Using stock market investments to win financial independence means running your portfolio like its your own business. A Market FIRE investor should be able to enjoy MUCH more control over his own time than when working as a W-2 employee, but still his investment portfolio must be run like a serious enterprise that can be customized towards his cash flow and wealth accumulation objectives.
There are a few key components of my own Stock Market FIRE approach to achieving and maintaining financial independence. Offered for educational and informational purposes, this is a general outline of these key components, which will be elaborated upon in later posts. Note that this list is geared towards structuring stock market investments, not specifically related to managing options trades. Nonetheless, optimizing stock market investments so that a portfolio is compatible with use of a covered call options strategy is a recurring part of these components.
I. Actively managing a diversified portfolio of individual stocks offers greater opportunities for compounding growth and income than passive investing in index funds.
The general Market FIRE approach to stock market investing is an active management approach to a stock portfolio. This is in contrast to the many FIRE advocates who embrace passive investing through index funds and ETFs. Though there is nothing wrong with index funds and ETFs per se, active stock portfolio management allows for achieving financial independence with less upfront accumulated savings by carrying greater potential for earning option premium income and greater prospect for more substantial capital gains.
The stock market, as often has been said, is a market of stocks. There are stocks in a multitude of sizes, industries, and stages of growth, and with management teams of varying degrees of effectiveness. Some of these companies may be more likely to work in some types of economic conditions as opposed to others. Index funds necessarily include stocks from underperforming companies or in underperforming sectors, as well as some outperforming stocks. An active approach may allow an investor to significantly outperform the average 8% rate of return in the stock market, which may be necessary to achieve and maintain financial independence well in advance of traditional retirement age.
After all, 8% annually (and less in many years) may be sufficient with a multi-million dollar portfolio, but Market FIRE is based on the premise that it shouldn’t be necessary to accumulate that degree of wealth before achieving financial independence.
Additionally, beyond conventional stock market investing, leveraging stock holdings by selling covered call options against the stock positions in one’s portfolio is a fundamental component of the Market FIRE approach to financial independence. Although covered calls can be sold against ETFs or stock indices, the premiums generated by a covered call options strategy will generally be significantly greater if the call options are written against individual stocks. This is because options derive their value not only from the portion of the price of the underlying equity that is in-the-money (the “intrinsic value”) but also the implied volatility of the equity combined with the time value (the “extrinsic value”). Because stock market indices blend together the individual companies in the indices, the indices will have less volatility than many of the individual stocks.
Market FIRE can maximize the generation of options premium income with a portfolio that includes certain types of stocks, such as small cap or growth tech stocks, which have above-average volatility. Even in a down stock market, these covered call premiums can be used as cash for regular living expenses without having to sell stocks at a loss before they recover. The S&P 500 currently has a paltry dividend yield of less than 2% annually. An individual stock portfolio leveraged for covered calls under a Market FIRE approach can yield a “synthetic dividend” in the form of options premium of between 10% and 25%, and sometimes greater.
Of course there is also somewhat greater risk with any active investment approach, but any greater risk can be mitigated through a reasonable degree of portfolio diversification and through common sense understanding of evolving macro- and micro-economic conditions. One does not need to have an MBA or a background in corporate bureaucracy in order to be an effective active stock market investor. Knowledge of current economic and business affairs and some exposure to stock market cyclical history can provide a winning foundation in stock market investing. These factors are not specific to the Market FIRE approach and instead can be imported from many different schools of thought concerning stock investments; my preferred approaches and specific stock investments will be discussed in other posts.
Note that this preference for active stock market investing can be transitioned to passive index fund investing if a person has aged to the point of no longer having the financial need, initiative, or capacity to actively manage an investment portfolio, ideally after having had more than ample time for the investments to have grown and prospered with a more active investing approach.
II. Though an investor should be nimble in adjusting a portfolio, most stocks should be held as long-term investments for at least one year, provided that the underlying investment thesis has not changed.
In order to optimize a stock portfolio for Market FIRE purposes, most if not all of the stocks in the portfolio should be purchased with the general intention to hold those stocks as long-term investments of at least one year, rather than as shorter-term trades. Long-term investing is the best general approach (1) to maximizing overall capital gains, and (2) to allowing stock positions to be leveraged by selling covered call options against those positions.
Much has already been written about how attempts to time the market are futile and how out-size capital gains in stocks accrue by allowing gains to compound over time, even as these gains may be irregular and unpredictably timed. These benefits to a portfolio, which are a strong basis of many different approaches for financial independence, cannot realistically develop based on short-term holding periods that may be based on emotional reactions to events rather than any change in the fundamental justification for holding the stocks. Certainly, market conditions may develop after acquiring a stock position that would justify selling the stocks earlier than one year. Also, some information may justify a small percentage of a larger portfolio being devoted to shorter-term trades not intended as long-term investments. But these are exceptions.
It should also be noted that long-term holding of stocks can result in preferential treatment under the federal tax code. If capital gains ultimately result from a stock position held longer than one year, then any capital gain in that stock position would be taxed at a usually lower capital gains federal tax rate rather than a usually higher tax rate for individual earned income. Tax considerations by themselves may not be ample justification for driving any investment decision, but they may be well be considered in conjunction with investment-related non-tax financial considerations.
Even aside from these traditional reasons for long-term buy-and-hold investments, a longer-term approach to investing is justified by more mechanical factors needed to apply a Market FIRE approach to investments. As discussed above and elsewhere in this site, consistently selling covered call options and actively managing those options is a fundamental part of the Market FIRE approach to investment. The ability to consistently generate options premium income from selling covered call options while minimizing the likelihood that the stocks will be called away requires in many instances holding onto the underlying stocks for longer periods of time. At a minimum an investor must hold onto the underlying stocks for the duration of a single option contract or until the options trade may be closed profitably before expiration. But additionally, the underlying stock often may best be held for multiple contract lengths in order to ensure the options trade overall is profitable if earlier options are rolled over because the shorter immediate options had to be closed at a loss.
In short, not only does long-term holding periods of stocks allow for greater capital gains based on long-term compounding, but it also allows for more consistent accumulation of options premium, including if there are contract periods when an options contract has been closed unprofitably. Underlying stock positions either can’t be quickly sold based on short-term events because of the option that is in effect against the stocks, or the stocks should not be quickly sold even after an options position has closed without being assigned because of a preference that the options trades even out profitably consistent with protecting capital gains.
Note that this strong general preference for long-term investing still allows for a small portion of a portfolio to be devoted to more speculative and/or shorter-term holdings, which can be in the form of holding stocks in a company or selectively holding long call or put options.
III. Shares of stock should be held in multiples of 100 shares per security.
As a specific mechanical consideration required to optimize a stock portfolio for writing covered call options, individual companies’ stocks in a portfolio should mostly be held in multiples of 100 shares per company. Ordinarily, the price per share and total number of shares held are not significant considerations in investments compared to total funds held in each stock and the amount and percentage of any gain or loss. However, because options contracts are structured based on control over 100 shares of stock per contract, a stock holding can only be used to write covered calls if there at least 100 shares of the stock in a portfolio. The ability of many brokerages to allow clients to trade in fractional shares does not address this basic structural aspect of options trading.
The 100 share-per-options contract principle means that, as a practical consideration, extremely highly priced shares won’t be added to a portfolio, because it may not be feasible to hold 100 shares of such stocks. Lower and mid-priced shares may be better stocks for covered call purposes.
If an investor has already accumulated a stock market portfolio and wants to optimize it for Market FIRE purposes, then shares might initially might have been acquired in multiples of something other than 100 shares per stock, because covered call considerations were not paramount when the position was acquired. Over time the investor may consider which stocks in the portfolio are similar to one another in sectors or company type and whether one is preferred over the others in the same category. If so, then a less-favored position can be sold and used to acquire more shares of the favored company in a given area in order to reach some multiple of 100 shares in that company.
An investor who generally pursued a covered call strategy may still want to hold positions in some companies that may not be realistic to hold in multiples of 100 shares. These might also be companies whose shares are held as a shorter-term speculative trade, which generally would not be encumbered with covered calls. As long as these are exceptions to the general rule, there is nothing wrong with holding an “odd lot” stock position in a company for these purposes.
IV. Periodic portfolio rebalancing should be done to lock in gains and free up cash for living expenses and for new investments.
Periodic portfolio rebalancing is not only a sound general investment practice, it is a vital practice for realizing Market FIRE. All the traditional reasons for periodic rebalancing apply for a Market FIRE portfolio: rebalancing allows an investor (1) to sell or trim winning positions that may be overheated before they might enter a downturn, allowing for locking in some gains while they are available and (2) to add to or start positions in otherwise sound investments that have attractive current valuations.
In addition to the traditional benefits of regular portfolio rebalancing, this action can be done when applying the Market FIRE approach for the purpose of generating cash for regular living expenses. Indeed, as discussed in greater detail in the personal finance portions of this site, in a generally rising stock market situation realized gains from periodic rebalancing may provide most of the Market FIRE investor’s freed-up funds for regular living expenses. In a declining or stagnant market situation, income premium from covered call options instead will provide most of the Market FIRE investor’s funds for regular living expenses. However, when the market is rising, income generated from covered calls will generally not be as high as when the overall market is either stagnant or declining (though this can be offset somewhat by greater use of selling cash-secured puts). At the same time, trimming winning long stock positions will naturally result in more significant funds in a rising market than in other market conditions.
Even though winning long stock positions should periodically be trimmed, that does not mean that they should always be sold entirely. Often greater benefits can be obtained by selling only a portion of a winning position at one time. This is because the winning position may have strong prospects for continued long-term growth just as readily as a possibility for a shorter-term decline. Specific reactions of course depend on the specific longer-term prospects and nearer-term valuation of the stock. But generally either some trimming or outright liquidation is appropriate for a position that has had large amounts of appreciation.
V. Additional funds from options premium, portfolio rebalancing, and dividends should be invested in existing or new stock market positions on a regular basis.
Dollar-cost averaging is frequently recommended for investors who are in their “regular” working years and are still earning a regular paycheck. Because one can never know when the market is going to go higher or lower in the short term, investing new money in existing or new stock positions on a routine semi-regular (i.e., monthly) basis can be a sound general method for investing in a variety of market conditions and optimizing the use of new money to be invested. However, an investor who no longer is bringing in a regular paycheck due to early “retirement” does not generally have this regular stream of income to continue investing additional funds and often must rely solely on compounding of existing investments throughout the retirement years, supplemented by the paltry amount dividends typically pay for stocks in modern times. The Market FIRE approach can be used to lessen this financial risk of early retirement and instead allow an investor to continue to enjoy the benefits of dollar cost averaging with “new investments.”
With the Market FIRE approach to financial independence, an investor should be able to earn considerable ongoing cash flow under a variety of bullish and bearish market conditions that can be used to fund additional stock investments in new or existing positions, after using this cash flow to pay for ordinary living expenses. First, as described elsewhere in more detail on this site, an investor should aim to leverage his stock market portfolio to generate substantial income in the form of premium from selling covered calls and cash-secured puts and then managing those options on an ongoing basis. Second, as alluded to above, an investor can use money realized by trimming or liquidating stock positions as part of a regular rebalancing process for use in funding new stock investments. Third, an investor can use conventional dividends – despite the historically low yields they offer – to supplement options premium and rebalancing proceeds to fund new investments.
Because the amount of cash flow generated by the Market FIRE approach may not be constant each month, the timing of adding to additional investments may not be as frequent as when an investor was employed conventionally. However, the same general benefits of dollar cost averaging can be enjoyed by deploying newly earned cash at least quarterly or as occasions arise each quarter, depending on the amount of cash flow and relative valuations of prospective new investments.
After new investments have been added to a portfolio, then their value can be compounded not only by underlying capital appreciation, but by using those new stock positions to sell additional covered call options that will yield more premium that can later be used to continue adding to stock positions that ideally will appreciate over time. In this way, the Market FIRE approach to stock investing leverages stocks to create assets (covered calls) that can be used to “create” new assets in the form of additional stocks, which can be leveraged to create more assets in an ongoing virtuous cycle. This process allows for more layers of compounding and appreciation than simply letting index funds sit around in a portfolio and relying on compounding of a mostly determinate number of shares of those index funds.
VI. NEVER STOP LEARNING, AND HAVE FUN WHILE DOING IT!
The general approach to Market FIRE outlined above may not take as much effort as a full-time job that many investors have left behind, but it does require considerable effort to manage stock investments and related options trades. A continuing thirst for knowledge in new and existing areas of business can be helpful, as can an overall awareness of political and macro- and micro-economic conditions. Nonetheless, the Market FIRE investor can concentrate on specific business areas of interest without having to be familiar with everything in the stock market. Moreover, a Market FIRE approach can allow an investor to manage his stock portfolio around his own personal schedule.
Though there is no set or standard reading list or stock picking methodology that is necessary to allow for a successful investment portfolio, the materials suggested in this website are intended to be helpful in applying the Market FIRE mentality to using the stock market to achieve and maintain financial independence. The critical thing is that the investor needs to maintain awareness on a regular basis of current news and developments affecting stocks held in the portfolio, potential stocks to be acquired, and overall market and economic conditions. This can be done through use of financial newspapers, financial news television, analyst reports, internet news sites, company balance sheets, valuation metrics, or some combination of these types of sources.
Due to the active management approach involved in Market FIRE, the constant fluctuations of the stock market will usually be noticeable and will occasionally be frustrating to the investor. However, each development can be looked at as an opportunity as long as the long-term history of the stock market as an engine for growth is remembered. For many people, with the proper mindset and investment background, the stock market and all its gyrations can be calmly leveraged to allow for financial independence far earlier in life than a passive approach to financial management would allow. Therefore, by actively and competently managing one’s own stock portfolio, each day in the stock market can be looked at as helping to finance that investor’s journey through the remainder of life as a financially independent person.
Though successful management of stock and options with an active Market FIRE approach may not be an automatic process, it is a far cry from the often thankless toil of working for someone else. Managing one’s own stock and option portfolio to achieve and maintain financial independence means that you are always working for yourself, that you will be the one who enjoys the fruits of your capital AND labor, that you will be keeping your finger on the pulse of society, and that you will have the time and financial resources to slow down or speed up as you wish and enjoy life more on your own terms.
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