Options Trading Part I – NFW Edition

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?

Put-selling-sucks
NB: Whoever wrote this is a moron

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?

That’s you, when you sell puts.

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.”

put-selling-is-a-horror-cliche
Put selling always ends up as a horror movie cliche

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 ‘synthetic 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 newsletter 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 – Delta-hedging options from a Trader’s Perspective

 

 

[1] That stands for “No Flipping Way”

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2 Replies to “Options Trading Part I – NFW Edition”

  1. Let’s say you can cover the amount that you would have to pay if all the puts get exercised, so there is no leverage essentially. Would selling puts in that case still be a problem?

    1. Great question. If you have all the money you need in order to end up with your puts exercised then I agree you eliminate the financial leverage part of the equation and thus moderate the problem of financial wipeout. The two original problems remain, namely that the short time horizon means this is speculative at best, and the retail nature means you’re going to get terribly disadvantageous pricing. On top of that, a typical retail investor does not understand volatility pricing (as described in part 2) so may not be aware of even how to value the option for insight into whether it is cheap or expensive. An additional problem with selling puts, which I implied but did not go into detail on: There’s a selection bias to the times when out of the money puts will be exercised…meaning, more often than not if you’re exercised on an out of the money put then you are catching a falling knife. If a stock suddenly drops 10% in a month, you’ve broken the ‘normal’ trading range for a stock or for the market, so you’re no longer in ‘normal curve’ territory. You probably are dealing with negative skew and excess kertosis.

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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