Selling put options is definitely a good return on capital and it cannot outperform buy and hold. That’s been proven, so I’m not going to rehash all of that, but there’s a lot of caveats or as my old branch manager would pronounce as, “Kaveet,” which was hard not to laugh in his face – he’s a sweet guy. You got to be careful because these things, when the trades go against you, they can get ugly real quick. Let me tell you a little quick story. When we were in 1995 to 2000 and all those internet names you VerticalNet, Siebel Systems, Global Crossing, CMGI, JDSUniphase, right? You all remember the darlings, then you’re like the NVIDIA’s of today. They couldn’t go wrong if it had four or five letters in the ticker it was going up. That was the buying criteria. What’s the ticker of the symbol? JDSU?
Yeah, absolutely buy it. It’s a buy signal. Four letters in the ticker was a buy signal and so you could make money.
People were just buying stuff. Revenues and net income didn’t matter anymore. It was all about the eyeballs. And so people just got used to doing these things. Again, we talk about trading with an underfunded account, they started getting a little careless and so what you find out, I’ll have to find the study, but I think it goes a little bit like this. It takes only about a 10th of the time to see a correction of a certain magnitude than the time it takes to get there. That’s a big mouthful. So say it takes like 10 days for the security to appreciate, say 5%. The way people hit the sell button indiscriminately typically means that you could see that happen in one day.
And that’s what kind of happened with those stocks is what we were coming into March 10th, 2000, which was the high near term high for the NASDAQ Composite. And people had been selling a lot of these puts because the premiums were juicy. I mean implied vol was like 400% or something. It was really high. So you were selling like $15 to $35…$40 premiums for things that were right under the market and they were all going up $20 a day for no particular reason that it was just related to the internet. So people were like, man, this is great. I’m just going to sell these out of the money puts, I’m going to bring in all this premium and everything’s going to be great. And of course that selling puts is bullish buying calls, same side of the market. But in this case the premium was so large and because folks didn’t have a great trading strategy and thinking on how they could take $15, $20 out of a trade, especially if they were day trading, they could sell these premiums and make monster gains Whenever you sell, I’m sure you know this, whenever you sell a credit or a net credit, that’s your max gain.
So what ended up happening was, and I was there, I was in management, you had all these options that were all of a sudden out of the money
And money and then there was this cataclysmic fall where things were getting blasted and they would go from being pretty far out of the money to damn in the money and these little old ladies in Pasadena were getting delivered against because someone else owns the option. They have the right to put it to you. So people were selling these puts and they didn’t have any type of risk management going on whatsoever. All they knew is they had enough money in margin to meet the margin requirement to sell the naked put. Now there are ways to hedge. You could short the stock. Typically that’s considered a covered position, but I don’t want to get into that here. One thing that you can do is if you’re going to sell a put with say a $700 strike is you could buy something underneath it like $680 or something, and then this way if there is a massive correction, you are at least hedge to the downside.
That would be like, because selling a put is bullish and you’re bullish if you’re along the lowest strike. So that would be a “net credit vertical bull put spread,” holy macro, that’s a mouthful. Net credit selling the higher put that’s going to have a higher premium. You buy the lower one, so you still get a net. So it’s a net credit, it’s vertical because you’re just changing the strikes. And net credit, vertical bull put spread right along the lower strike. So that’s a mouthful. That’s one way to do it and to be hedged, obviously whatever you could make and lose is going to happen between the strikes. So you have to kind of figure that out. What’s your winning percentages and this and that because it’s going to be hard to find stuff that you’re risking for to make six kind of a deal, at least on paper.
You’ll have to see what the damn thing looks like as far as the deltas are concerned and this and that. Anyway, just be careful when you do these because when the market’s unwind and when everything is looking rosy, you do it once and you have enough on, you’re like, man, I didn’t have a big enough position on let me sell two or three more. So then you start selling next thing you know, got your whole account in this damn thing. And I can remember people calling up saying, I own VerticalNet, Siebel Systems, I don’t even know what they do. I’m in Global Crossing. It’s like the backbone of the internet. And so the last thing you want to do is be in those positions, and that’s one thing I don’t like about selling options is you’re not in control. So granted, you can get paid first because you got the credit of the net credit, but you still have to be super careful and not because man, these things can blow right through the strike and be down a lot. So even if you’re selling a 15 or $20 premium, I’ve seen things move so quickly in my life, especially in futures where you could be 20 cents in the money to all of a sudden be 40 cents. I mean 20 cents out of the money to 40 cents in the money and it happens so damn fast. I also know I get a lot of emails from folks on the QT saying, Hey, I want to tell you this story, please help me out, but don’t mention my name.
They’re not trading options with stops, right? Because the spreads are wide. So they sit and watch ’em and they figure the thing’s not going to move. The delta’s like 50, so there’s a big swing in the stock. It doesn’t necessarily translate to what’s happening with the option. And so they kind of let it go and that’s with or without putting their maximum amount of risk unit on. So you got to be super careful with these things just because you might’ve been making money with them ongoing. It doesn’t mean that one. Look what happened to Victor Niederhoffer, right? This guy was selling naked S&P Puts on S&P 500 futures, and if I read the book correctly, he was selling silverware and artwork to have to make up the margin call and he was trading for George Soros at the time.
So really, really smart people can take it up the wazoo. What does he need insurance for? He’s got money coming up the wazoo. So you have to be very, very careful. Although the strategy, and again, options admittedly are very hard. It’s hard to get the data, so it’s very, very hard to backtest option strategies. You also have to contend with the spreads being pretty wide. So be very, very careful with what you do. If you haven’t sold stock short, I don’t think I want to be the guy to help you do that. You could also just buy a lower strike on the puts and to create that bull put spread might be better risk reward for you, right? You might not make as much, but you got to remember your goal is longevity here. Everyone likes those grand slam trades, myself included, but I got to be able to come back and play tomorrow and I don’t want to take such a loss that it’s going to hurt me both financially and also destabilize me emotionally because then I lost my confidence.
I’ve lost my nerve and I can’t come back and play in the sandbox if I’ve lost all my marbles or a good chunk of it. That’s very, very painful. I’m sure there’s a lot of comments, you might be doing it a certain way. I appreciate everybody’s success, whereas we might all be traitors, but the way we do things can be as unique to one another as is our fingerprint. So it’s not a judgment call to say you’re doing it right or wrong. I’m just trying to be the voice of reason to say yes, the strategy is proven out over time to be very, very successful and to work, give you good return on capital. But just be careful because you could be in a really good name. They might be able to report, I don’t know, earnings tonight after the close. But suppose the market takes a dump when the tide goes out. A lot of times all the boats can go with it. So it doesn’t matter if you have a good earnings report, if the stock gets blasted right in the middle of your good earnings report, you might get hit too. That sucks. It’s bad luck, bad timing, but it’s going to happen anyway.