Options Trading Part I – NFW Edition

My first guess about what NFW stands for was 33.3% wrong. However, my friend Michael Taylor’s opinion of selling put options is clearly expressed by the title. Michael is adamantly opposed to retail investors selling puts as a means for generating income (in exchange for agreeing to buy a stock, typically at a lower price).

In the following article, Michael responded to a question I asked him recently after learning that he does not like put-selling. I was surprised at his disdain for this trading method and also curious because I know several traders who frequently sell puts as a proxy for going long a stock, including authors featured at this website. Along with other criticisms, Michael’s main problem with put selling is the huge “blow up” potential that results from a combination of leverage and a high level of risk.

 “Put sellers are like the lone teenager in the horror movie who says ‘Did you guys hear that noise? I’m just going to check that out with my dim flashlight, by myself. You guys stay here.'” Classic.

For more by Michael, visit his website Bankers Anonymous. He also writes a weekly column for the San Antonio Express News. ~ Ilene

Options Trading Part I – NFW Edition

By Michael Taylor, Bankers Anonymous

This is a highly speculative trade, not an investment, so run away, retail investor!

options just aheadA friend in the finance-writing space sent me a query not long ago about the idea of “selling puts” as an appropriate and lucrative investment activity.

Following my swift reply of “NFW[1],” she asked for an explanation. After all, a friend of hers had been writing a regular ‘investment newsletter’ describing all the clever money he made writing puts on stocks. The newsletter-writer described a ‘win-win,’ in which either the put seller pockets the option-premium, or manages to purchase stocks at a discount to current prices.

Selling puts, I should explain, involves giving your counterpart the option, for a limited amount of time (between one and three months, typically) of selling you shares at a set price. A ‘put seller’ often picks a price lower than current prices.

For giving someone else this option, the put-seller pockets some money, known as the option premium.

How about an example?

XYZ stock sells for $50 in the market today.

I sell 3-month puts, let’s say 1,000 of them, with a ‘strike price’ at $40. That gives the put-buyer the right to sell me up to 1,000 shares of XYZ at $40 anytime for the next 3 months. For that privilege the put-buyer pays me – I’ll make this number up – $3 per put. In this example, I pocket $3,000 in premium ($3 x 1,000 puts).

In my most optimistic moments, I can tell myself that I ‘win’ if I just pocket $3,000, and I also ‘win’ if the shares of XYZ drop and I end up buying up to 1,000 shares at a 20% discount to the current market price.

Run away

However, I’m here to tell you to run, not walk, away from put selling. Do not try this at home, for a few reasons.

I’ll list them in increasing order of importance.

First, options trading for non-institutional investors (you and me) are always speculative trades, not investments, because they are short-term in nature. “Investing” means that your time horizon spans more than 5 years, disqualifying all but the most exotic options, none of which are available to you and me.

Second, options for retail investors – because they are slightly exotic and opaque – involve costs that make them inappropriate for non-professionals, trading in small sizes.

Third – Most importantly for this particular ‘newsletter advisor’:

You’re telling individual investors to sell puts? Are you f-ing kidding me?

That’s you, when you sell puts. This is the kind of bull-market nonsense that only people who have been in the market for about 3 minutes would fall for. Do you know that phrase “bending over to pick up nickels before the oncoming bulldozer?

You make a little bit of money this week, you make a little bit of money next month, you collect a few more nickels for a couple of months, and then BAM! You are dead.

And you never even saw that bulldozer before you became part of the asphalt. Because the market will always, always (ALWAYS!) punish put sellers.

It’s a rule written down somewhere that they only show you AFTER your investment portfolio has been taken out on a white sheet and dumped into a shallow grave.

Put sellers are like the lone teenager in the horror movie who says “Did you guys hear that noise? I’m just going to check that out with my dim flashlight, by myself. You guys stay here.”

Screen Shot 2014-08-29 at 8.19.28 PM

I do not believe that markets have anthropomorphic personalities, or particularly recognizable patterns, or act as sentient beings, except in this one instance: put sellers always get killed. It’s just a rule.

Put-selling as a ‘synthtic long’ in the market

Prior to getting killed as a slaughter-house put-seller, you should understand that selling a portfolio of puts acts as a proxy for being long, or bullishly exposed, to a stock or set of stocks. Provided the stock goes sideways or up, put-selling provides a nice stream of income based on the non-exercised put options.

In addition, like many other derivatives, options give investors ‘leverage,’ by exposing an investor’s portfolio to larger movements in markets than would be otherwise available through regular stock purchasing.

Because put-selling resembles a synthetic long and leveraged position in the market, put sellers may briefly (all too briefly!) fool themselves into believing they’ve stumbled upon a neat and uniquely profitable way to ‘play’ the market. I think this is what the put-seller newsletter pushed, wittingly or not, on its audience. As long as the market basically goes up, put-selling appears even more profitable than buying ordinary stocks.

Then, as I mentioned, you’re financially wiped out. Because leverage goes both ways, and put sellers always get smushed.

Ok, now that I’ve told you my strongly held opinion of this guy’s garbage, I will spend the next two posts teaching interested folks a bit more about the options market.

 

Please see subsequent related posts:

Options Trading Part II – The “Currency” is Vol, not $

Options Trading Part III – Options from a Trader’s Perspective

 

[1] That stands for “No Flipping Way”.

Thanks for visiting Bankers Anonymous. Be sure to sign-up for my newsletter so you never miss what’s happening on my site. You can also connect with me on Facebook and Twitter to keep the conversation going.

 

Did you like this? Share it:
About Ilene
%d bloggers like this: