A Way to Make Money Almost All the Time

We’ve been talking about options the last couple of days, so I wanted to warn you about a couple of ways to make money with options almost all the time.

NAKED PUTS

I met this guy in the Eighties who was trading naked puts. His broker — a genius — had turned him on to this money machine. Basically, there was the stock market is a powerful, long-term upswing. So say a stock of some solid company was 60. If you wrote (sold) a put on it at 50 — well, what was the chance it would fall that far in the two or three months til expiration? Very low. At the end of those two or three months the put expires, and you get to keep the premium you were paid to write it. Ka-ching!

Yes, there can be occasional nasty surprises even in a bull market. Say you were paid $300 to write a put obligating you to buy 100 shares of this currently-$60 stock at 50 and that — drat! — some scandal erupted that caused the stock to plunge to 35. Rarely happens, but then you’d be on the hook to buy it at 50 (paying $5,000 for 100 shares) even though it is only worth 35 (meaning you have a $1,500 paper loss, less the $300 you were paid to take this risk, plus commissions).

To avoid even this small risk, my friend was well diversified. And that made it pretty much a money machine. Month after month, he’d pocket the premiums on these “far out of the money naked puts” he was writing. His broker enjoyed the commissions. And, in truth, since virtually all of the puts expired worthless, there were only half the commissions there normally are in a trade — i.e., just the commission for writing the put, but no commission at the other end. The puts would expire worthless, the premium was my acquaintance’s to keep (and pay ordinary income tax on).

He made about a million dollars doing this.

And because he was so well diversified, there was really no risk. His broker calculated that the Dow would have to fall something like 300 points — in a day! — for him really to get burned, and that was . . . well, c’mon — back then 25 points was big move and 75 was jaw-dropping front-page news.

Smug may not have been exactly the right term for my acquaintance, but the Christmas gifts he was sending his broker were probably even more lavish than the Christmas gifts his broker was sending him. It’s =nice/= having a money machine.

And then of course, in the fall of 1987, the market dropped not 300 points but 508 in one day. He lost the million he had made and millions more.

It turned out to be one of those strategies that always make money — until you go broke.

There are others.

Naked puts are scary. So, too, naked calls. (There, with a stock selling at 60, you’d write a call obligating you to sell it to someone at 65, say, even though you don’t own it. No sweat! Unless it rises above 65, you’re cool. But if it rockets to 90, someone will in effect say: “OK, here’s my $6,500. Gimme my 100 shares.” And you will have to pay $9,000 plus commission to buy and deliver them.)

Really, you can construct lots of games at which you will almost always win a little, but eventually lose it all. Here’s one more. Go to Las Vegas with $2,000. Bet $1 on red. If you win, you’ve made $1. Do it again. If you lose, bet $2. If you win, you’ve still made $1 (the $2 you win less the first dollar you lost). Now start again at $1. If you lose that $2 also, double your bet again, to $4. Sooner or later you will win (it can’t =always/= come up black) and so sooner or later you will win $1 more than you lost. Then just start all over again betting $1, doubling, as needed, until you win.

This is a virtual printing press for dollar bills. You will just keep winning them all night. And you will even get free drinks. The only conceivable problem would be if it came up black 11 times in a row. The chances of that happening are almost nil, of course. But at that point you’d have lost $2,047 and — to win it back and make your dollar — you’d need to double your previous bet ($1,024) and bet $2,048. But you ain’t got it. (Or the table limit may not allow it.) You’re wiped out.

It’s one of those deals where you always win until you go broke.

Tomorrow: Covered Calls