Turbocharge Wealth Accumulation with Naked Puts

Post written per special request from a new reader

I’ve been playing with options for almost a decade now. Some trades have made money, and some have lost money. It’s the nature of the beast. However, I eventually honed in on one strategy that was a sure win-win: selling naked puts. It’s less daunting than it sounds and can be a real moneymaker if you know how to use it right and compensate for its limitations. Let’s first explain the nature of option contracts.

The Basics of Options

An option is a promise or a bet on a security. You can be either the buyer or seller (also known as writer) of options. As the seller, you get to choose the security, the date the option expires, and the strike price. Then there’s the type of option. The big two categories are calls and puts. You can remember them with the mnemonic call me up and put me down. In other words, a call is a bet that a the subject of the bet will rise, while a put is a bet that it will fall.

The main permutations of the above controllable aspects of options thus becomes translated as such. A seller of a call option sells the promise of “I will sell you ___ security on ___ date at ___ price.” Correspondingly, a buyer of the same call option has the option (that’s where the terminology comes from) of “buying ___ security on ___ date at ___ price.” At the scheduled date, the buyer can decide if it’s worthwhile to exercise the option. Obviously, that will depend on if the price of the security is above or below the strike price. If the buyer chooses not to exercise the option at the date, it expires worthless. In return for owning this flexibility, the buyer pays the seller a certain amount of money called the premium.

Our strategy focuses on put options, so let’s explore that side of things. Using the same terminology, the seller of a put option sells the promise of “I will buy ___ security from you on ___ date at ___ price.” This is selling downside protection, or insurance against a market crash. As you can imagine, there would be a lot of people interested in this type of insurance, namely those sitting on big gains who fear losing it all in a market crash. It’s here where we can exploit a psychological inefficiency. People feel a lot more pain losing money than they gain in pleasure from making the same amount of money. Thus, premiums on put options are quite high. If only there were a way to pocket that for ourselves.

Creating a Win-Win

Here’s another reason that put options are win win for the seller (the one exploiting the fears of buyers). Let’s imagine the two possible outcomes, based on what I actually do each year. Every year in January I check to see what level the S&P 500 index fund (SPY) is at. Let’s say it’s selling right at $200 per share. I then sell/write a put option for a year out (next January) for the SPY security at $180 (my preferred 10% margin of error). In return for doing so, I pocket about $7 per share upfront as the premium. Fast forward a year later. If the stock market stays the same or rises, the option expires worthless and I make money. If the market has dropped, I would be forced to buy in at $180. The only way I would lose money from this is if the price of SPY is less than $180 – premium, which comes out to a break even price of $173. Although it looks like in this situation I would have lost money, I choose to see it in a different light psychologically. I’m a young person with a long time horizon, and stock indexes over the long run have done well. If I would have been comfortable buying in at $200, I should be ecstatic to be able to buy in at an even lower price. Even if I’ve lost money in the short run, I’m in the accumulation phase of my investing life where dollar cost averaging and staying disciplined buying at regular intervals will pay off.

In other words, think of put options as being paid to hold a limit order at the strike price you want.

You can also tweak the margin of error to suit your personality. If you are more conservative or are worried about imminent market drops, set a larger margin of error (known as selling options far out of the money) and sell fewer options. Keep in mind that each option is equal to 100 shares of the underlying security.

I would never sell options like this on individual stocks. That’s far too risky and exposes you to company specific random tail risk events (like Deepwater Horizon). Instead, the SPY security is widely traded, incredibly liquid, and a low cost investing vehicle that I would love to own at any time and at almost any price.

I also like to set my options for a year out. YMMV, but I’ve found that this gives me a reasonable time window to avoid being hit by flash crashes. My options tend to get exercised less the longer out I write them for. This makes sense because over longer time horizons, the more likely it is that the stock market will go up.

Swimming Naked

The astute investors among you may notice a problem. In selling an option, you need to place on hold the underlying security (for call options) or money (for put options) as a kind of escrow. Using the above strategy, this can easily tie up hundreds of thousands of dollars each year. That’s huge opportunity cost due to not being fully invested. This is why my strategy really only took off once my brokerage approved higher level options trading – naked options. Selling naked options means that I don’t put down the escrow. Rather, due to a large portfolio size, the brokerage has calculations that estimate how much margin they can extend you. Mind you, this is different from margin trading, which actually uses margin. Having margin on hand allows us to sell the above put options and use our margin buffer as escrow. An added benefit is that since the margin is not being used unless the option is exercised, we don’t get charged interest.

This also raises the importance of risk management when using margin. Again, I’m a conservative investor who likes having enough buffer to survive unexpected market situations like a big crash. This means that I never write more options than is the value of half of my margin. I also try to keep the total dollar value of all options to be less than my yearly salary. This way I can start planning to save up the cash in case it looks like the market is dropping and there is a chance that the option may be exercised by whoever bought it.

The Perfect Setup

Now for the kicker. While my dad likes to invest in real estate, I’m much more of a stock person. However, from talking to him I’ve discovered the perfect complement to the above naked put writing on margin strategy – home equity lines. Think about it this way. We all need a place to live, and real estate is generally a good investment, as long as you’re in a growing rather than dying area. Most people have a substantial amount of their net worth locked up as equity in a house. That to me is idle cash sitting around not doing any work! Why not use that to act as the “cover” for naked put options?

Let’s say you have a $750,000 house that’s fully paid off. You can easily get a $500,000 home equity line of credit on it. Now let’s assume a $1 million stock portfolio. By my above buffer estimates, this is safe enough to write $500,000 worth of options each year on margin and still have all but the most apocalyptic scenario covered. Using the above guide, I write $500k of naked put options on the S&P 500 index in January, for the January of next year. I pocket $17,500 in premiums that I get to keep no matter what (I normally just plow it back into the market). In most years the market goes up or stays steady, so I get to pocket the premium year after year without ever activating my credit line. Once in a decade or so there’s a big enough crash that my options are exercised. Great! That’s the time that I should be buying in anyway (what did I way earlier about market discipline?). Even when that happens all I have to do is withdraw the cash from my home equity line and buy into the market at a bargain bin price. Then I slow down my option writing, keeping it very conservative in the next few years as I diligently pay off my home equity loan with my income and dividends from my portfolio. As it gets paid off, I start writing larger options and the process begins anew.

This setup is infinitely scalable. The more houses and lines of equity you have, the more put options  you can write. I would even add bonds to the mix. With a healthy 10% portfolio allocation to bonds, that’s also kind of like money sitting idle. I mentally add that to my total of liquid cash equivalent instruments that I can tap to cover my options.

So there you have it, this strategy can guarantee you a 1-3% boost in total returns over the market, with very little risk. By mostly holding low cost index funds tracking the market, we can juice our returns and guarantee a beat every year.

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Another Reason to Tune Out Market Gurus

If the examples in my book didn’t already convince you of this, the latest flip flop on Marketwatch should convince you that the so-called experts don’t know what they’re talking about.

On Jan 24, the head of the world’s largest hedge fund said, “if you’re holding cash, you’re going to feel pretty stupid.” That’s the gist of it, but if you click through you’ll hear some blah blah justification about how the market is rising, valuations are reasonable (even though by CAPE they’re expensive), and that there’s still room to run.

Then we had the 10% market swoon in the beginning of February.

The next time we hear from the same guy, he’s singing a different tune: “I think we are in a pre-bubble stage that could go into a bubble stage.” He goes on to say that the chance of a recession are 70%.

Luckily, though Marketwatch doesn’t call him out on the rapid change in tone, it does provide helpful links to his prior comments. Any discerning reader with even a modicum of financial knowledge would think that this guy is utter crap and going along with the prevailing tone, fanning the flames in a bull market and turning on a dime at the slightest whiff of panic. Why would you entrust your money to someone who doesn’t know what he’s talking about?

It amuses me to have recently received mass emails from both Fidelity and Schwab advising clients to stay calm in the recent market turbulence. It seems that with each boom-bust cycle, we attract new speculators without any inkling of what it means to truly invest. What am I doing? Tuning out the noise, rebalancing, and overall staying invested in a stock:bond ratio that matches my risk tolerance and time horizon. The market’s short term gyrations don’t matter a whit.

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Don’t Do Something, Just Stand There

Another week, another all time in the stock market. North Korea’s saber rattling and the devastation wrought by the hurricanes don’t seem to have put a dent in the market’s relentless ascent. Furthermore, with this being the “most hated” bull market in history (or so they all say), things don’t seem primed for a major collapse. A mild pullback on the order of 5-10%? Sure, perhaps it will happen within the next year, but a major recession doesn’t seem to be in the cards.

What’s the best mentality for an average investor to have? The same as always – don’t change your long-term strategy due to short-term circumstances. Ignore the noise going on around you and robotically invest what you won’t touch in the next 5-10 years. The mantra that my mentor in medicine told me, which brings “do no harm” into the modern world, is encapsulated by the title of the post. Sometimes it’s simply better to do nothing than to react like a jumpy cat to every slight movement.

Take this advice of this article for instance:

“If you don’t want to invest in equities because you fear a market crash, then you should never be in equities, because equities always crash,” Ritholtz said, speaking at Morningstar’s annual ETF conference.

He noted that there was a bear market in equities—defined as a 20% drop from a peak—every five years, on average, although the recent market environment has been bereft of even much smaller declines. Current valuations have led to concerns that such a crash could be imminent, but “If you’re under [the age of] 50, you should be rooting for a market crash, because it would be nice to have a 20% discount and then 20 years to compound that discount.”

He added, “there’s no escaping this: markets go up and down, that’s what they do. But if you’re still worried, you should significantly lower your expectations for future returns” by buying safer—but lower growth—alternatives. He noted that over the past century, U.S. stocks have returned about 10 times what Treasurys have, although they also experienced numerous massive selloffs over that time, something the government bonds hadn’t.

“The risk you assume when you buy equities is that there will be a significant drawdown in the 20 to 30 years you own them. But you get rewarded for that risk. Treasurys don’t have the same kind of drawdowns, but don’t deliver the same kind of returns.”

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Secrets to Successful Investing

It feels like we’re always hammering the same points on investing over and over again. Don’t watch your portfolio. Stop tracking the market’s daily gyrations. Focus on the long term. Stay diversified. Don’t try to stock pick or market time. Stick with the asset allocation determined earlier and rebalance. Stick to these tried and true principles based on solid research and you’ll be fine.

Sometimes, we feel that we can be exceptional or lucky and we try for the moon. Humans are poor learners from others’ failures, and rather learn best from a strongly emotional personal experience (like a major loss in the market due to a self-inflicted error). I believe everyone should learn that by starting out playing single stocks with small amounts of play money, ideally earlier in life rather than later, so we can quickly return to the right path having learned our lesson in a way that sicks.

In other words, use the “the martyr system” to your advantage, letting the hippocampus impart the long-term financial scars from personal failures that will leave lasting memories of what not to do.

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No Regrets

My last post touched briefly on the nature of regret in missing out (selling too soon, buying in too late). However, this is not a healthy mindset to have. As Marketwatch pointed out today, very few people have the intestinal fortitude to ride out the market’s gyrations and hold for the 10+ years needed for wealth to compound exponentially. How many of us would have sold out during one of the times when bitcoin or Netflix crashed >50%?

This Morningstar article serves as a reminder that we are our own worst enemies:

Well, it’s really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You’ve got tremendous diversification. They don’t cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to ’08, ’09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.

The best returns actually came from disciplined boring investing. As Monevator likes to say, keep investing as boring as watching paint dry, so you won’t be tempted to buy and sell all the time. As another former mentor once told me, “Don’t just do something, stand there!” That is really the approach to take when investing.

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Take More Risk in Tax Advantage Accounts

The Bond King Bill Gross likes to philosophize about profound emotions such as joy and melancholy in his investment rants, and this post is driven in part by the emotion of regret seeing Bitcoin hit all time highs, and even surpassing the price of gold.

Such is the case for many in my field. When I was finishing my last year at Berkeley, I came upon news reports of the fancy new cryptocurrency idea called Bitcoin. Independently at the same time, so did my fiancee’s brother, childhood friend, and cousin-in law (all techies). We didn’t think much of it, and as risk averse as I was, I didn’t even bother putting $50 or so of play money into there. If I did, it would be worth almost a million! Similarly, my fiancee’s aunt regrets not buying Apple stock when it was down in the dumpster right before Jobs took over (seriously, most smart money was on the company going bankrupt, not staging a phoenix-like revival).

While we can all regret not doing the most “optimal” thing (life doesn’t have a save/reload button) in hindsight, we can also never with certainty predict what the future will hold. What we can do, and it will sound boring, is to make sure we have the right types of investments in the right places, and to stay allocated to assets in a way that allows us to sleep well at night. If we do dedicate a small (e.g. 5%) portion of our portfolio to lottery ticket bets on small cap stocks, that’s fine. Just make sure to do it in the tax advantaged section of the portfolio.

Standard portfolio theory suggests that we should make sure that our money is invested in the way that takes advantage of legal tax shelters to our benefit, as much as possible. Just to recap, there are in general three big categories of holdings: taxable, pre-tax 401k/IRA, and Roth 401k/IRA. Here’s what we should put in each:

  • Taxable: The goal here is to hold for as long as possible and to minimize the number of transactions and income generated, since each sale can generate a huge tax bill for capital gains. The best choice is a low fee total stock market index fund (Vanguard, iShares, and Schwab are all good choices) that is held and not sold until death. Then we can take advantage of the tax free basis step up when we bequeath to heirs. The small amount of dividends generated is taxable, yes, but at a much lower rate than the marginal rate. Bond holdings should be in tax-free municipal bonds as much as possible, doubly so if you’re in a high tax bracket.
  • Pre-Tax: We have to pay tax on the whole thing anyway but not until we cash the money out from the account. That quirk makes pre-tax accounts ideal for traders, stock pickers, and market timers who move in and out of positions with regularity. It’s also a good place to stash taxable bond funds and high dividend funds that throw out a lot of periodic income.
  • Roth: This is where you should make your highest risk “lottery” type bets. Let’s say you could (and want to) invest in bitcoin, startups in their infancy, micro cap stocks, penny/value stocks, turnaround stories, Greek bonds on the verge of default, and foreclosed homes. You would do so here. The bigger the potential gains, the better it will be. Whether you stumble upon a 10-bagger or 100-bagger doesn’t matter. You won’t pay any tax on it at the end.

So in summary, you want to use the right tool for the job. A balanced portfolio should consist of stock funds, bond funds, and maybe a dash of play money. Instead of making each tax category holding the same, we should concentrate our investments in the type of account that is best-suited from a tax perspective. Big gainers should be in the Roth, slow steady accumulator broad market funds should be in taxable, and income spewing investments in the pre-tax account.

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Passive Clearly Beating Active

These past few years have not been good to actively managed funds, or their managers. As this Morningstar article shows, funds are continuing to lose investor money and as a result, they have to lay off their fund directors. Shed no tears for them though, as they’ve had several years of high six figure+ income without providing a corresponding return to their investors.

Let Uncle Warren and Jack Bogle light the way. It’s no secret why the biggest indexer, Vanguard, is growing more than everyone else combined!

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The Few Proud Stock Winners

Remember my exhortation against stock picking, due to the few winners driving gains and the majority of stocks being meh or losers? This Morningstar article posted an insightful finding based on a recent study:

Half of U.S. stock-market wealth creation has come from 0.33% of listed companies.

Please note, that figure is not 33%. It is one third of 1%—one security out of 300.
Of the 26,000 stocks that appear in CRSP’s database, 86 provided half the aggregate wealth creation, 282 are required to reach the 75% figure, and 983 account for the full 100%. That is, after the 983 highest wealth creators, the remaining 25,000-plus securities are net neutral. Some made money for their investors, and some lost, but overall they were a wash.
Let’s re-emphasize. 86 stocks drove half of the gains of the market as a whole. If you were to randomly pick a stock to place your bets on, you would only have a 0.33% chance of picking a major winner. What’s the lesson, Morningstar?
In other words, do as your columnist prescribes, not as he does: Diversify. Widely and broadly.
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There’s a Reason They Promote Active Management

Just saw this ad on Morningstar:

marketwatch ad

Investors have started to wake up to the high fees and poor performance seen with active management, and as a result, big financial service firms are trying to stem the flow of money away from active funds to passive funds. As a result, they’ve ramped up advertising trying to sell potential customers with fear. “Now is a turbulent time,” they say. “In an uncertain world, it’s not good to be passive.” “Have an expert guide you.”

But really, if they have to work that hard to sell you on something, it’s probably a bad investment. Just remember: they’re worried about profit, not about working in your best interest. They (apart from Vanguard) have little incentive to sell you on low-margin passive products.

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Why Boring is Best in Investing

Are you a solo investor trying to imitate the big boys? It may not be such a good idea. You may have seen hedge funds, institutional investors, and big university endowments delve into “alternative” investments, meaning esoteric low-liquidity products that ordinary people wouldn’t have access to. Financial service providers, hoping to capitalize on a trend, created mutual funds and ETFs allowing ordinary people to buy into these supposed hot new strategies. Warning: they just want to charge high fees.

The performance has been dismal. As the chart on the link shows, a boring tried and true approach with stocks and bonds has outperformed all of these newfangled products.

The article goes on to explain the reason for the discrepancy:

Ben Johnson, Morningstar’s director of global ETF research, says many alternative ETFs have serious flaws. “Those guru-type portfolios are just equity strategies taking the long side of some well-known hedge-fund managers’ positions and following them on a lagged basis,” he told me.

“Oftentimes what you see in these ‘mimicking’ strategies is the derivative of the underlying asset that is many times watered down or is otherwise not directly connected to the…real asset.”

In other words, the ETFs are very poor substitutes for the real thing. Institutions like Yale get to pick the best private equity and hedge funds, and can buy, say, actual timberland rather than the WOOD ETF.

So yeah, if you can buy and operate an acre of farmland and know how to run it profitably, you may do ok. But for the rest of us, just stick with a diversified collection of stocks and bonds.

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