NAKED PUT OPTIONS

Several people looking for ways to make money while the market's overpriced have written in asking about options trading. Read on.

Phil,

Your book is a great introduction to the Graham / Dodd style of investing.  I was thinking of a strategy to augment returns during this time when the market seems over priced.  There are a lot of great companies out there, however finding ones with a good MOS are rare.

If I find a company I like but does not meet the MOS requirements, would it be wise to sell naked put options while I wait for the price to come down?

At least this way I make some money selling the contracts. If it comes time to cover the option, I know I'm entering the position with the margin of safety I want.  Conversely when I do own the stock, I could write covered call contracts where the strike price is at or near the sticker price.  When it comes time to sell the stock, I've locked in my gains along with extra money I've made selling the contracts.

Is this a good strategy to follow.  I'm trying to figure out if this strategy violates rule #1.

Sincerely,

Brian B.

Brian has an interesting thought about naked puts.  A naked put essentially happens when you sell someone else an option to sell you the stock at a set price sometime in the future, usually in a month or so. 

The idea is that you are willing to buy the stock at some price that is lower than what it's selling for right now. 

As Brian points out, while you are waiting for the price to come down, you pick up a bit of income, and when the price comes down, you are happy to buy it from the option holder at the lower price.

Selling naked puts is a very good strategy when you are totally solid on the value of the business.  The problem with selling a naked put in this market is that you might have to buy the stock at a price that is quite a bit higher than the price the stock is selling for -- and that hurts. 

Let's take an example:  ABC stock is selling today for $30 a share.  You like it a lot at $20, so you sell someone the option to sell you the stock at $20.  They pay you $0.50 for that option.  Then the stock starts dropping like a brick down to $15.  Then the option holder requires that you buy the stock at $20.  You must, and thus you immediately are 30% in the red.  And that's why I'm not a huge fan of naked puts.

For me it's mostly psychological.  I love to be in cash and watch a price crash on a business I want to buy.  It's like I'm a consumer of hamburgers and the price of the burgers is going down, down, down.  I LOVE it!  My beloved burgers are getting cheaper by the day and since I am consumer of burgers, that's a good thing for me. 

But if I've set a limit to how cheap they can go by selling a naked put, then I only want the burgers to go down to that price and no further.  That's pretty hard to do -- to nail the bottom price of something. Especially since we know that Mr. Market is quite irrational sometimes, particularly when he's panicked and afraid and is fully capable of naming a ridiculously low price for a business.  It is just horrible to have to pay more when Mr. Market is being so cooperative as to sell it to us at a massive discount below its true value.

And, fortunately or unfortunately, that often happens:  If we sell the option at a price that represents a nice margin of safety, we can't be sure that Mr. Market won't totally panic and sell far below the MOS price. I've seen Mr. Market do exactly that over and over. 

For example, in 2001, Valero, a really good oil field business, was worth about $20 and it was selling for $7.  Urban Outfitters was worth $6 and it was selling for $2.  And there are more extreme examples that come up from time to time when markets do what they do -- fluctuate.  If you had sold the put option for Valero at the MOS of $10 or URBN at the MOS of $3, you had to start your position down about 30%.

Having warned you about the downside, let me suggest, Brian, that excellent investors do naked puts regularly, particularly when they have a very good feel for the Sticker Price and a very good feel for the bottom that the stock might drop to.  And even when you are wrong about the bottom, getting Valero at $10 and Urban at $3 would have given you quite a nice result:  Over 800% in both cases in the last five years.

So how do you know what to do?  Make sure the premium that you are getting paid for the option is worth the risk. If it's a pittance -- say 1% or so -- don't bother.  If it's 5% then you might be on to something. But that big percentage is only going to happen when there is a lot of volitility, so know your 4Ms and then go ahead.

Now go play.