Airport lounges are one of those little perks that makes the misery of travel almost bearable.
I say “almost” because it’s still pretty awful. But free drinks, Wi-Fi and a comfortable chair away from the hoi polloi go a long way in making it marginally civilized.
The reason I bring this up is that I’m writing from an airport lounge at Dallas/Fort Worth Airport. And, by chance, I ran into a friend of mine while at the airport. We caught up over a drink.
Taking Advantage of Options
Jim has an interesting job. He runs a portfolio that specializes on one particular trade: writing put options on the S&P 500.
His fund sells put options on the S&P 500 that he expects to expire worthless. When they expire worthless, he does it again. And again. And again…
If you’ve read my income newsletter Peak Income, you’re probably aware that my friend and colleague Lee Lowell runs a similar strategy. Though rather than writing put options on the S&P 500, he writes options on individual stocks.
I love it. It has everything I like to see in an active trading strategy: simplicity, routine, a high win rate. And, if you manage your risk appropriately, the downside can be capped.
For those unversed in options, a put option gives the buyer the right without any obligation to sell an underlying asset at a given price by a certain date. For example, you could buy a February 21, 2020, put option to sell Amazon.com (Nasdaq: AMZN) at $2,140 for about $23.20 per share ($2,320 for 100 shares).
Why would you want to do this?
Well, let’s say you have a large position in Amazon and you’re concerned it might fall in value — Amazon’s current stock price is $2,149. If the price of Amazon slide to $2,000, you could exercise your option and sell for $2,140, or simply sell the option itself for a profit.
This is portfolio insurance.
As you probably know, insurance is expensive. Whether it’s your house, your health, or your life, people tend to overpay for insurance and buy more than they need.
Portfolio insurance is no different. Investors tend to overpay for portfolio insurance, which is great if you’re the insurance company.
I mean, how often do you hear about insurance companies going out of business? It’s rare, and it generally only happens in cases of fraud or extreme negligence on the part of the insurance company.
Well, portfolio insurance is the same way. If you keep your risk under control, you can take the occasional setback in stride. And you can even buy “reinsurance” too in the form of deeper out of the money puts.
Let’s get back to the Amazon example, but let’s say that you’re selling the puts rather than buying. You sell 1 put option contract, giving the buyer the right to sell 100 shares of Amazon to you for $2,140 and collect $2,320 in premiums. Not bad!
The problem is, you’re exposed to a large open-ended risk if the Amazon stock price tanks — you have to buy the shares at $2,140.
But what if Amazon bombed its quarterly earnings and the shares fall all the way to $1,900? You’d have to potentially buy 100 shares of Amazon at $2,140 that were only worth $1,900. That’s a $24,000 loss, minus the $2,320 you collected in premiums, for a net of $21,680.
This is where reinsurance comes into play. You can buy a put option expiring February 21 with a strike price of $2,000 for $2.60, or $260 for 100 shares. This reduces that $2,320 you collected on the options you sold, but you’re still netting $2,060.
But now your losses are capped.
You can’t lose more than $11,940. (100 * ($2,140 – $2,000) – $2,060). And if you wanted to pay more on your hedging, you could reduce potential losses even further and even make money were the stock to really fall.
I bring all of this up for one reason: stocks are expensive today by virtually every conceivable metric.
And I don’t believe that investors buying and holding the market over the next several years will make much money. They might even lose a fair bit.
But by getting creative with active strategies like these, you can eke out a respectable return.
If you’re interested in income-based strategies, then I highly advise you to check out my income letter Peak Income.