Passive income. That’s the dream, right? Make money while you sleep.
For investors, passive income refers to the money you earn from sources like dividends and interest. It is the money that your money earns for you and is deposited in your family's bank account whether or not you get out of bed in the morning. The ultimate goal of most investors is to generate enough passive income that they can live a comfortable life upon retirement when they are no longer able to earn a paycheck.
For marketers and sales, passive income refers to the money you earn from successful referrals, by promoting other people's products often through an affiliate network.
When building an investment portfolio, one trick you can use to stay the course and get rich is to measure your success by the amount of passive income you are generating in cold, hard cash each year. Following this philosophy is simple because you can see tangible proof of your progress as checks are sent to you in the mail or directly deposited into your bank account.
Let's see how you can earn passive income from dividends from stock investing and interest from carry trade.
Using Stocks, Dividends and Funds for Passive Income
Owning equities such as stocks and bonds is one of the easiest and most efficient ways to generate passive income. This strategy requires the discipline to save and invest in the stock market. We recommend using an index fund in the form of either a mutual fund or exchange-traded fund (ETF). Using an index fund allows you to get diversification at a very low cost as well as the simplicity of a couple of funds instead of a number of stocks. An S&P 500 index fund, as well as a broad-based bond fund composed of government, corporate and municipal bonds in addition to an Index real estate investment trust (REIT), represents three great areas to start which brings broad diversification.
An Example of Using Passive Income As Your Measuring Stick
Imagine you have $10,000.00 in savings that you want to invest for the long-term. You decide to buy 833 shares of General Electric at $12.00 per share. Let's say the current dividend per share is 12 cents per quarter. That is, every 90 days, you would get a check for about $100. If you have the money directly deposited, at the end of the year, you'd have nearly $400 in cash sitting in the account.
Next year, you save an additional $10,000. You add the $400 in cash from your General Electric dividend, giving you $10,400 in fresh cash. This time, you want to diversify so you buy 74 shares of Johnson & Johnson at just under $140 per share. Let's say their annual dividend is $3.60 per share.
At the end of the second year, you are now generating $400 in passive income from your General Electric dividends and $266 in passive income from your Johnson & Johnson dividends for a grand total of $666. You ignore the fluctuations of the stock market entirely, focusing on one thing and one thing only: Whether you can get that passive income figure to grow faster than inflation. You think like a long-term business owner, not a speculator.
Continue reading or start playing around with a stock simulator and notice how you can earn passive income in real-time. Additional, earn a 12% fixed annual interest rate (APR) on your account balance.
Using Carry Trade (Interest) for Passive Income
Carry trading is the classic pure forex play for passive income. Note right from the start that it uses leveraged instruments, and depends greatly on your forecasting a given currency trend correctly, so carry trading is for more active investors who understand leverage and have the risk and money management skills to deal with it. Passive income investors without the time or expertise should approach carry trading by using a proven trader via a managed account or social trading network. If you want to do it yourself, first get four to six profitable weeks using practice accounts, then you can more safely consider doing your own carry trading.
In essence, carry trading for passive income is just:
- Buying the currency that pays you a higher annual yield and getting that interest paid daily into your account.
- Selling the lower-yielding one and paying out the daily portion of that annual interest.
- Earning a passive income on the difference.
That means you’re either taking long positions in pairs that have base currencies with much higher yields than their quote currencies (like the AUDJPY) or taking short positions in pairs with higher-yielding quote currencies (like the GBPAUD).
Given retail forex’s justified reputation as a tool for short-term speculators, you may find it surprising that you can earn steady passive income via carry trade.
Differences between Forex Carry Trade and Traditional Long-Term Buy-and-Hold Instruments
Here’s how carry trading differs from typical long-term buy-and-hold income instruments.
1. The carry trade is a classic kind of forex trade and so carries higher risk and demands more time than buy-and-hold investing.
2. Greater risk and reward via leverage. The use of leverage magnifies both gains and losses.
- The Reward: Magnified Interest and Price Appreciation Concerning carry trading, if you’re long a pair that has a higher-yield base currency (the one on the left), leverage magnifies the actual interest earned.
For example, if you are using 500:1 forex leverage with a $200 margin deposit to control $100,000 of AUD via having borrowed $100,000 of JPY, that annual income is based on the full $100,000 of AUD controlled, not the $200 margin deposit. Thus the annual income here is 4.65 percent of $100,000 or $4,650 (paid out on a pro-rata daily basis). Using just $200 allocated to that position, this is a 2325 percent return before considering changes in the AUDJPY’s price.
As always, if the pair rises in value, leverage magnifies those gains, too. For example, at 100:1 leverage every 1 percent move is a 100 percent profit on your margin deposit. At 500:1 leverage every 0.2 percent move is a 100 percent profit on your margin deposit, which would be another $200 in the previous example
- The Risk: Magnified loss as previously noted, as long as you’re going long on pairs that have higher-yielding base currencies compared to their counter currencies, the magnified interest income can only help.
If, however, you were short a pair like the AUDJPY, you’d be paying out that interest for each day you held the short position.
The real risk of loss from leverage with carry trading is no different than with any other kind of forex trading —the risk that price moves against you. Using the previous example, every 0.2 percent move against you is another 100 percent of your margin deposit. This is why we recommended having cash in your account equal to at the very least 20-30 times your typical margin deposit as a general guideline. So while in the previous example you may be earning 2325 percent on the $200 deposit, you need to keep enough cash on hand (either in your forex account or somewhere else where it’s quickly accessible) to absorb whatever percentage move against you you’re willing to tolerate. That would cut your overall income yield from your account, but at 2325 percent returns on the margin committed, the net yield can still be handsome. You could keep less cash in your account and more in a higher-yielding account elsewhere as long as you’re able to transfer funds into your forex account on short notice. In addition to wire transfers, most forex brokers accept deposits via credit cards, allowing for quick deposits over the phone.
Here’s another way to deal with the amplified loss risk from leverage: punctuated buy-and-hold.
Using the proper risk and money management, you can enter and exit positions as needed. So rather than simply buying and holding through possibly crippling losses, just keep entering and exiting your selected high-interest-differential currency pairs over time, riding a multiyear trend for various periods, exiting and then reentering as per our technical analysis and risk and money management.
To be successful with this type of passive income, remember:
- Carry trading works only in times of optimism or risk appetite.
- Higher-yielding currencies generally hold their value or appreciate only in times of optimism, so carry trades are generally not successful dur- ing bear markets in risk assets. You risk losing more from falling markets than you earn from the interest.
- Carry trading requires more careful use of technical analysis and risk and money management
Because leverage adds to risk compared to traditional non-leveraged passive income investments like bonds or dividend stocks, we employ the full range of risk and money management such as:
The Key to Carry Trading
Ideally, you want to be long a currency with a rising interest rate and short a currency with a stable or falling rate. If there is any significant chance of the opposite occurring in your planned holding period, don’t take the trade; your capital losses could easily outweigh your income—remember that leverage magnifies losses as well as income. Using the previous AUDJPY example, assuming you held the position for one year and earned 4.65 percent, a mere 4.65 percent drop in the pair would wipe out your gains for the year. It’s not uncommon to see pairs move that much in a matter of days. You can ride out those moves if you’re confident in the longer-term trend and have the cash to avoid a margin call. Otherwise, skip the trade.
- Your technical analysis should indicate a healthy uptrend for your intended holding period. Those seeking a long-term (multimonth or multiyear) hold should look for pairs with healthy multiyear rising trends on monthly charts.
- Your fundamental analysis via news released on the forex factory economic calendar, or the analysts you follow, should indicate that the currency you’re considering being long has interest rates steady or rising relative to those of whatever currency you’ll be shorting.
At a minimum, you want to be long one of the higher-yielding currencies and short one of the lower yielders, the difference in their interest rates expected to widen, or at least not shrink.
Understanding how to earn a passive income is important, but if you need help MT5 AM Broker provides access to a wide range of income vehicles.