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.
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.