’s Retire Young, Retire Rich book.

In his book, he explains how he is able to write options on stock that he does not hold, making a nice quarterly passive income. He also goes on to explain that this is not risky because the options he was writing, were for stock of a company he wanted to own anyway, and that the profit he makes from writing the options for the previous quarters would be used to acquire the stock in the event of the options excercised by the owner of the options.

I have come to learn that this strategy is called a buy-write, because the writer is obligated to buy the stock at the strike price, if the option is excercised. The opposite of this is a covered-call, whereby the writer of the option already owns the underlying stock, and is writing a call option to sell the stock at the strike price should the option be excercised.

So how could these strategies be used to make money, and what risks are attached to each strategy?

Buy Write Strategy and Risks

To make money using the buy-write strategy, it seems you have to agree to buy up shares of a company you want to own anyway, and then make money from selling your obligation to buy the shares at the strike price.

The risks with this strategy are that you could be obligated to buy shares in a company whose share value is taking a nose-dive. So for example, you may be obligated to buy 10,000 shares in a company that normally trades at £10, but your option is excercised when the share price hits £9, meaning you need to stump up £90,000 to meet your obligation under the contract. Now if the shares plummet to say £2 (as some UK bank shares did last year), you could be £70,000 down on the transaction (of course you could hang onto the shares and hope for them to recover).

Covered Call Strategy and Risks

This is where you agree to sell shares that you already own, at the strike price, to the owner of the call option you wrote. Sounds simple enough. If you own the shares already, and are happy with them, it may seem stupid to sell them, however, this is a strategy for increasing the returns on your existing shares, by making extra money by writing the call options.

For example, if you owned the same 10,000 shares that are currently worth £10 a share, and you were able to sell a call option for 10,000 shares at a cost of £5,000 each quarter, then you are making passive income (assuming the option is not excercised) of £20,000 a year. This is over and above any dividend income you may be receiving from the shares as well.

The risks with this strategy are that your shares my drop in value, but that is a risk with holding onto any shares, so is not confined to this strategy. The risk that is inherent in this strategy is the opportunity cost associated with being obligated to sell a share that is sky-rocketing.

For example, if you own 10,000 shares which are currently worth £1 a share. On the back of some good news about the company, the share price quadruples to £4 a share. If you weren’t obligated to sell the shares under the option contract, you could have hung on and sold for £3 a share profit, but instead, may have to sell at £1.50 (for example), thus the contract has an opportunity cost of £2.50 / share in this instance.

Hopefully this rudimentary explanation of how options trading from the point of view of writing the options, rather than simply buying and selling them offers an insight into how to make extra money from existing shares, and also how to earn money without even owning the shares. I don’t profess to be an expert in options trading, but found this option traders journal website to be very useful.

With the economy in a state of flux, asset prices mixed up and generally not making much sense to those in the know, let alone those in the dark, is it such a stupid idea to invest your money in an Italian sportcar when you could buy a one bedroom investment property for the same price? I don’t think it is, in some ways….

Before you look at your calender to check that it isn’t April Fools Day, please indulge me. By my reackoning, both of the potential investments are roughly the same price (assuming you don’t live in London where property prices are wrong). A Lamborghini Gallardo costs £130,000 on the road, and you can comfortably buy a 1 bedroom investment property for the same amount.

Now conventional wisdom would say something along the lines of “don’t do it you fool, think of the depreciation!!!!”. However, in the current economic climate, and property market, you’d be hard pushed to find much difference between the depreciation on the car against the investment property.

According to these property price predictions, the general opinion is that 2008/2009 will see the following falls in UK property prices:

• 20% - Morgan Stanly
• 25% - Nationwide
• 25% - Savills
• 20% - London School of Economics

Which does not paint a very rosy picture, and this comes off the back of news recently that the UK property market has already declined by 16.2% in 2008 according to Halifax.

So given that a Lamborghini Gallardo would depreciate in the region of 20% year 1, then 10% a year thereafter, for the next couple of years at least, it will hold up well against an investment property.

But what about the yield I hear you say. Yes, what about it, I can tell you that with very little efford you could achieve a much better yield on the car than you could on the house. Yes, that’s right, I genuinely believe you could get a better yield on the car than the house!

Let’s look at some realistic figures here. A 1 bedroom property is at best going to rent at a yield of 6%, so if it costs £130,000, that gives you an annual rent of £7,800 (assuming it’s rented for 12 months of each year…).

How much could you rent the Lambo out for? Well this depends on what you do with it. You could rent it out to your friends and family and colleagues and most likely make a better return than the property. Or alternatively you could build a small part time business around renting the car out for track day experiences or even as a posers’ car for the weekend.

Track day experiences for this sort of car start from around £25 a lap, some of this will be eaten up by fuel, track fees, insurance, financing and depreciation. But if you get the model right, there will be plenty of demand for these experience days at the moment. Think about it, thousands of out of work bankers, thousands left in the industry without a six figure or for the lucky few (thousand), seven figure bonuses this Christmas, they must be looking for cheaper thrills, perhaps this could satisfy that need?

And of course, you could simply rent them out by the hour in the City - normally bankers and City types would have just bought a Lambo or a Ferrari - but as I’m sure many of you will have heard the joke:

What’s the difference between a pigeon and an investment banker?
A pigeon can leave a deposit on a Lamborghini…

No doubt this joke has an element of truth in it!

In all seriousness, I’m not suggesting everyone should go out and invest in a Lambo rather than an investment property - simply illustrating the point that property prices are falling at rates similar to the depreciation on a thoroughbred sports car. And in light of this fact, coupled with the fact the sportscar could have a far higher yield, and with the tax relief you get on business expenses related to the running of the car, and its’ depreciation, it could actually work out a better investment in the short term. Who’d have thought it…

There’s lots of gloomy news about the recession and rising unemployment, I read on a website that 600,000 Jobs To Go In 2009, which is on top of 150,000 that have already gone in 2008. As the article rightly puts it, that’s 1,600 people per day being made redundant, that’s a lot!

There’s some good advice in the article about cutting costs, saving some money for a rainy day, updating your CV and registering with job sites and recruitment consultants. I think this is all very good general advice, and will certainly help you get through this current recession. But is this just a sticking plaster, a solution to cure the sympton rather than tackling the root cause of the problem?

Certainly by following the advice put forward you will be better prepared to handle a redundancy. It certainly makes sense to cut your spending, especially things like utilities, food shopping, petrol etc - these everyday costs may as well be as trimmed as much as possible. Also, saving money for a rainy day is great advice in a booming economy just as it is in a bust economy.

But is clinging onto the false notion that job security exists a good idea? I know you can insure against redundancy, but this only protects employees who have been with their current employer for a minimum of twelve months, and it won’t protect you if you get fired. I have a friend who is an employment lawyer, and he tells me that employers will look at finding creative ways of getting rid of employees who would otherwise cost a fortune in a redundancy payment. So even if you have insurance, you’re not necessarily protected.

In my mind it makes sense to start a home based internet business, even if you don’t get made redundant, you can make some extra money in your spare time, and know that you have a safety net should you get made redundant in years to come. It could even become so successful that you quit your job and join the scores of new rich internet entrepreneurs.

I’ve read some really interesting books recently about this subject, both written by successful internet entrepreneurs, who far from thinking that the internet bubble has burst, they both think that things are still booming, and will be for years to come. In short, there are plenty of opportunities out there, some are bigger than others, but the underlying theme is that there are enough small opportunities that you can easily replace your existing employed income with a self-employed internet business income.

To read more about this, see Four Hour Work Week by Timothy Ferris and Internet Riches by Scott Fox. You should be able to buy the books from their website or from Amazon or any other online bookstore.

There are many ways that passive income can be generated, through bonds, rental property, dividends from shares, royalties etc. Most of these require a significant amount of capital to generate a modest return of say 5%. If you’ve made the decision to get out of the rat race and become financially free, you’ll need to think about generating passive income, which is fine, but using conventional methods, this could take some time – are you happy deferring life for 10 or 20 years while you build up these assets?

Let’s take a look at a fairly typical example. Meet Steve, he’s works in sales, earning £50,000 a year. His wife works as a teacher, earning £30,000 a year. Together, after all their costs, each year they have £20,000 leftover. If they were to invest this £20,000 a year for 25 years, they would eventually have enough money invested at 5% to generate a passive income that could be used to replace their earned income.

But this plan means they have to defer life, make sacrifices with their money, and no doubt watch their friends move to better houses, take better holidays and drive nicer cars, while they scrimp and save and invest their money. Is this the best plan for them?

I would argue that it’s not. I would argue that the best thing for them to do would be to find ways of increasing the size of the capital that they have to invest each year.

Let me explain. If they could turn the £20,000 that they save each year into £60,000 within three years, and then invest that at 5%, they will achieve their desired passive income much quicker. If, after three years, each year they have £60,000 to invest for the long term, even if they simply put this money into a savings account that paid 5% interest, by tripling the amount invested, they will triple the passive income.

However, if they stuck this money into property, they would not only achieve 5% rental return, but in the long term would achieve capital appreciation and rental appreciation too. Better yet, if they leverage their money by buying the property with a mortgage, they stand to make significant gains in the amount of capital invested in the medium to long term.

They won’t be able to invest in any retail investment products that will turn £20,000 into £60,000 within three years, so they will have to seek alternatives. What are their options?

• Property development / Speculation
• Shares / Derivatives
• Businesses
• Land

There are no guarantees, but with enough knowledge of how these opportunities work, and if you do your homework you should be able to achieve significantly better returns than 5% year on year.

The secret to generating passive income quickly is first learning to generate capital. Once you’ve generated significant capital, you can create significant passive income. You can always do it the slow way, but ask yourself this question – do I really want to wait 25+ years to be financially free?

One of the reasons so few people ever manage to become financially free is their belief that they can not easily make any money outside their job. Fortunately that’s not the case, in fact it’s relatively easy to make money in your spare time, especially with the advent of the Internet. In fact as you are reading this, you almost certainly have everything you need to start an Internet business in your spare time (a computer and an Internet connection).

Starting An Internet Business

Starting an Internet business in your spare time is easy, the basic steps are:

1. Pick an idea;

2. Pick a business model;

3. Set up the business;

4. Market your business;

5. Refine, develop and grow the business.

You can learn more about each step by reading the post how to start an Internet business on my Business Opportunities and Ideas blog.

I’ve also written some more detailed articles on how to start a blogging business and how to start an ebook business. Two of the more common Internet business models, which anyone can do.

But What If You’re Not A Geek?

If an Internet business isn’t for you, then start thinking about services you can offer locally, for example cutting lawns, gardening, dog walking and so on. Almost anything that someone considers a chore is an opportunity for you to make some money in your spare time. The market for these services is going to grow too, as our population ages.

Just Do It!

The real secret to making some money in your spare time is to “just do it”, don’t spend ages thinking, talking or deliberating, just get out there and start doing something, if it doesn’t work, then try another idea and another idea until you find one that does.

Of course once you’re making some extra money make sure you save/invest it wisely.

I have recently become a property investor – not entirely by design, my wife and I split, neither of us wanted to live in the marital home, so we have rented it out – and I think now is the time to make a killing.

Interest rates are dropping, house prices are dropping and rents are increasing – could there be a better time to invest? Yes, wait six months and prices could be lower, as could interest rates, but even now it makes sense. I’ll give you a real world example to demonstrate the point.

My property is a regular three bedroom semi detached in Bristol. It’s probably worth about £150,000. The mortgage is currently on the lender’s standard variable rate (1.75% over base) and we are paying about £500 a month for the mortgage and buildings insurance. The rent is £795 a month, leaving us a nice little profit of around £300 a month.

I did a quick scout around to see what sort of rates would be available for buy-to-let mortgages and found that on MoneySuperMarket there were no rates available (I searched for £150,000 property purchase, 3 year deals with an income of £50,000 and no adverse credit). I found this strange considering I found deals on other websites.

I suspect this is because they make more money by getting you to complete an enquiry form, which is then sold off as a lead to a mortgage broker than they would if they allowed you to source your own product (likelihood is not many searches would result in any revenue for them).

I eventually found some useful information on the Cheltenham & Gloucester website, a lender that I put a number of deals through when I was a mortgage broker, and a lender that on the whole I found to be quite good.

Their buy-to-let range has products for 2, 3 and 5 year fixed rates, nothing else. The max loan-to-value is 75%, but if you can find a 40% deposit, they will shave 0.3% off the rate they offer you.

Let’s consider my investment property on the most expensive deal they offer, currently a five year fixed rate, max loan-to-value of 75%, 2.5% arrangement fee and a rate payable of 5.69%.

Assume a purchase price of £150,000, requiring a deposit of £37,500, stamp duty of £1,500, survey fees of £1,000 and legal fees of £1,000 (rough figures only). For a total of £41,000 you could acquire an asset that pays you a rental yield of 6.4%.

The actual return you would receive is £228.23 per calendar month. Over a year, this would be £2,738.76 or 6.7% return on your capital. I’m sure there are better mortgage rates out there, and I’m sure when the govt and the lenders stop arguing over passing the base rate cuts onto the borrowers, the rates will come down even more so, which is good news as it will make this deal stack up even more.

The best bit is that in ten years time, the property will most likely have doubled in value, so you will have had money in your pocket each month and a nice capital gain too.

Calculations

£150,000 purchase price
1% stamp duty: £150,000 x 1% = £1,500
25% deposit: £150,000 x 25% = £37,500
75% loan-to-value: £150,000 x 75% = £112,500
2.5% arrangement fee: £112,500 x 2.5% = £2,812.50
Total borrowing: £112,500 + £2,812.50 = £115,312.50

Monthly interest: (£115,312.50 x 5.69%) / 12 = £546.77
Monthly costs (interest + buildings insurance): £546.77 + £20 = £566.77
Monthly profit (rent less costs): £795 – £566.77 = 228.23
Yearly profit (assume 12 months profit): £2,738.76
Return on capital: (£2,738.76 / £41,000) x 100 = 6.7%

I went to Devon and Cornwall a couple of weeks ago and stayed with a friend who has built up a very nice holiday cottage business for himself. As I’m always interested in how people have made themselves, we were soon chatting about how he got to where he is now.

He told me that he bought the first property, which was an old farm barn back in the late 1980’s, and decided to “extend” the property into what it currently is. It took him about five years, during which time he mainly lived in a caravan on the site, and did most of the work during his spare time when he wasn’t working on various building sites in Dorset.

By the time he actually finished the project, the boom of the late 1980’s had turned into the recession of the early 1990’s and the interest rate on his mortgage had gone up to 15.5%, needless to say that he could now no longer afford to live in what had become his dream home.

What did he do? He let the property as a holiday let, and has been doing so ever since. He even let my wife and I use it for the weekend and I can confirm that it is well worth the money that people pay - over £1,000 a week if all ten beds are used in high season.

As a business, it’s great, they have the place busy all year round thanks to the fact that, unlike many other holiday homes, they have an indoor swimming pool in the grounds of the property which means it’s an all weather holiday home, useful in Cornwall where the weather tends to be quite wet during the winter.

He even managed to buy the farm house next door when the owner moved on, and now has two very lovely holiday cottages which he rents out all year round.

I really admire this guy for what he’s done with his life. He’s not been reckless with his money, always watched the pennies. I doubt he’s ever earned large amounts of money, but through wise decisions and hard work, on paper he owns property worth over £1million pounds, which generate a very comfortable, almost passive income through the holiday business.

If you would like to know more about the holiday cottages mentioned, please check out www.cornwall-holidays.com.

I’ve been watching the series Deadliest Catch on Discovery Channelfor the past few weeks, and have really enjoyed it. I like the way the guys who work on all the boats are real characters, and the trials and tribulations they all face.

What I find most fascinating is the notion that these crab fishermen go out onto the Bering Sea and fish for a couple of weeks, and then come back in with a haul of, in some cases, over $1million worth of king crab. After the costs, the deckhand’s usually end up taking a cut of around $40,000 – not bad for a few weeks work, hell even for a whole month!

I wonder how many of the deckhands just blow their money as soon as they get onshore? I know that if that had been me in my early twenties, I would definitely be looking to have a good time with all that money.

What would I do with the money now? I would be looking for opportunities to invest some of the money made into providing an income for me all year round, as fishing is obviously a seasonal business.

What opportunities could you buy with $40,000? A whole range of things. You could use the money as a down payment on an investment property, though if the buy-to-let market in the states is as bad as it is in the UK, then it may well be worth holding off on that. Perhaps you could invest the money in another business, $40,000 won’t get you that far, but it may be enough to buy into a franchise business, which as long as it turns a profit each year could provide you an income when you’re not at sea.

Alternatively, you could buy income bonds, although a fixed income bond @8%, is only going to generate $3,200 a year in income, so you would need at least $400,000 worth of income bonds at that yield to generate a reasonable yearly income.

I think if I was a crab fisherman I would use some of the money I made after each season to clear some of my mortgage, put some money into savings, put some money into a personal pension plan, and live off the rest.

I really don’t know how often these guys go to sea, I would guess they fish for about 6-8 months of the year, so they may well be earning some decent money. In which case, if I were in their shoes, I would be looking to save/invest a lot of the money made, so that I could either take early retirement – from crab fishing at least – or move into another profession that didn’t carry with it the risk of dying in icy cold water! Perhaps I’m being too risk-averse, perhaps half the reason they do what they do is for the thrill of the chase, and the dangers it carries.