Transcript:
Easan Arulanantham:
Talk about your fruit tree method for kind of pruning these large stock positions. And then with that method, you talked about covered calls and how they generate income. Could you explain that a little bit more? And also, what’s a covered call?
Tom Vaughan:
Yeah. Okay, that’s a complex question. So the fruit tree method is just somebody who has a large holding in an individual stock, usually, it’s because they work there. As far as that goes, but not always. And so you’ve got this big position, it’s worth a lot, it’s becoming a dominant part of your portfolio, there’s some concern, if something happens to that company, that it would have an adverse effect your overall financial health. And so sometimes what we’ll do is we’ll pick a target, some dollar amount, or some percentage of assets, so let’s just make up a number to say a million dollars. So if it grows to $1.1 million, right, then we’re going to prune and or take off the fruit of the fruit tree, they’re gonna take out that higher $1,000 and put it in some something else, something more diversified. And so we’ll keep it going, it just keeps that million dollars there. And that’s the fruit tree concept, I think it’s a cool concept actually allows you to continue to benefit from a company that could be fantastic, without ending up with 90% of your money, potentially, in this one thing that then falls apart, and now you’re in financial ruin, right? So kind of bridges the gap. But then you have to get, there’s some strategies that you can use to try to kind of enhance even that. So now I’ve got 1.1 million, I want to sell 100,000. Well, one of the things that we can do there, which I which I really enjoy, you can put in a stop loss, under that $100,000 worth of shares, pretty close, like just 5%. Below, you know, so if it drops a little bit, you’ll get, you’ll get your 95,000, that’s fine. And what you want to do then is maybe do a call option, a 3030 day call option, maybe 10 or 15%, above the price. And so I’ll explain what that is in a minute.
But in essence, what happens if during that 30 days, your stock grows 10 or 15%, in that timeframe, you’ll often be called away, so you might get 110 or 115,000. But whenever you sell that call option, you’re also getting money, you’re getting an income source. So theoretically, if that thing stays between the stop loss and the call, and you do call months, after months, you can actually make money on that and still be protected on that fruit piece of that tree. So call option industries have what’s called a covered call, is where you have the actual stock. So Apple or something. So I have Apple, and $100,000 with the Apple that is going to be my fruit that I want to pick off in this tree. And so I can go and sell a call options that just give somebody else the right to purchase that Apple at let’s say 10 or 15%, higher, you know, than the current price. And that is a strategy that works out really well. Because it you know, allows that 100 to grow, if it’s going to continue to grow, still moving up that stop loss, you know, kind of every month, and then essentially keeping that call option going month after month, and you can generate income off of that, while you’re waiting to sell that stock instead of just selling it, you have a chance maybe you sell it, it’s 150,000. And you’ve generated five, six months worth of income off of the call option. before it finally triggers one way or another either comes down and hits the the you know, the stop loss, or it goes up and gets called away. Right. That’s a That’s an awesome strategy, in my opinion. And it’s kind of fun. It’s it’s an easy thing to do. It’s that sounds somewhat complicated. But it’s it’s a strategy that is I think, pretty fun to implement as far as I’m concerned.
Easan Arulanantham:
So for the stocks in these, like covered calls, or their arguments, I know usually for a call contract, you need 100 shares, at least when you do these contracts.
Tom Vaughan:
That’s exactly right. So works well for the fruit tree concept, because usually we’re talking about pretty big dollars. But exactly right, you need 100 shares to buy one contract. So for example, if you wanted to sell 50 shares, you couldn’t do a covered call on 50 shares, you have to have 100 shares. So, and that’s why it’s kind of interesting with some of these stocks that have really high prices. Amazon and Google are a lot higher than say Apple. But yeah, exactly. That is one of the criteria. Generally speaking, in my opinion, you don’t want to do that on a little teeny stock. Personally, there’s just too much volatility. The call options aren’t that liquid. So but, you know, we live in Silicon Valley, I have yet to see a company that doesn’t have a lot of liquidity here to Nvidia and Apple and Cisco and Intel and eBay and PayPal and square. And yeah, there’s an awful lot of companies that have plenty of liquidity in their in their option market. At least here. You know, we’re kind of lucky in that way.