After experiencing middling success with building a portfolio stuffed with income trusts, Derek Foster is trying out a new strategy of selling puts on stocks on his watch list and collecting the premiums. In online forums such as Canadian Business and Financial Webring and media interviews Derek has claimed that he is receiving “money for nothing” and marketing his half-baked ideas in a new book. I’ll show why selling puts is not the free lunch Derek claims it to be – something readers of his new book might want to keep in mind.
If you are already familiar with Derek’s strategy of selling puts, you may want to skip this section. Let’s say Derek thinks that shares of ABC Corp. (Ticker: ABC), which is currently trading at $50, would be interesting at $45. He would like to purchase 1,000 shares and finds that put options on ABC at a strike price of $45 can be sold for $2 per share. So, he sells put options on ABC, collects a premium of $2,000 and sets aside $45,000 in a cash account to cover the contingency that ABC falls in price to $45 or below and the option is exercised by the buyer (He could buy back the option but for the purposes of this discussion, the costs will be the same).
As it turns out, I think ABC would be interesting at $45 as well and would like to purchase 1,000 shares. But, unlike Derek, I didn’t know enough to earn premium income by selling puts or know enough to stay clear. Either way, I have the cash sitting in a brokerage account.
Now, let’s see why Derek claims his strategy is “money for nothing”. There are two possibilities with ABC stock. It never reaches $45 and both Derek and I did not get to enjoy any upside. Or, the stock reaches $45 and both Derek and I now own the stock. It keeps falling to $40 and both Derek and I have experienced a loss but Derek’s loss is smaller because he collected $2,000 in option premiums. How’s that for financial alchemy?
It seems like a very clever argument but if you had a nagging feeling that there has to be catch, you’d be right. Here is the key difference: I have the intention of buying the stock at $45; Derek might have the obligation to do so. There is a world of difference between the two.
Consider the following scenario now: With the stock trading at $47, ABC’s CEO has suddenly resigned. Rumours are swirling that he has written a letter to the board admitting to cooking the books and all hell has broken lose. The trading on the stock has been halted pending a news conference.
What would I do? I would be foolish to think that the stock is still interesting at $45. Most likely, I’ll decide that ABC isn’t worth the trouble after all and abandon my intention to buy. At the very least, I would want to wait for the dust to settle and more clarity to emerge. And I have my capital intact.
Derek has no such luxury. He has a contract to buy the stock at $45. If the stock hits $25 when trading resumes, he is looking at a $18,000 loss – substantially higher than the $2,000 premiums he collected.
Investors tempted to speculate in the options market should remember that options are a zero-sum game before commissions and expenses. The buyers of the puts Derek is selling are not giving away free money out of the goodness of their hearts. They are paying the seller to assume some risks they are not willing to bear and it would be wise to assume that the premiums reflect the risks involved. Only fools rush in where angels fear to tread.
