For investors who pursue Market FIRE, there are several key components to budgeting in order to conform the Market FIRE framework to the essentials of personal finance. In part, these components will vary depending on the size of the investor’s portfolio, the amount of anticipated personal expenditures, and overall stock market conditions. Overall, however, there are certain structural considerations that will make investors’ personal finance structure align with Market FIRE opportunities. The first two steps are not specific to Market FIRE and are common parts of most schools of personal finance, but the ensuing steps are tailored to calibrate basic constructs in personal finance with the opportunities of the Market FIRE approach to financial independence.
I. Determine base annual and monthly expenditures
As with any plan for personal finance, the budget for a Market FIRE investor must determine the basic level of expenditures that is realistically desired, which for the sake of computation and comparison should be done as an annualized figure. For new Market FIRE investors, the starting point for this computation can be the annual expenditures made by the Market FIRE investor during the one-year period prior to leaving conventional employment, adjusted by any unusual non-recurring expenditures during that one-year period or expected during the following one-year period. Budgeted expenditures should also reduced by any amounts deemed upon review to be unnecessary that the Market FIRE investor is willing to eliminate. The budgeted amount of expenditures should further be re-computed and re-determined each year, in order to allow for any upward and downward adjustments over time.
As a means of confirmation, the Market FIRE investor should compute annual budgeted expenditures by figuring anticipated monthly expenditures in the span of typical budgetary categories, multiplied by 12 to arrive at the annualized figure. These categories should include, but are not limited to, housing, utilities, transportation, insurance, food, clothing, educational and childcare expenses, entertainment, travel, debt payments, and any anticipated major purchases (such as a new car or down payment for a new house, if any such non-recurring expenses are foreseen).
One fluid category that should always be recognized is an amount for making additional investments. This figure obviously does not need to be the same level every month, as it is not needed for any ordinary expenditures for daily living. Nonetheless, this category should be included in any budget as a basis for providing for expansion of the total value of the investment portfolio and thereby for continuing financial independence. An expanding investment portfolio, crafted using some version of dollar-cost averaging, is a means of guarding against potential future market declines, as well as a means of facilitating any future increases in cost to the investor’s desired standard of living.
As a reminder, at least 7 to 10 months’ of annual living expenses should be maintained in an accessible after-tax brokerage account in order to enjoy the full benefits of the Market FIRE construct. If an investor has less than this amount but still wishes to partially enjoy the benefits of Market FIRE, then he can try to do so provided there are other sources of income and/or revenue, such as from part-time employment or freelance work.
II. Maintain sufficient cash reserves for an emergency fund
Before embarking on the Market FIRE path of living off of stock market equity and options returns, a Market FIRE investor should take care to make sure that sufficient cash amounts are set aside to cover at least six months, and preferably one year, of ordinary living expenses. Whether an emergency savings account is sufficient should be checked after the figures for monthly and annual expenditures has been calculated. The one-year amount of reserves is especially appropriate for an investor who is first starting to forego full-time conventional employment in favor of living based on the market, given that the expected amounts to be generated (further discussed based on category below) may be considered to be more tentative.
As a cash reserve, an emergency fund should NOT be invested in the stock market in the form of individual stocks, stock ETF’s, medium- or long-term bond ETF’s, actual medium- or long-term bonds, or any kind of options. A “cash reserve” means cash in a liquid FDIC-insured bank account that can be readily accessed with no more than one business day’s notice.
If necessary, this emergency fund reserve account can be in the cash sweep portion of a brokerage account, which would allow consolidation with cash used to finance short options trades, provided that an appropriate amount is always maintained. This should only be done if the investor is confident that he has a sufficiently high degree of financial discipline to maintain the requisite amount of cash in the cash sweep account to cover at least six months’ worth of living expenses, at all times and regardless of cash needed to be deployed for the purposes of making stock or options trades.
III. Determine realistic annual and monthly dividends and options premium that can be generated based on principal amount of money in investment portfolio and type of securities held in portfolio
The first priority source for ordinary living expenses for a Market FIRE investor should ordinarily be income generated from options premium, along with any conventional dividends distributed by the company in which the investor holds shares of stock, along with any non-stock recurring sources of revenue. Before relying on this income, and preferably before entirely leaving full-time employment, the Market FIRE investor should approximate the amount of monthly net premium plus dividends that can realistically be generated, based on recent past actual performance using the stocks held in the investor’s portfolio.
Then, the Market FIRE investor should determine a monthly target amount of net options premium that he intends to generate, at a minimum, from selling covered calls along with cash-secured puts plus dividends. If financially feasible from a standpoint of generating sufficient income to balance one’s budget, this monthly target should be somewhat less than the average monthly amount of net options premium plus dividends actually generated, in order to allow for some margin of error, particularly given the variability of options premium that can be expected under different market conditions. Any other non-stock recurring sources of income or revenue — such as real estate rentals, pensions, annuities, and royalties, if applicable — of course can also be considered in offsetting the amount for the monthly options premium goal in relation to expected monthly expenditures.
By “net premium amount” generated from options, I mean the premium generated from initially selling covered call and cash-secured put options, MINUS the amount used to buy-to-close such options. A Market FIRE investor should recognize that including only the amount generated from opening a short option by selling it is not accurate and will artificially make it appear as though the trades will be generating more income than they actually generate. If an option is sold within a given month and not yet closed out during that month, it may be acceptable to only include the amount generated from selling the option in the monthly figure, provided that the amount used to buy-to-close the option is taken into account in the calculation for whatever month in which the option is closed. As long as the method of accounting for net monthly premium is done consistently, then both sides of the transactions should be accounted for.
Because a change in overall market or stock-specific conditions can happen unexpectedly within any given year, a Market FIRE investor should periodically (i.e., at least quarterly) re-evaluate the amounts of net options premium actually generated and also the monthly target amount of net premium that he should formulate. For instance, a portfolio experiencing a sharp decline in underlying stock prices could ordinarily results in a lower expected monthly net options premium from covered calls and cash-secured puts. A portfolio experiencing a bull market with most stocks substantially increasing in value might also generate a relatively lower expected amount of monthly net options premium. This is due to the need to select strike prices further above the stocks’ market prices and perhaps the need to devote more of the gross options premium generated towards the funds needed to roll over covered call options during times when they are not profitable, which may occur more frequently in a bull market.
On the other hand, a portfolio with generally declining but not steeply declining stock prices, or one with stocks that trade sideways within a range without significantly increasing but with some internal volatility, could be expected to generate a relatively more significant amount of net options premium from covered calls and cash-secured puts. This can be a rare partial benefit of a market correction or bear market, in that the greater net options premium generated from covered calls can help offset the absence of capital appreciation in the underlying shares of stock.
The feasible monthly options premium and dividends target should then be compared to the budgeted monthly expenditures. If the target, plus any reliable non-stock recurring sources of revenue, is equal to or greater than the budgeting monthly personal expenditures, then additional revenue or income may not be needed to bring the budget into balance. On the other hand, if the budgeted monthly expenditures figure exceeds the monthly options and dividends target plus any other non-stock sources of recurring revenue, then the Market FIRE investor will need to generate additional income, first from selling some underlying stock and then if still necessary from taking on part-time or freelance work, as further described below.
IV. Generate additional revenue from trimming or selling winning stocks during regular portfolio rebalancing or specific stock sale if necessary
To the extent that options premium and dividends are not sufficient to satisfy monthly and quarterly expenditures, the Market FIRE investor should next take advantage of periodic portfolio rebalancing to trim or sell winning positions and devote a portion of the proceeds from those sales towards ordinary living expenses. Portfolio rebalancing should generally be done either quarterly or at least semi-annually as part of the general systematic process for portfolio management. It can also be done irregularly at such time as is necessary to make up the deficit between monthly expenditures and options premium plus dividends and other non-stock recurring sources of income.
Trimming winning positions does not necessarily contemplate selling entire winning stock positions. Many times, winning stocks continue to win. Complete liquidation of such positions may result in foregoing outsize returns that can result from future gains compounded upon prior gains. Many other times, sector rotations of preferred securities on Wall Street may make yesterday’s winners to be viewed as overvalued and subject to heavy future selling with resulting price declines. A failure to take profits in such scenarios can enable quick future losses as market conditions and investor preferences change. A decision about whether to partially trim winning positions or liquidate them entirely must be made on a case-by-case basis and should depend on a sober-minded assessment the stock’s future near-term and long-term prospects. Given general market volatility and tendencies towards at least annual sector rotations in overall investor preferences, at least partial trimming of winning positions is preferrable over letting them stand without taking any profits for more than one year.
If sufficient funds cannot be generated from trimming winning stock positions, then it can be appropriate to selectively sell stock in losing positions, preferably positions that are only marginally losing relative to the market as a whole so as not to lock in temporarily exaggerated declines.
Of course, before any stock sale of any of these types can be accomplished, any existing covered call options regarding any of the affected stocks must have already been closed. If a Market FIRE investor believes that an existing stock position may be an appropriate candidate for sale in the near-term future, then he should refrain from re-writing a covered call option on that same stock position unless he ultimately chooses not to sell the underlying stock position. Often the time chosen to sell the underlying stock may be one or more days (possibly weeks or months) after buying-to-close the covered call options. This gap is because the closure of the option may be occasioned by a sudden drop in price, either because of general market conditions or conditions specific to that stock or stock sector. Often at least a partial rebound may follow a steep drop in price, and it would be more advantageous to sell the underlying stock at the higher price that would result from a partial rebound in price, which would free up more funds than selling at the short-term low price.
The balance of funds generated from such stock sales, beyond what is needed to finance ordinary living expenses, can then be devoted to stock acquisitions for either new positions in desired fields or existing positions in companies believed to be undervalued, which often are associated with presently unrealized losses that may be believed to change to future gains.
This means of balancing a Market FIRE investor’s budget should be disfavored relative to use of options premium and dividends and other reliable non-stock sources of recurring revenue, because stock sales necessarily involve dipping into the principal of the investor’s investment portfolio. However, it may be necessary to do so at times, depending on the total size of the portfolio and nature of market conditions. When there is generally upward trending bull market, this means of balancing one’s budget is more likely to be appropriate than in declining or sideways market conditions. Net covered call options premiums will generally be lower in raging bull markets and also opportunities for generating revenue by trimming winning stock positions will be greater in such bull markets. In the latter scenarios, the total principal should still be increasing even after withdrawals to satisfy personal expenditures.
V. If necessary, stock and option revenue should be supplemented with income from part-time employment or freelance work
If there still is any budgetary shortfall in income generated from short options, dividends, portfolio rebalancing, specific stock sales, and any other reliable non-stock recurring revenue, then a Market FIRE investor should supplement his income through part-time employment or freelance work on an as-needed basis. Even though one common objective of financial independence is the avoidance of conventional work, temporary part-time or freelance work is financially preferrable to depleting one’s stock portfolio, which would presumably require long-term full-time employment in order to be fully rectified. Of course, even without needing to work part-time or engage in freelance work in order to balance one’s personal budget, a Market FIRE investor may also engage in such work for enjoyment or to provide additional revenue for added investments.
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