Don’t PUT Yourself In A Position To Lose
December 12, 2007 | Joe Ponzio | about: AEO / BSX
Last month I discussed selling options against positions when the markets are high and everyone is happy. The markets can do anything on a minute by minute basis; still, they tend to stay within certain ranges from month to month – even if those ranges are hard to predict. As with all investing, you need to estimate the odds of a certain event happening and invest your portfolio accordingly.
As a general rule of thumb, I expect the markets to drop swiftly and climb slowly. That’s precisely why I don’t like selling puts against my positions.
The Markets Are Driven By Cautious Psychopaths
Investors tend to be a finicky bunch. They’ll slowly enter the markets as it is climbing (or at the top) – and then sell at the first sign of bad news. In general, the markets will follow them – slowly climbing up and then quickly dropping.
It is hard to predict when that panic will happen; still, it seems to be a safe bet to assume that the markets will rise slowly and drop quickly on a regular basis.
Incorporating Options
If you believe the above, then it makes sense to bet against the markets (or your positions) running up quickly. It also makes sense not to bet against them dropping quickly. After all, it will generally take time for Mr. Market to work his fears or uncertainties out of his mind and price your companies right; it takes mere seconds of reading a bad report or hearing bad news for him to slam your company’s price down.
If you plan your options strategies around that, you’ll see how selling calls is practically stealing and how selling puts can be very dangerous.
Remember Buffett’s Rules
Warren Buffett tells us:
Two rules:
- Don’t lose money;
- When in doubt, see Rule #1
If you buy 100 shares of XYZ at $30 and then sell a one-month call at $35.00 (and collect $0.50 a share), you are locking in profits, lowering your effective basis, and protecting yourself slightly from Mr. Market’s swift panic. In this case, your risk is that
- the stock price runs beyond $35 and you collect a $5.50 per share profit – 18% in one month; or,
- the stock price drops, remains flat, or increases but stays below $35 and you keep the $0.50 a share.
Either way, you are making good money and sticking with Buffett’s rules. Now, there is another trade that can be made – selling puts against your position. Instead of selling the calls (and expecting the stock to do very little for the month), you can sell the puts and hope the price doesn’t drop. In that case, you would sell the one-month put at $25 and collect your $0.50 a share. Let’s look at the risks:
- the price does little or nothing (or increases) and you keep the $0.50 a share; or,
- some news about your company, its industry, the economy, the world, or the universe hits and the stock price plummets to $22 virtually instantly (and before you can cover your position because you aren’t watching it every second). You get $22 worth of stock for $25 and are now down $8 a share on your original position and $3 a share on your newly acquired shares.
But wait – don’t we own more of a great company at a lower price? Yes. But what if that news was actually news – not noise – and your company no longer appears to be great. In fact, it downright stinks. Now, you want to sell your company – and you have just compounded the losses.
Another Way To Think About It
Why sell options against your positions? The goal is not to make money on everything (though that would be nice); my goal in selling options is to lower my net effective basis and to increase my cashflow until Mr. Market realizes what a mistake he made by pricing my business so low.
If my stock is called, I collect the cash from the sale (at $35 in the above example) and I can immediately turn around and buy my company again – or find a new opportunity for my cash. If it isn’t called, I keep the premium and decide whether or not to sell another call.
If I’m selling puts, I can run into a situation where I’m virtually guaranteed losses – and I can end up compounding those losses when the stock price plummets. Or, I could end up with twice as much stock – perhaps too much in that one position – and now I have more risk.
Capitalizing On Your Options
Of course, you don’t have to just write the calls and forget about them. Just as the markets tend to move in cycles, stock prices also often move in cycles. When you sell a call and your stock is high, you collect a nice premium. If your stock price tanks, you can buy back that call, pocket a nice premium, and start again when the price inches back up.
I happened to do this on my positions in American Eagle Outfitters and Boston Scientific. At the end of October and early November, I sold December calls: AEO @ $25 and BSX @ $15. If I got called, I would have made a nice profit. Instead, both stock prices dropped – and the call prices dropped with them.
I was able to buy back the calls for mere pennies on the dollar and earn 469% in just over a month. On AEO, I paid $0.11 a share to get $0.89 a share; on BSX, I paid $0.06 to collect $0.34 a share.
The Long And, er, Short Of It
If you are going to go short and sell options against your positions, make sure that you give yourself the best chance to make money without losing too much. It is easy to see those juicy premiums and want to sell anything and everything – covered and naked. Considering that anywhere from 50% to 80% of all options expire worthless, that’s not necessarily the wrong thing to do. After all, there are a million and one ways to make money in stocks.
Me – I’m not a big fan of risk so I’ll stick with low risk, consistent income with Buffett’s Rules at the start of every move I make. Hope that helps!
Filed under: Workouts, Arbitrage, & Hedges
Joe,
I love this site and I have learned a great deal. But I have to present my thoughts on writing puts because it is identical to what you are talking about for selling covered calls. Writing covered-calls = writing puts. (There is a put-call parity, whatever play you can do with a call there is an identical play with a put.)
In your example you bought the stock at $30 and wrote the $35-strike calls for $0.50. Two things can happen.
1. The stock closes above $35 and you make $5.50 per share,
2. The stock closes below $35, you pocket $0.50 per share and you have 100 shares at a basis of $30 per share.
Now instead let%u2019s write the $35-strike puts and collect about $5.50. Again two things can happen.
1. The stock closes above $35 and you make $5.50 per share.
2. The stock closes below $35 you own 100 shares at a basis of $35 but you made $5.50 per share.
Same net result in both cases.
Mike
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The best book I have read on options is “McMillan on Options” by Lawrence McMillan. There is a lot there. So for a first book I would suggest “LEAPS What They Are and How to Use THem For Profit and Protection” by Harrison Roth.
A LEAPS (Long-Term Equity AnticiPation Security) is just an option with the exercise date many months out. So no difference between a LEAPS and an option so I suggest this book because it is well-written by the late Harrison Roth.
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The best book I have read on options is “McMillan on Options” by Lawrence McMillan. There is a lot there. So for a first book I would suggest “LEAPS What They Are and How to Use THem For Profit and Protection” by Harrison Roth.
A LEAPS (Long-Term Equity AnticiPation Security) is just an option with the exercise date many months out. So no difference between a LEAPS and an option so I suggest this book because it is well-written by the late Harrison Roth.
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I learned options (for the most part) by watching my loved ones make tons and then get crushed in the late nineties and early 2000s. I have a few books on the subject, but nothing worth promoting.
MikeR: I agree with your use of puts to a certain extent. Still, the major drawbacks I see are threefold:
- The markets tend to overreact more swiftly and vehemently to bad news than push a stock up on good news. As such, a seemingly wonderful business can quickly become unwonderful – and a sale – if bad, hidden news hits.
- A put strategy assumes that you are correct in your intrinsic value calculation and that nothing will go wrong. While I don’t want to be a pessimist, there are a lot of variables out of our control. Personally, I’d rather bet against making quick money in the short-term than bet that I am aboslutely right and that profits are right around the corner.
- If your portfolio is fully invested and shares are put to you, you may now have to sell a wonderful business or begin paying margin interest to maintain your perhaps over-weighted position.
Here’s an example: A few years back, I had an investment in Patterson Dental (PDCO). Over the course of a year or so, my investment had doubled. Then, news hit that they were doing something shady with their stock options (or something, I don’t remember now). The business went from wonderful to “I’m not sure anymore” and the stock opened 10% lower the next day. It was downhill for the next year.
Had I sold puts on PDCO, I would have been stuck with shares in a company that I didn’t know how to analyze or that I didn’t want because I knew it was bad. Instead of easily liquidating my position and covering a call (for a small profit), I would have had to scramble to update my valuation with the new news and been double-invested (grossly over-weighted) in a company I didn’t know if I wanted.
My point is this: You can certainly make money selling puts. In my humble opinion, I think it is a better strategy to bet against radical growth in the short-term, but only hedge my bet in a way that allows me to reap satisfactory gains no matter what happens and that affords me the freedom to make quick decisions with the bulk of my investment in a particular company. No matter what position I hold, the options premiums will be small relative to the equity holding. As such, I’d rather have absolute freedom and immediate liquidity with 98% of my money than put myself at risk of being double invested if things go sour while I’m out for coffee.
My two cents anyways. Hope that helps!
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Hi Joe
With all due respect, i think you misunderstood what MikeR was saying.
His ‘writing put’ strategy is not against the stocks you hold. What he means is that:
Long stock@30 Short Call@35 = Short put@35 Cash
You are doing the LHS of this equation (put-call parity) and he is suggesting the RHS. They are both exactly the same (assuming that the options are priced correctly) and have exactly identical Payoffs. There is no question of ‘double exposure’ in Mike’s strategy.
From my experience, your startegy is better because you collect the dividends from the stocks, which theoretically should be adjusted in options prices, but very often are not fully adjusted.
Another thing that can make a difference is what is happening with the stock currently. If the stock is tanking, its better to play Mike’s startegy because put options will be overpriced due to the fear (this is valid only for exchange traded puts). However, if the stock if rising, it might be better to play your strategy as the call options might be trading at a premium to their theoretical fair value.
Nish.
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Also, if one is fully invested in the stock market, then writing a put can get you in a situation where you have to go on margin, or sell a stock you don’t want to sell, as Joe has pointed out. I am about 20% invested right now, so when I write a put, I have the cash in my account earning interest at 5% in case I get put to. If I were fully invested at this time, then I would be exclusively using the covered calls strategy. I am writing puts to get myself into stocks I want to own at better prices. At least that is what I am trying to do.
Everyone have a great day.
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Hi Joe,
I really like your posts, What you wrote in this post is very informative. Selling calls against your position is basically covered call writing, which is a great way to generate some income on non-dividend paying stocks. But i never heard of selling puts against a position. But writing naked puts is a valid scenario. So if i want to buy a position (based on your model which you described beautifully in previous posts) then instead of buying the stock out-write i can write a put option and this way if the stock drops in price i will be assigned the stock (which i don’t mind holding anyway). If it does not drop then i can keep the premium and so generate some income.
Thanks again for your great posts, keep them coming
- Anand
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