What are “Stock Rental Royalties?”

By Travis Johnson, Stock Gumshoe, July 14, 2020

Today I thought I’d explain what’s being teased in ads for Andy Crowder’s High-Yield Trader Inner Circle service from Wyatt Investment Research… it’s a relatively expensive service, $1,495/year, and does not offer refunds (the guarantee has lots of stipulations, and the reward for complaining and demanding a refund is “you get an extra year” — publishers love the “if you don’t like it, we’ll give you more” guarantee because it means they never have to give back cash)… so you should know what you’re getting before thinking about signing up, right?

So what’s the idea? Crowder teases the strategy of getting “Stock Rental Royalties” as being similar to buying a house and renting it out… without paying the full price for the house. (That’s what most real estate investors do, too, of course, they use mortgages to cover much of the up-front cost, but those mortgages are also an obligation… so it’s not really a reduced cost, just a delayed one.)

He says that real estate has been one of the most common ways to build fortunes throughout history, but that it’s tough to get started because the up-front costs are high, and that means there’s also a big risk because most people would have a lot of their net worth tied up in one property.

So the next best thing, if you don’t have a huge amount of money to “get rich on real estate” or you don’t want to worry about maintenance or tenants, is doing something similar to being a landlord… but in the stock market.

He keeps the real estate metaphor to explain… what if instead of buying a house for $250,000, you could put down just a security deposit, only $70,000, but still earn the full rent from the house for the year and get your security deposit back in a year… with the possibility that the value of the house could also rise during that year, and your security deposit would rise in value as well (they do note that values could fall, too, so you risk maybe losing some of it, but probably not all of it).

And we can do the same thing with stocks, we’re told.

Crowder says you can “put down a ‘security deposit'” on prime, blue chip stocks for up to 75% less than retail value, and then rent those stocks out every month for thousands of dollars in immediate cash income, which is what he calls the Stock Rental Royalties Program.

This is teased as a way to get your money generating income faster, and compounding your returns faster… without having a large amount of capital to invest today. He says that the average 7-10% per year you might get from the stock market is not enough for people who need bigger gains, or who need current income.

And he provides a few examples… here are the details from one of them:

3M (MMM) today is at about $155 a share. So 1,000 shares would cost $155,480.

Instead of paying that much for 1,000 shares, you would put down $41,500 as a “security deposit”, which is about 73% less.

He says “That allows us to benefit from the price movement for a year — if it goes up, you get a gain, if it goes down your deposit will be returned at a small loss. But now you can rent it out.”

And that rental can generate some meaningful income… “$960 on February 5, $2,250 on April 15, $3900 on June 10… in total, from January to May, you could collect $16,171”

And it sounds safe…

“You’ll get your security deposit back when the year is over, and you never bought a single share.”

So you get current income, and it’s also somewhat scalable — you could start smaller with what he calls the “minimum required security deposit” of $4,150, instead of buying 100 shares for $15,500.

And a bunch of other examples are tossed out, too, including Caterpillar, Twitter, Verizon, Chevron, Cisco, Pfizer, J.P. Morgan, IBM, Exxon, Proctor & Gamble. Other than Twitter, that’s pretty much the usual suspects for any “blue chip” list of companies.

We’re told, as well, that this is open to anyone — you can collect these royalty payments in any regular brokerage account, including an IRA or 401(k).

So what’s the story?

Well, you won’t find the word “options” in their webinar or presentation anywhere… but that’s what we’re talking about. This is basically a covered call strategy, but instead of buying the underlying stock and selling a call option against your position, you buy a long-dated in-the-money option, with at least a year or so before expiration (these are often referred to as LEAPs), and then sell short-term call options against that position.

So instead of buying a house and renting it to someone for a year, it’s more like you’re leasing a house for a year and trying to make that money back (and more) by doing short-term rentals to other people… though if the house doesn’t fall in value during the year and your short-term renters didn’t have a lot of destructive parties, you do get your lease payment back.

Most people would call this a leveraged covered call or LEAP-covered call. The leverage comes from the fact that you’re buying options instead of buying stock as the base of your strategy, and therefore your base will be more volatile — if the stock falls a lot during the next year, your capital is at more risk than it would be for an equity position. I’ll go through some examples in a minute, but every marketer de-emphasizes risk in some way, and the most important way they do it in this ad is by pooh-poohing the potential for meaningful loss of that “security deposit.”

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Call options are leveraged derivatives — they are standardized and publicly traded, most brokers offer options trading, and they essentially are a way to control a lot of stock for a fraction of their price. A call option gives its owner the right (not the obligation) to buy the underling stock at a set price (the “strike price”) before a specific date (the “expiration date”). We’re not talking about put options here, but that’s just the reverse — it gives you the right to sell the stock at a set price before the expiration date.

If you’re selling a call option, you do take on an obligation — you’re obligated to sell that stock to someone else, the buyer, at the strike price, and that buyer can exercise the shares at any point before that expiration date. Your broker will only allow you to sell those call options if you can back up your obligation — most commonly you would do that by owning the stock, a lot of people own stock and then also sell call options against their shares to make a little income, but you can also back up your obligation with call options as long as they expire later and at a lower price than the options you’re selling.

Probably the best way to explain is with an example, we’ll use one that they mentioned in the ad.

Let’s stick with 3M (MMM), which is priced at right about $154 as I type — there is very little liquidity in most options contracts, so it’s hard to be fair about the pricing since someone coming in with an order for even five contracts could impact the price pretty severely (a major complaint among subscribers to options trading services in general, by the way)… but right now, the January 2022 call options at $115 a share for MMM would cost you about $43 a share or $4,300 per contract (that’s the midpoint between the bid and ask prices). That gives you the right to control the stock (but not get the dividend) for almost a year and a half, at a fairly low premium for this “in the money” contract.

“In the money” just means that the contract is one you could exercise now — the stock is above the strike price today. And the premium you pay above that is based on what the market thinks the longer-term potential of the stock might be, so taken on its own this is just a bet that MMM by the expiration date will be above $158. That seems low, for a stock that’s at $154 now, reflecting a lack of real enthusiasm for MMM in the marketplace, but do keep in mind that MMM pays a fairly high dividend — six quarters of that dividend before expiration would provide almost $9 more in return over that time for shareholders, and options don’t account for regular dividends.

Standard options contracts cover 100 shares, so that’s why they talk about a “minimum” for these “royalties programs” … buying those January 2022 call options at a strike price that’s roughly 25% below the current share price, would therefore cost you about $4,300 at a minimum, that would be one options contract.

So you’ve bought that options contract, you’ve now got the right to buy 100 shares of MMM for $115 a share whenever you want (before January of 2022), and that means you now have something you can sell to generate a little income — what you sell is the near-term upside potential, by selling shorter-term call options that are “out of the money.”

If you want it to be close to “monthly”, then you would sell call options for the next month available, and at a price that’s close enough to the current price for the option premium to be meaningful… but far enough away (above the strike price, or “out of the money”) that there’s a decent chance the shares won’t rise dramatically above that price. For a month, you’d probably be looking at a strike price that’s 3-8% above the current price if it’s not a super-volatile stock — close enough to tempt speculators, but also not terribly likely to be exercised in an average month (you can’t prepare for non-average months).

So, for example, with MMM you might go with the August 21 call options at $165, that’s 38 days away and 7% above the current $154 share price. If you sell your $165 call right now, it will get you income of roughly $2.75 per share — so $275 for each options contract, or income of 6.3% for just over a month. (Going out another month, to September expiration on Sept. 18, would only get you another 50 cents or so, surprisingly enough — that’s mostly because the known catalysts that might be predicted to impact the share price, the earnings report and the next quarterly dividend, come before the August options expiration, with nothing obvious to expect in the way of news between that and September expiration).

This is a real way to get income, but it requires some discipline and a diverse enough portfolio of positions that you lessen the risk of a big loss, and if you’re doing it outside of a retirement account it will generate short-term capital gains income, which comes with a meaningful tax bite. And, of course, the more you risk, the more income. For many stocks the timing can work out for you to sell 10 contracts in a year (some stocks have contracts available every month, some have 6-8 expiration dates per year — and you can’t sell the same thing twice, so you have to wait for contracts to expire (or buy them back) before you can sell the next one).

In the case of that MMM example, if MMM stays at roughly the same price, and the options contracts in the future trade at similar prices, then you might have income of close to $4,300 for a year and a half from the $4,300 you invested (~$2,750 annualized), plus get that “deposit” back for an effective 100% total return (since the $115 call option would still be worth roughly $43 a year and a half from now if MMM remains in the $155-160 neighborhood at that time).

That’s a big if, of course, options premiums rise and fall as investors perceive more or less risk and potential, and the stock could move dramatically higher or lower at any time to completely upset the applecart, but it does mean that you’d almost certainly break even as long as MMM stays above $138 or so over the next 18 months… and you might make quite a bit of money if it rises, or even just stays flat in the $150s.

If MMM rises gradually over the next year+ and ends up at, say, $180 in January of 2022, then if things work perfectly you could sell a different tranche of options each month and the stock would rise gradually but not quite get above the strike price as you go (ie, you sell the $165 options for August and September and the stock stays below that, then maybe the $170 options in October or November because the stock has continued to rise into the $160s, etc.), and at the end your underlying long-term call option has also risen in value — so your $115 call option you paid $43 for would be worth $65. That’s the dream, roughly 5% monthly income plus a 50% capital gain at the end, but this is also an active strategy and it would not be unusual for the options you sold to be exercised (like if the stock is above $165 at expiration next month, for example), which would either force you to exercise your underlying call options (or try to buy back those short-term options at a loss before they get exercised).

That wouldn’t necessarily be a crisis, of course, selling covered calls should generate a profit for you even if they are exercised, but it does create more activity in your account, which means more taxes and commissions, and then you have to recycle that capital into your next “blue chip” idea (or restart the whole thing with MMM again). If MMM has a big surge right away and is at $168 at expiration next month, for example, up 10% or so from here, then you hit your obligation — if you don’t take action to put more capital in instead, your broker will exercise your January 2022 $115 options so you can sell those shares you promised (at $165 each) — if you combine all those transactions, then in that scenario you effectively earned $8.75 per share (or $875 per contract) for that month. A solid return of about 20% on your investment in just a month, because the underlying stock rose 9%, but then you have to restart with a new position.

If you’re someone who has trouble “missing out,” you should also be mindful of the fact that selling even these kinds of levered covered calls means your returns will often be lower than stock market returns in the headiest days of a bull market. You get some stability and income in exchange for taking some risk, but you give up some potential return — if, for example, MMM has a really crazy surge in August and goes to $200 a share, then owners of the common stock would get a 30% return… but because you sold those $168 options, you’re still only getting 20%, even though your position is leveraged. In this strategy, the leverage works for you over the long term to get returns that are better than the stock if the stock rises gradually… but if the stock rises in fits and spurts, as sometimes happens, the options will be exercised and called away from you and you won’t get any “windfall” leverage. The same is not true on the downside, sadly, your upside is capped but you still would have a fully levered experience if the stock collapsed (more on that in a minute).

Commissions and fees will take a little bit of the return from you as well, but those fees have been coming down sharply so at discount brokers it won’t be noticeable — Fidelity, for example, charges 65 cents per contract. The bigger hit will be taxes, if you do this in a taxable account, since almost all of your “income” will be from short-term capital gains.

All of those income scenarios sound fine, of course — the real problem arises when a stock falls dramatically. The ad downplays this by always talking about getting your “deposit” back, and sometimes taking just a small loss on it… but it’s not always a small loss.

If, for example, MMM announces terrible earnings, or a scandal, and the value of the stock drops by 20-30%, that can drop the value of the long-term option, your big up-front investment, by maybe as much as 80-90%… and if that happens late in the term, near expiration, it can be terrible, but if it happens right away, before you’ve really earned any income from selling those short term alls, it can be even worse. If MMM collapses to $100, for example, your $115 call options would likely lose at least 90% of their value, depending on when it happens, and then you also wouldn’t be able to really sell call options for much to try to rebuild, since you’d only be able to sell calls above that $115 level, either generating minimal income or locking in that 80-90% loss if you sell a $120 call, for example, and it is exercised the next month.

The value of the long-term call option will fluctuate widely if the shares rise or fall meaningfully, and that’s where most of your risk lies — you can always sell them to take a loss, but sometimes it will be a very meaningful loss… and you can also try to hold on and sell more covered calls to recover some of your losses over time, but it’s tough to rebuild an 80% loss in 5% bites. That’s why these strategies use “blue chip” stocks and use deep in the money calls, 25% below the current price, because those kinds of stocks are supposed to be less volatile… and 25% gives you quite a bit of wiggle room, so you can still recover if the stock drops by 15% and you keep selling calls against your holdings, but if the stock drops much more than that you’re unlikely to make money even if you keep selling calls, your best hope is that you’ll just lose less money than regular stockholders.

MMM is not a very volatile stock, but stocks don’t often move in a steady, straight line. It was at $200 in early 2019, so we can use the past year or so as an illustration of the risk. If you had bought $150 call options in March of 2019, for probably $60 or so, and collected your call option income to get probably about a 4% monthly return (options prices were a little lower last year, volatility was lower), you would have been shocked by the huge drop a few months later when the stock dropped from $200 to $160. That dropped your option value from $60 to probably $10-20, for a 60-80% loss, and it also would mean that you’d have to sell call options at much lower prices to generate income, like selling $170-180 options through the rest of 2019 for smaller amounts of income. That income wouldn’t have made up for that big drop, but it would have closed the gap a bit.

But then the nightmare scenario occurs, and if the base of your position was March 2020 options and you never sold out of them to take your loss, you just kept scraping off more income by selling more call options each month to try to break even, then you would have hit the expiration date in late March… and it so happens, those options expired near the worst possible time, when the stock dropped sharply again from $160 to about $120, and that call option would have expired worthless. You lost your $6,000 initial investment, and the fact that you probably managed to scrape off about $2,000 in income from selling call options against it over the year probably wasn’t much solace. You probably end up with something like a 50-70% loss while the common shareholders lost 35% after dividends.

So that’s the major risk — that the underlying call option position you hold could drop dramatically, or go to zero, if the stock (or the whole market) falls substantially during the time you hold that option. You could add some complexity by hedging the whole operation with a put option, but that, too, can be expensive — buying a short-term put with the money you earn selling call options would eat up much of the income (getting protection from more than a 20% monthly drop with a $125 put for August, for example, would cost you about $1 a share — almost 40% of the income you got from selling the call option), and buying a longer-term put to protect against severe disaster would be expensive as well, buying a $115 put to match your $115 call for January 2022 would cost you an extra $10 or so per share, or $1,000. Hedging to protect you from some downside risk is not quite as expensive as it was a couple months ago when we were all in panic, but it’s still expensive.

I wouldn’t try to talk you out of this kind of strategy if you like actively trading and can follow a disciplined strategy and not get discouraged by the gains you might miss from a covered call-type of strategy. It’s certainly less risk than a lot of trading strategies, with usually better odds of success than many more speculative ones, and in a fairly normal market, with no 20-30% rises or drops, it could work out OK and generate some solid income — particularly if you have enough capital to commit to at least 6-8 different positions, and have some confidence in the stability of those companies. If you have eight different holdings going this way, with some differentiation across sectors (and using longer-term options as your base that don’t all expire at the same time, just in case you get unlucky with a crash right near expiration), then you can probably still do OK most years as long as only one of them turns out to be disastrous… but if you get two disastrous stocks that collapse quickly, or a really ugly bear market that comes at the worst time, you can easily lose a lot of money, more than the common shareholders lose, so do keep in mind that these are leveraged positions. You’re paying for that higher income by taking on more risk. The risk is not that you might hit a 20% stop loss and have to sell, or that returns might be disappointing, the risk is that there’s a possibility, with non-trivial probability, that you can lose all, or nearly all, of your investment if a bad market move hits you at a bad time.

Or, to come back to that real estate analogy, you should note that the rent doesn’t just give people the right to live in the house — it gives them most of the windfall appreciation that house might enjoy in a given month. And if the house drops in value by 30% after a year, whether because the housing market crashes, or because it turns out the house was built on an ancient burial ground and is haunted, or for any reason, you still get to collect that rent during the year… but the rent falls a bit over the course of the year, and maybe some months nobody’s willing to rent it if the walls are bleeding and ghosts are screaming, so the income is a little lower than you were expecting, and the value of the home has dropped so much by the end that your 25% “deposit” is never returned.

If you like the idea of selling covered calls but don’t want to lever up your risk, you can also do the same thing just by buying the stock — it’s not levered, so your returns are lower and it would take more capital to build a diversified portfolio, but the risk is also lower. With those same options assumptions as in the relatively optimistic scenario above, owning 100 shares at a cost of roughly $15,000 and selling a contract 10X a year for roughly $275, you might get a 20% annual income return from selling covered calls (or 25% if you include the dividend) instead of the 60% income return from the levered strategy. But if the stock falls 30%, you’ll likely only lose 15-30% depending on the timing and the dividend, not 40-80% with this LEAP-covered strategy (those aren’t guarantees, of course, just my estimates of likely scenarios).

I don’t know what Andy Crowder’s track record is like, or how he did managing his subscribers through the collapse and recovery in March and April if he was actively recommending positions using this “stock rental royalties” strategy at that time, so if any readers have experience with his service please do click here and share your impressions with your fellow investors. These kinds of basic options income strategies are fairly mechanical and easy to recommend, I expect the difficulty mostly lies in choosing the best stocks that have liquid options trading available, and managing the trades that inevitably go ugly against you from time to time.

And that’s all I’ve got for you today, dear friends — an options income strategy masquerading as “rental royalties,” and I’ll leave you to it… are you a fan of covered calls? Like selling options for income in other ways? Let us know with a comment below… thanks for reading!

Disclosure: Of the companies mentioned above, I own shares in 3M in my Real Money Portfolio. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.