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Don't PUT Yourself In A Position To Lose

December 12, 2007
Joe Ponzio

Joe Ponzio

3 followers

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:
  1) Don't lose money;
  2) 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

  1. the stock price runs beyond $35 and you collect a $5.50 per share profit - 18% in one month; or,
  2. 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:

  1. the price does little or nothing (or increases) and you keep the $0.50 a share; or,
  2. 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!

About the author:

Joe Ponzio
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.8/5 (14 votes)

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