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Tuesday, November 27, 2012

Don't Be That Guy. Smart Put Selling

One of the more interesting discussions around Chez Melvin this past weekend has now spilled over into the week. The topic of option selling came up as a couple of folks have recently had their heads kicked in and net worth diminished by disastrous short put positions. I have been known to sell puts form time to time and found the conversation of great interest. The traders with losing option positions were experienced investors but new to the option selling game. Thyme made the same mistakes I always see made by pros and neophytes alike.

Selling puts on stocks, indexes and ETFs can look like free money.  We all know that most out of the money options expire worthless with the seller keeping the premium. What most traders fail to take into account is that option payoffs are asymmetric in nature. You can sell premiums and have 90% winners and end up broken by that final trade. Option sellers can find themselves collecting pennies and paying out dollars.

I only sell options on stocks I want to own. Valuation of the underlying stock is the first and foremost concern. If it is not cheap I do not care where the option prices. I have no interest in the trade. This is where most people lose money as option sellers. The premiums on the darling and popular stocks are often fat and just too tempting to pass up for many traders and investors. Why sell options for a 2 or 3% monthly return when you can collect much more than that by selling premium on stock like Apple (AAPL) or Chipotle (CMG)? After all they just keep going up and everyone loves them. What could go wrong?

What can wrong is the stock can fall out of favor as we have seen with these two glamour names this year. If you sell puts on one of these names and collect the fat premiums and the stock falls out of bed you are going to lose a lot of money. You could end up being put the stock and being forced to buy a stock you do not really want to own for the long term. If you compounded the error by posting minimum margins you are going to face a margin call of epic proportions. I always post the full purchase price of the underlying stock at the strike price.

The other mistake I see made is going to seem counter intuitive  I really do not like to sell options on a rising tape. It would seem that selling puts when the prices are rising. The price goes higher and you collect the premium. The problem with this theory is that each time you roll over the position you will be selling higher strike prices. In a rising tape volatility is usually rising and pricing is weakening. Markets are not unidirectional and if you have lost track of valuation first and sold at ever higher prices a small correction cap wipe out a years’ worth of gains.

I like to sell puts on stocks no likes at prices that I think are too cheap not to own. I am hoping the stock gets put to me and forces me to buy at lower than current market prices.  I prefer to sell them when there market is declining and there is a touch of fear in the air as this leads to fatter options pricing and better back in entry points for my long term position or higher premiums in my pocket. As a rule I pretty much never want to sell options of any kind when the VIX is below 20. I have seen way too many people carried out of the arena on their shield because of a volatility spike. I would rather be the guy selling insurance when everyone is willing to pay too much to protect against a downside that has already started.

I have found over the years that my best experience selling options have been in stocks that are so unloved there is not much option related activity. These usually have wide spreads and lower open interest. I will post an offer between the spread based on my calculation of option value and I get filled more often than not. It may take a few days but I am able to sell an option on a stock I like at a price I like. I scale into stocks so I do not need to sell 50 or 100 contracts at a clip. Just as with stocks my best results in the options selling business have come from doing what no else is doing and trading where larger competitors simply cannot.

Options selling can be a profitable tool for value investors. As with all tools there is a time to use it and a time to leave it in the box. Using the tool in manner for which it was not unintended can lead to serious injury or even financial death. Don’t be that guy.

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