From Jarrett: I came upon this strategy, and for the life of me I can’t figure out how to lose money with it. I don’t mean paper losses, I mean lose actual money commonly used to buy Twinkies and the like.
After researching Pioneer Aviation (a fictional company: Symbol: PIOAV), say I decide that it is a good value (let’s assume for a moment that I am correct about this). It is currently selling at 15. I then sell the July 15 Put, and take whatever premium is offered – let’s say, since it’s selling at the money and it’s almost expired I get paid 5/8 ($62.50 for a put on 100 shares, less commission). One of two things now happens. Either the option is exercised, in which case I have to buy 100 shares at 15 where I was going to buy it anyway – but I’m $62.50 richer – or it expires and I buy 100 shares at whatever price it then is (which would have to be 21 before I see a paper loss).
[A.T.: Well, that’s the first flaw. Jarrett misplaced a decimal point. Paying $2,100 for 100 shares of this stock, instead of $1,500, sets him back an extra $600. The $62.50 he got for selling the put barely puts a dent in that. What I think he meant to say is that he could pay as much as 15-5/8 – not 21 – before this strategy gave him a paper loss.]
Several years later in January, PIOAV is selling at 85. I think 85 is plenty, and I want to get out, and I would be completely happy with $85/share. But instead of selling, I sell a June 85 Call, and get paid a premium of 17 ($1700). (Incidentally, 85 and 17 are the actual numbers from yesterday’s Intel closing price.) Three things can now happen:
- The call is exercised and my 100 shares are called away from me at $85. So I get $8,500 plus the $1,700 plus the $62.50 I got for selling the put. (Net profit, $8,500 less $1,500 to buy the shares = $7,000, plus the two option premiums = a total profit of $8,762.50.)
- The option expires with the stock above 85.
[A.T.: Actually, this would never happen. No one would “leave money on the table” this way. Even if the option purchaser forgot to exercise the option, his brokerage house almost surely would do so for him.]
- The option expires worthless, with the stock below 85, so I keep the $1,700. In that case, I either wait for it to rise or sell another call and make some more money on it.
Now, I know the price of PIOAV could very well go to 125 in February, and I’d have it called away from me at $85. But if I hadn’t sell [sic] the call, I would have sold the security in January when it hit 85 – so at least I have the extra $1,700. What is wrong with my logic? If this works then why is everyone anti-option? There are LOTS of scenarios where you can lose a ton of money with options, but I don’t see it here. Help me out please.
A.T.: Well, let’s do these one at a time. If you definitely wanted to buy PIOAV, then selling the put is not dumb. You either get a small premium for doing so – but lose the chance to buy it at 15 because it shoots straight up, say. Or else you do wind up buying at 15, but with this little 5/8-of-a-point discount (in your example).
It can certainly work, and some smart people do buy stock this way. But it’s not a free lunch, because you tend to buy only stocks that aren’t doing so well and miss the ones that do indeed sprint to new highs.
There’s also the risk that you’ll get cocky and forget that for $62.50 (less commissions and taxes) you have put yourself on the hook for $1,500 – even if fraud is discovered at the company and you have to pay 15 on a day when the stock has collapsed to 3. So maybe you’ll sell more puts than you can afford to – it seems so innocent, so no-lose – and in a meltdown come home to find yourself more heavily invested in PIOAV then you like.
But if you’re careful and are truly prepared to buy all the stocks you sell puts against (because if the market melts down, you’ll get ALL of them, not just PIOAV), then be my guest.
Now, what about when it comes time to sell. At that point, I believe you should just sell. There’s no reason to hold on just to get the call premium. (Better, indeed, to buy some other stock you think has brighter prospects and, if you like, write out-of-the-money calls on it.)
Except for taxes. Taxes can be a good reason to hold on to a stock you think may be headed south – if you believe it will ultimately come back – and write calls on it in the meantime. You get the dividends, you get the call premium, you avoid forking over the taxes.
The problem is, the market is wily. It’s not uncommon for it to foil one’s best laid plans.
- You sold a call at 85, accounting irregularities are discovered, and now it’s 45 – a la Cendent. You got a little premium but missed the chance to sell at 85. Oh, no!
- Or gold is discovered, and now it’s 125. You took the risk of it falling to 45, yet reaped little or none of the gain from 85 to 125. Oh, no!
In short, your strategy could earn you a Twinkie or two and every once in a while make you too sick to your stomach even to think about Twinkies. It’s not terribly dumb to do what you describe from time to time when you feel the circumstances are right, but neither is it remotely a no-lose strategy for easy money.