A Great Way to Make Money

Insurance companies are the ideal businesses.  Well, almost.

Stock options have gotten a bad rap.  And yet, some strategies are so safe, the government permits them in IRA accounts. 

Some think that option techniques are complicated, full of jargon, full or arcane numbers and obscure formulas.  That may be true in academic circles, but for practical application, it needn't be.  There are some principles that must be understood, but they are not complicated.  For example, you know that to lose weight, you need to take in fewer calories than you expend.  That's it; it's really no more complicated than that.  However, the application of that formula has brought many to tears.  For another analogy, you already know that you should save a certain amount of your paycheck for a rainy day.  Again, simple formula, but perhaps difficult implementation.  But the difficulty arises not from the formula itself, but rather because of people's unwillingness to play the game, people's resistance to learning the rules of the game, and the almost universal desire to have things handed to them on a platter.

What if I told you that it's easy to make money? Your tendency would be to resist my assertion, perhaps pointing out to me that if it were so easy, everybody would be rich.  True, but the problem is that "everybody" does not apply the rules, and indeed, does not even bother to play the game.

Selling naked puts is my favorite strategy.  Some readers may have heard that naked puts are risky.  In fact, they are no more risky than covered calls, the same strategy permitted by the government in retirement accounts.  So what does selling naked puts entail?

Without getting too elaborate, options come in two varieties: calls and puts.  Calls represent the right to buy; puts represent the right to sell.  One can either buy or sell either calls or puts.  Both calls and puts cover lots of 100 shares of stock, where 1 option controls 100 shares.  Both calls and puts are represented by strike prices.  Strike prices are either at the current market price of the stock, in this case MSFT at $31 and are known as at the money (ATM), below the current market price of the stock are out of the money or in the money (OTM for puts, ITM for calls), or above the current market price of the stock, known as in the money for puts and out of the money for calls (ITM for puts, OTM for calls).  With MSFT currently at $31,

                        PUTS              CALLS

Strike 30                    OTM                  ITM

Strike 31                    ATM                  ATM

Strike 32                    ITM                    OTM

Moreover, options are "wasting assets" because the life of the option has a time limit.  Let's also stipulate that options are traded within a brokerage account, such as Fidelity or OptionsXpress, or any number of other brokers. 

Since this article is about selling naked puts, let's explain this a bit more deeply.

A put option represents the right to sell, specifically, to sell a stock.  Frequently, people will buy a put option to protect their portfolio.  How does that work?  Suppose you own 100 shares of Microsoft (symbol: MSFT) that you've been accumulating over the years, or received as a gift.  At its current price of $31, your 100 shares are worth $3,100.  If you are worried about the stock falling and losing some of your money, you would buy a put option at, say, a strike price of $30.  Recall that a put represents the right to sell (a stock).  If MSFT falls to $27, you own the right to sell the stock at $30, which was the strike price of the put you purchased. So, it would not bother you that MSFT had fallen to $27 if you own the right to sell it at $30.  So, the put gives its owner the right to sell the respective stock at the strike of the put option.  Recall, too, that the put option has a time limit - the longer the expiration date, the longer you can hold onto this protection of MSFT at $30. 

Now, if you bought the put option, someone had to sell it to you.  Why would someone wish to do that?  Because when you sell something, anything, you get the money (and likewise, when you buy something, you spend the money).  And what was the intention of that seller of the put? That seller essentially took on the risk that MSFT would stay at its current price, and not fall.  For that risk, the seller received a premium (from the buyer who wants to protect his MSFT shares).  In this case, the seller sold a naked put, meaning that his/her put does not have a corresponding position.  It's out there, alone, unsupported.  He is taking a risk, and for that, he is being paid. 

Imagine the same situation in real estate.  You, as a buyer, are interested in buying property in this depressed market, thinking that you'll snatch a real bargain.  You look at several properties, and find one that you really love.  But you want to keep your door open, to find other properties that are even better.  So you give the seller an option to buy the property at, say, $200K.  You are buying an option to buy that property (while the seller is selling you an option to buy the property) at a certain price by a certain date, say 6 months.  And for the privilege of "holding" the property at $200K for the next 6 months, you are willing to pay the seller a premium to cover his risk of higher prices.  Why is that a risk for the seller? Because the market may suddenly switch course and rocket higher, while he, the seller, has just committed to sell you his property at the lower price of $200K.  If, at the end of 6 months, you have not completed your contract by buying the house, the seller keeps the premium you paid. 

So it is with put options.  By selling a put, the seller collects a premium for essentially selling insurance on the stock, taking on the risk that the stock would fall.  For that, he receives a premium, just as insurance companies do.  But under the right conditions, expiration of the option term arrives and the stock has not fallen, the entire premium remains in the seller's pocket. 

Let's see how this works out in the "real" world.

MSFT's closing price as of 09/07/2012 was $30.95.  For the sake of this article, let's call it $31.  Suppose someone wants to sell a put on MSFT at a strike of $30 expiring in December 2012.  That put is currently priced at $1.12.  Please recall that options are represented in lots of 100, so the $1.12 would really be $112.  He receives the $112 in his account the very next day, and he is free to use that money as he sees fit.  What the seller is betting is that MSFT will not go below $30 by expiration December, and he will keep his entire premium of $112. 

But wait, there is more!

In order for a person to be able to sell this insurance, the brokerage house requests a certain collateral be put up against the risk of the stock falling.  The formula for such collateral is not complicated, and is as follows:

Price of stock x20 percent + premium received - any out-of-the-money amount

Wait, what's "out of the money"? As depicted above, a put strike below the current market price is known as out of the money (OTM).

So, accounting for an option controlling 100 shares, let's multiply our numbers by 100.  Plugging in the numbers into the formula, we get the following:

$3100 x 20 percent =$620 + $112 (premium received) - $100 (OTM amount) = $632 as collateral.

If December expiration arrives and MSFT is still above $30, then the put expires worthless, and you, the seller, get to keep the entire $112 you received as premium.  But, you say, this isn't such a big deal!  No, not yet, not until you realize that $112 represents 17.72 percent return on your money in three months ($112/$632=17.72 percent).

If 17.72 percent return in three months is not to your liking, imaging going out farther than December, to, say, January of 2014.  Now, the $30 put premium expiring in January of 2014 is $3.85, or $385 for each contract that controls 100 shares.  Your return in this case would be:

            $3100 x 20 percent=$620 + $385 - $100=$905.

And your return percentage:  42.54 percent for a year and a half.  Not bad in my book.