a question about selling puts versus buying the stock

[Guest hpmst3]

e

[Opihiman]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

[twacowfca]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

 

 The question is option trading focused rather than being focused on the value of the underlying security or hedging or mispricing in the option market.  These would all be appropriate topics for discussion, IMO.

 

The judicious use of options may sometimes provide a cheap source of nonrecourse leverage or help lock in a future long term gain when a stock shoots up above it's intrinsic value.

 

Or, selling a put, especially when its implied volatility is high, can be a nice way to get paid for waiting for a great company to come down to a bargain price.  :)

[bargainman]

Hmm, I'm not so sure why this is considered a 'trader's' question. Buffett used Puts to get into KO years ago.  He also recently sold a pile of index puts he was much maligned for.  Others on this board have often spoken of options trades, both puts and calls, on stocks they've fundamentally analyzed.  I'll just mention a coupe of things.  When you sell puts, you are taking all the downside risk and getting a limited upside gain.  It's kind of like a bond where you have the risk of default, and only get a fixed payment/max profit.  So it's important to look at companies you think have limited downside.  You may also want companies you don't think will run away on you.  If you sell a $20 put on a $23 stock, and say you get $1, and then the stock goes from 23 to $50, you get to keep $1!  That's it.  So there is the risk of losing out on gains.

 

[finetrader]

about selling puts

 

I'm looking at: 10 dec 12.5 put for MFC

 

anybody else find the premium attractive and a way to get in MFC at a cheap price?

[Opihiman]

I'll put it another way. When one considers the margin of safety related to going long equities (shorting puts is a long equity position), one should reference intrinsic value of the underlying.

 

But OP's question doesn't reference margin of safety to intrinsic value - only to an option's strike and premium. That is the usage and framework of a trader. It speaks of price, without reference to value.

 

I never took issue with discussing options as a tool per se, as some appear to assume.

 

Anyway, I'll reiterate my original comment, and apologize if I 'sounded' unduly harsh.

[twacowfca]

about selling puts

 

I'm looking at: 10 dec 12.5 put for MFC

 

anybody else find the premium attractive and a way to get in MFC at a cheap price?

 

 

If you like owning MFC and you would like to buy it with an increased margin of safety, selling a put would be something to consider.  The downside would be opportunity cost (something better comes along in the meantime) or exposing yourself to unanticipated risk (something bad happens to the company or the market in the meantime).  Therefore, you might want to pass unless the put you would be selling is expensive).  The BS implied volatility compared to the historical vol can be a useful clue about the relative dearness or cheapness of an option.

Puts are generally dear now with the recent high volatility in the market.  High volatility is usually fleeting.

[Uccmal]

Finetrader, I had a look at the MFC put you were discussing.  It looks like you could get 0.90 cents/unit.  So you would get $900/10 contracts.  It looks relatively risk free at the moment.  The problem I have with puts in this context is that they eat up an enormous amount of margin. 

 

If everything works according to Hoyle you will make $900 less fees.  If the position moves against you, you will have to post more margin.  That amount of margin starts to rise dramatically as the stock drops.  If the price of MFC drops in the US from 15.50 down to 12.50 which is only another 25% you will have to post the entire value of the purchase price of the stock as margin.  12500. 

 

What I am getting at is that you need to have 12500 of available margin before you even consider this strategy. 

 

I have learned this from experience.  During the 2008 meltdown I sold some put positions and had to post collateral on them.  I hadn't lost that much money but what happened was that I had used up my margin availability writing the puts and got successive margin calls.  At this point I had to call the broker and have them "loan" me the money to complete the transactions to free up the margin so that I could further reduce other positions.  I was in a frozen state.  I will re-interate that this was due to writing puts, not due to other losses suffered in my portfolio. 

 

So, unless I see a huge dislocation somewhere I am staying away from this strategy I am staying away from this tactic.  I have had it work as well buy the returns are dwarfed by anything I can earn by buying stocks like MFC cheap, or using Leaps on some occasions.  The thing I like about Calls and Leaps is that they are straight up purchases.  You cant get use margin to buy Calls.  So therefore, if the value of your call goes to zero it wont force you into a sell position.  You can keep it to expiry and hope it recovers.  Options are volatile and this happens alot.

 

My final comment is that if you have to buy in the puts you will have to pay the full amount for the stock in all likelihood.  Liquidity tends to dry up at these times. 

[link01]

If you like owning MFC and you would like to buy it with an increased margin of safety, selling a put would be something to consider.  The downside would be opportunity cost (something better comes along in the meantime) or exposing yourself to unanticipated risk (something bad happens to the company or the market in the meantime).

 

he might also consider buying half a position of the stock & selling otm puts simultaneously. he then has uncapped upside exposure fro owning some stock as well as being paid a premium to wait for the stock to fall into a more attractive buy range. the opportunity cost downside that you mention & the unanticipated risk of something bad happening to the company or market in the meantime exists to some degree or other regardless: whether you have a position of stocks, options, or cash, or a combo of all of them. 

[finetrader]

You have to have cash to buy the stock if put goes in the money.

I think you could get 1$ premium. For someone with cash on the sideline and happy to own MFC at 11,50$US(strike minus premium). If it does'nt go that much lower you get to keep the premium. (then make 1$/11,50$*12/7= 14% annualized return on cash)

Sounds like a win win situation.

 

Agree that opportunity cost is an important factor to consider too.

[SharperDingaan]

 

You might want to consider that we don't measure 'opportunity cost', & we don't pay our advisor for it. We pay only for realized & unrealized (MTM) gains. Opportunity cost is nice but if you ultimately didn't invest in the opportunity - what's the point

 

SD

[Uccmal]

I completely goofed that commentary up so I deleted it.  Left my brain somewhere while I was writing it. 

 

Sorry.. 

[ERICOPOLY]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

 

Consider that it wasn't too long ago where for every put you sold at-the-money in SHLD you collected enough premium to purchase two calls at-the-money.  This gave you 100% upside while only taking risk of 50% downside.

 

Moral of the story:  never dismiss an asset class.

 

[Opihiman]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

 

Consider that it wasn't too long ago where for every put you sold at-the-money in SHLD you collected enough premium to purchase two calls at-the-money.  This gave you 100% upside while only taking risk of 50% downside.

 

Moral of the story:  never dismiss an asset class.

 

 

Again ... we're thinking like a trader. If SHLD is 100% overvalued, only a trader could find upside in buying calls. That you missed my point (below) spoke volumes:

 

I'll put it another way. When one considers the margin of safety related to going long equities (shorting puts is a long equity position), one should reference intrinsic value of the underlying.

 

But OP's question doesn't reference margin of safety to intrinsic value - only to an option's strike and premium. That is the usage and framework of a trader. It speaks of price, without reference to value.

 

I never took issue with discussing options as a tool per se, as some appear to assume.

[ERICOPOLY]

That you missed my point (below) spoke volumes:

 

I can't wait to hear it.

 

I'm a big boy, please tell me what "volumes" it spoke.

 

[valuecfa]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

 

Consider that it wasn't too long ago where for every put you sold at-the-money in SHLD you collected enough premium to purchase two calls at-the-money.  This gave you 100% upside while only taking risk of 50% downside.

 

Moral of the story:  never dismiss an asset class.

 

 

 

I recall that SHLD opportunity, and regret not entering it. I came very close to doing that transaction but decide to just nibble on the common instead.  :-\

[bargainman]

Oh my.. Opihiman,

 

are you serious!?  You're telling Ericopoly something like "it speaks volumes"!?  Ericopoly has been around this board since the MSN board days, and has spoken volumes, let me tell you!  Volumes of incredible insightful information and spot on calls!  I'm not sure how long you've been lurking, but your profile says you've posted 8 times.  Now I'm a relative newbie and am in awe of some of these guys, but let me post my newbie opinion...

 

No one said anything about only being able to post questions about valuation on this board.  In fact there are posts about taxes, cross country currency issues, brokers, arbitrage, ticker symbols etc etc etc.  On the specific topic of options, options are a technically challenging beast, and asking for a walk thru on a trade is nothing out of the ordinary IMO.  You need to understand the mechanics of the trade before you can take advantage of any valuation insight.  There are many here who 'trade' on valuation, and hence are 'traders'.  To me the distinction between a 'trader' and an 'investor' is mostly semantic. (with some exceptions for chart reading and tea leaves).  

 

Anyway, you may want to take it down a notch, and not tell senior members of this board what not to talk about.  And please don't make snippy snooty comments like "speaks volumes" to the senior members of the board that we all respect and enjoy commentary from.

 

from an Ericopoly fan.

[rtgross]

 

Although I do not have many posts I have been reading this board for a couple years.  I must say I'm a bit surprised by what appears to be a display of strong emotion intensity in the comments on this topic.

 

That being said I have had many strong conversations in the past with fellow investment professionals on the topic of options. 

 

One of them has a very strong distaste to options saying they bring nothing good to the world due to the act of tying up capital on an instrument that does nothing but act as a conduit for wealth transfer rather than going to a company that can employ it to produce capital goods.  I would say this is valid point in the theological debate.

 

I started reading about Buffet around 10 years ago and noticed that both he and Charlie generally had negative opinions on derivatives.  That being said, Buffets actions have often spoke quite differently as has already been commented.  For many years I avoided options mostly for reason of the theological argument already mentioned.  However, in the last 2-3 years I have started to use options fairly regularly.  Most often as a seller when implied volatility on the contract is very high (40-50 when stock is trading at strike).

 

My normal path of action is to begin with the valuation work.  Once I have identified something as a favorable prospect then I will begin to look at the most cost advantageous method of putting on the trade.  Sometimes I sell puts, sometimes I buy the equity, sometimes I do both.  I will also often sell short term covered calls (1-3month) on my positions when they approach my valuation.  Part of this is an attempt to keep my emotions in check on a company that has had a rapid advance in market valuation.  It is well studied in behavioral finance that both novices and professionals will increase their valuations as the market price of a followed company rises.  It is an easy trap to fall into and I find selling the covered calls help me avoid it.

 

A couple weeks ago I did a case study on my Burlington Northern merger arb position.  You may find the spreadsheet helpful in grasping the various methods of analyzing the structure of your investment.

 

Enjoy,

Rich

 

http://rtgross.wordpress.com/2010/05/14/mergerrisk-arbitrage/

[Myth465]

Greenblatt has shown that options / leaps can be fairly profitable. Many here have retired off FFH leaps and Prem uses puts to hedge his portfolio. I think you have an idea of what true value investing is, but most here tend to follow Buffett and Klarman, there are no bad assets, just bad prices. Buffett doesnt have much faith in derivatives but a mispriced asset is a mispriced asset. That being said I am net down on options / leaps, that speaks more towards my investment skill though.

[twacowfca]

You've expressed the concerns and calculations of a trader Hugh. Here we try to think like business owners. Might I suggest you take this question to the options board at www.elitetrader.com - I believe you will be very happy with the multiple responses you get there.

 

I'd be disappointed (and surprised) if this sort of query was entertained and encouraged at The Corner.

 

Consider that it wasn't too long ago where for every put you sold at-the-money in SHLD you collected enough premium to purchase two calls at-the-money.  This gave you 100% upside while only taking risk of 50% downside.

 

Moral of the story:  never dismiss an asset class.

 

 

 

I recall that SHLD opportunity, and regret not entering it. I came very close to doing that transaction but decide to just nibble on the common instead.  :-\

 

I passed as well, but with no regrets.  Well, maybe just a little.  :). It was nearly identical to the Fairfax trade that we made a bundle on a few years ago: a short attack, but dedicated long term value investors holding most of the good cards.  Oh excuse me, most of the stock.  The perfect set up for a short squeeze.

 

What disuaded me was the value trap of the underlying business. This was very different than the clear sailing Fairfax was experiencing with fair weather likely ahead as the hurricane season was shaping up to be a zero loss year.

 

Lets be honest with ourselves.  We, the active posters on the board are indeed mostly traders with a value perspective rather than classic buy and hold value investors.  :)

[bargainman]

Lets be honest with ourselves.   We, the active posters on the board are indeed mostly traders with a value perspective rather than classic buy and hold value investors.  :)

 

Um.. what 'classic buy and hold value investors'?  usually the classic buy and hold variety are the growth investors and the Bogleheads.  The classic value investors sell the stock when it hits intrinsic value!  Buy when it's at 50% of IV, sell when it's at 90%.  That's the 'classic' Graham Value investor no?  Buffett's whole 'buy to hold' bit only came after he was influenced by Fischer and Munger, and after he had way too much money to be trading in and out of stocks all the time.  I guess I'm splitting hairs, but I agree with the rest of your statement.

[twacowfca]

Lets be honest with ourselves.   We, the active posters on the board are indeed mostly traders with a value perspective rather than classic buy and hold value investors.  :)

 

Um.. what 'classic buy and hold value investors'?  usually the classic buy and hold variety are the growth investors and the Bogleheads.  The classic value investors sell the stock when it hits intrinsic value!  Buy when it's at 50% of IV, sell when it's at 90%.  That's the 'classic' Graham Value investor no?  Buffett's whole 'buy to hold' bit only came after he was influenced by Fischer and Munger, and after he had way too much money to be trading in and out of stocks all the time.  I guess I'm splitting hairs, but I agree with the rest of your statement.

 

 

Good point!

[Myth465]

Lets be honest with ourselves.   We, the active posters on the board are indeed mostly traders with a value perspective rather than classic buy and hold value investors.  :)

 

Um.. what 'classic buy and hold value investors'?  usually the classic buy and hold variety are the growth investors and the Bogleheads.  The classic value investors sell the stock when it hits intrinsic value!  Buy when it's at 50% of IV, sell when it's at 90%.  That's the 'classic' Graham Value investor no?  Buffett's whole 'buy to hold' bit only came after he was influenced by Fischer and Munger, and after he had way too much money to be trading in and out of stocks all the time.  I guess I'm splitting hairs, but I agree with the rest of your statement.

 

Agreed, the value traders are the true Gramham and Buffett of yesteryear value investors. I have some owner manager stocks I plan to hold for the long hall (FUR, FFH, SSW, LRE) and eventually Loews. But if they get crazy expensive they are gone. I know Buffett and understand him, I aint managing billions and can sell when I want.

 

Truth be told, I have been hurt more by holding then selling.

[Opihiman]

I can't wait to hear it.

 

I'm a big boy, please tell me what "volumes" it spoke.

 

That is a kind invitation, but I'll decline.

 

I've made my points, and I'm pleased to see most people get it. As for the rest well, I'll leave it to Warren: "If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is."

[ERICOPOLY]

There is somebody else that has been talked about recently on this board that tried to talk like Warren in his letters, but it ultimately turned out that the character of the man shined through.