A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Be the Casino, Not the Gambler
01/30/2012 11:15 am EST
Ken Trester thinks everyday investors could benefit from learning about put selling, and explains how the process works and how to position your trades for good profit with less risk.
Ken, you focus on options. You say there are some strategies that average investors—or people aspiring to be more active or aspiring to trade a little more—should look at in today’s markets. Which on the surface of it, it looks like so crazy people don’t even know whether they want to be in stocks.
Yes. Well, what I really like…we have talked about option buying in the past, but what I really like is taking the bet instead of making the bet. In other words, being the casino instead of being the participant.
Well the casino always wins, doesn’t it?
That is correct, and there is a way to win very frequently or very much of the time and that is by writing options.
OK, so explain to us what that means.
Okay, writing options. You know if you go to a casino and you want to make a bet at the sports book, you are talking to a person whose title is a sports writer.
That isn’t someone who is covering, say, the Dodgers or the Giants? That is actually sitting behind the desk and writing bets.
Yes, that is right. OK. So you want to do the same thing. So what I like to do, for example: in this very volatile market, put premiums are very high.
Because everybody is betting the market is going to go down because the market has gone down already.
That’s right. Everybody is panicked. I love panic because that causes premiums to go so high, OK?
Then what I want to do is I want to write those puts, which means take the bets where the premiums are so high on stocks that I would like to buy. OK? I want to write them way out of the money, which means way far from the present price from the stock.
Let’s take an example. Goldman Sachs (GS), it is at $110 a share, okay? The one month option, with one month to go, is selling for $65—not the $110, but at $65—for $100.
So I can write that option, receive $100, and wait for the stock to drop, which it will unlikely not do in one month. But I’m going to make that $100 as my consolation prize if it doesn’t get there.
So you are writing a call is what you are doing?
I’m writing a put.
You’re writing a put?
Right, I’m writing a put. I’m selling the put. So when I sell a put, I am obligating myself to buy that stock at $65 a share; that is what I’m doing. But rather than just go ahead and buy it at $110 right now, I will try to get it at $65 and I get paid to wait for it to go down.
Okay, but if it doesn’t go down there?
I get the $100. It is mine; that is it. The $100 is mine, it goes into my account, and that is it.
So the advantage of that over, let’s say, buying a call is what?
Well, you could buy a call, but you are paying the heavy premium for them and if nothing happens, that premium is going to disappear.
So at least you are getting paid something when you write a put.
And you are getting paid to wait for the stock to come down there. So it’s as safe as buying a stock, except you don’t have to buy the stock right now. You can wait and try to buy it at a much lower price.
Now this sounds too good to be true. What is the risk?
The only risk is that you are going to get the stock at $65 a share.
Well, that is cheaper than Warren Buffett got it, wasn’t it?
That’s right, exactly. That is the whole key and that is what I did.
I see, OK, well we obviously don’t know how it turned out…but it sounds to me like the risk-reward on that…
The probability is very low that it will get down to $65 a share. In fact, we have a simulator; it’s an iPad simulator that just tells you that there is a zero chance that it will get down to $65. Now that is probably not true, totally.
There is also a zero chance that housing prices ever go down, too.
That’s right, and they have. But it is unlikely we will see change in one month down to $65 a share.
If Goldman was actually down to $65, that is the least of our problems, right?
That’s correct. That means the world is falling apart.
Related Articles on STRATEGIES
There was no shortage of reporting last week on the long-awaited verdict for the U.S. versus AT&...
There’s a somewhat unprecedented shake-up taking place within institutional investment portfol...
On balance, we are most enthusiastic at present about investment opportunities in the U.S., explains...