writing put options: a simple way to make easy money

**zhao_xing** Fri Apr 14, 2006 10:28 pm

writing put options: a simple way to make easy money
Is there a stock that you would like to purchase at a cheaper price than its current quote? Would you be interested in receiving premiums months before you have to purchase the stock? If your answer is Yes, then writing put options may be a good strategy for you.

Although writing put options may not be referred as "Value Investing", I firmly believe this strategy does make money consistently as long as you do very well on risk control and make enough diversification.

Statistics shows that around 80-90% options expire worthless and less than 10% options are exercised eventually. Although theoretically buying options can limit your loss and maximize your gain to unlimited, the real story is that 80-90% greedy and naive option buyers lose while Wallstreet institutions make decent gain from option selling year over year. In conclusion, buying options is like playing casino, every time you pay 1 dollar to get very little chance wining 3 dollars; selling options is like running insurance business, you collect 1 dollar premium but take very little risk losing 3 dollars. Which way is better? I believe everybody should have very clear answer.

Selling put option strategy is very simple. If you are very confident on the fundamentals of an underlying stock, then short-sell put option of this stock at a very conservative strike price that you are willing to pay for. Let's take an example, say Wal-Mart(WMT), WMT earned 2.63 per share in 2005. It will probably earn 3 per share in 2-3 years. (historically, WMT's earning never goes down, so I am quite confident to assume that WMT at least can keep earning flat) Given (very conservative) 12-15 PE, you will be very comfortable to buy WMT stock at price 35 in 2008. So you sell WMT-2008Jan-Put-Strike35 to earn 0.9 dollar per share. If in 2008 Jan, WMT's stock price is above 35, you earn 0.9 dollar easy premium, otherwise, you lower down WMT's purchase price to 34.1, at such attractive entry price, you still have big chance to make decent profit by holding the underlying stock for long term.

In my option, risk control is VERY VERY important in this kind of option selling business. you need to be very diversified, otherwise, you may be wiped out one day. Here is the way I do option selling and risk control.

1. I only buy stocks on which I am very confident, like those recommended by BIRTP or those I have done deeply study myself and believe they are significantly undervalue.

2. Pick some stocks to sell short their put option. The ideal candidate can be some restaurants or retails , or other stocks that has very stable business model. No potential earning declining stocks, Absolutely no cyclical stocks.

3. Set the expiration time-frame of those selling options as long as possible. For those stable business, the longer time frame, the more valuable for underlying stocks, therefore, the more safety for underlying stocks. However, it's ironic in option selling to pay you more premium for longer time frame. (Good deal for me-:))

4. Set the Strike price at what you are willing to pay in expiration date. Eg., I am confitable to pay Ebay for 25, WMT for 35, HD for 35, Dell for 25, Sohu for 17.5 in 2008.

5. Only sell each option for very small amount of money, and fully diversify to different positions.
Suppose I have $50,000 USD in my margin account. I will be confinable to collect 560 USD premium from 4 Ebay 25-put contracts. If my judgment is wrong, my 10,000 dollar is ready there in 2008 for option exercise. Setup around 8-10 such put selling positions. (8-10 put selling position is OK for me, not too many, too over- leveraged) That will be 5000 USD gains and 5-10 percent improvement for your annul performance:-)

6. last one, please always use limit order to sell option. I believe you don't want to waste money in ask/bid spread.

Please vote for me:-)

**ffreedom** Sat Apr 15, 2006 5:20 pm

assume you gain all premium for your 5000 $. you gain 5000/50k = 10% until 2008. So, you can calc your return now. :-)

**zhao_xing** Sat Apr 15, 2006 8:07 pm

Quote: assume you gain all premium for your 5000 $. you gain 5000/50k = 10% until 2008. So, you can calc your return now.

Yes, it's 5% annually. Not reach 10%.
:oops:

%5 is jsut an example number. you can adjust the leverage-level acoording to your personal situation; or close some short positions you already win majority of premium, then open some new positions.

I am using this strategy to earn some extra bonus plus BIRTP picks for my portofolio. :) I believe this strategy works. One advantage is, unlike picking buy-and-hold stocks, you don't need to study those underlying option selling stocks very deeply. Just making sure they have stable business is OK.

Of course, BIRTP picks still make me most of money. So we all need to thanks BLAST anyway :)

**zhao_xing** Sat Apr 15, 2006 8:11 pm

a danger situation for this strategy is a big crash like Oct 87.

Of course, that's a nightmare for all of the margin accounts.

**zhao_xing** Sat Apr 15, 2006 8:15 pm

I believe 2000-2001 bear mark would not hurt me if I were there, Because I am quite conservative.

As a value investor, I will avoid most of stocks in 1999. Most of stocks were just too expensive at that time.

**zhao_xing** Sat Apr 15, 2006 8:45 pm

As far as I know, Chfriend03 also uses this naked short put option strategy to collect some extra bonus.

**elton.mccain** Sat Apr 15, 2006 9:42 pm

an excellent article for investment
I think it's a good idea to take advantage of these useful resource , such as financial reports , analytical model and etc, especiallly for those guys with less knowledge and skill on risk control

**blast_investor** Sun Apr 16, 2006 12:58 am

Just a quick note here for those who are not familiar: put writing = selling put.

One of the biggest difficulties in investing for individual investors is margin management and risk assessment.

Put writing is generally not suitable for individual investors. Put selling would give investor false sense of security while in reality, the under-line stock and therefore the put writing itself may not be safe at all. The margin risk management of put selling actually is pretty complicated.

Of course, for those who can assess and manage the risk of put selling, and put selling is nice extra tool.

The danger is: many of those who believe they know the risk behind put writing, actually they don't. I have seen too much cases like that. The difficult part is not the put writing itself, the difficult part is analysis on the stock behind the put plus the margin management.

I would recommend individual investors to spend most of research efforts on stocks investing.