As it is June option expiry tomorrow, I will postpone doing the weekly model portfolio update until Friday. By the end of tomorrow, we will find out if our WES June 29.50 puts have been assigned or not. If they are, we will sell covered calls over our newly acquired WES shares on Friday. If not, we will sell more puts.
Today I would like to discuss a topic which I normally reserve for my mentoring students but last week I received a disturbing email from a reader who kindly wrote to warn me because he had lost a lot of money in 2008, trading what he believes is essentially the same strategy as what we are doing here. I have replied personally to this gentleman but I feel I should discuss some of the points he raised on this blog to warn other readers who may be trying to implement this income strategy on their own.
The first point I would like to readers to note is that we do not sell “naked” puts. Although we do sell puts, all our put options are “cash secured”, meaning we have the cash to buy the stocks if our puts are assigned. Some of the “ground rules” that I teach in my training videos on selling options are:
- Only sell puts on stocks that you have pre-qualified and are happy to own long term
- Be prepared to buy the stocks if your put options get exercised
Selling “naked” puts is very risky. Many novice put sellers make two common mistakes:
1) Selling too many option contracts
When you sell puts, you are only required to put out a small amount of money up front to cover margins, which may be as little as 10% of the exposure you have. If you sell 10 put option contracts of a $10 stock, your exposure is $10,000 (10 x 100 shares per contract x $10 strike price) but the initial margin required by your broker to cover the position may only be $1000. Your broker will allow you to sell 10 contracts if you have enough money to cover the initial margin required. However, if the stock falls in price, the margin will increase and you will be required to add more cash to cover the additional margins. If you do not have the cash, you will be forced to close your position at a loss.
If you only have a capital of $1000, you should only sell 1 put option contract, not 10. If you sell 10 contracts, only 1 is cash secured and the other 9 are “naked” as you do not have the capital to cover your exposure.
2) Focusing on option premium instead of stock quality
Some put option sellers use scanning software to find stocks with juicy option premiums without doing due diligence on the underlying stock. Option premiums are usually very high when the stock price in falling so you need to understand why the price is falling. If you are not comfortable with owning the stock, then you should NEVER sell put options over that stock no matter how attractive the option premiums may be.
In our model portfolio, we have sold put options on a few stocks that have fallen in price (Rio Tinto, Iluka, and Newcrest) but if you look at their fundamentals, they are all healthy and highly profitable companies. We are happy to own shares of these companies as I am confident the share price will rebound sometime in the future. I certainly will not be selling puts on fundamentally weak companies such as Qantas, Myer or Billabong whose share prices are also falling, as I am not comfortable with owning these stocks long term.
Our “worst” position currently is our RIO July $64.00 puts which we sold in April for $2.04. If our puts get exercised, we will buy RIO stocks at a cost of roughly $62 ($64 strike price – $2.04 option premium). Based on the current market price of $55, we would have an unrealised loss of $7 per share. However, when we look at a long-term chart of RIO (shown below), we will see that RIO has only traded below $60 for only a few months in the last seven years. Even though it is currently trading at $55 and has even gone as low as $30 in the panic of 2008, the share price eventually recovered.
If you had sold naked $60 puts on RIO in December 2008, you would have lost a lot of money if you had to close this position as RIO fell to $30. However, if you had the money to buy RIO shares when your puts got assigned, you would have achieved a tidy profit six months later when RIO shares went back up to $75. If we own RIO shares, we can also sell covered calls to generate income while waiting for the share price to recover.
The other point I would like to readers to note is our position size on RIO. We only sold 5 contracts of RIO $64 puts because we determine the number of put contracts to sell based on our exposure. As our capital is $200,000 and we only want to hold 5-7 stocks, we have allocated a maximum exposure of $30,000 for each position. Although we have an unrealised loss of $7 per share on RIO, this represents an 11.3% loss on our RIO position and a 1.75% loss on our total portfolio. Our total exposure to volatile mining shares is only 30% of our portfolio and the rest of our exposure is to safer less volatile income stocks like WES, WOW, and TLS. Proper money management (position sizing and diversification) is also key to achieving success in doing this income strategy.
As mentioned in our e-book, options are powerful instruments and can be dangerous if you do not understand how to use them properly, or if you trade without adequate capital. This is not a get rich quick strategy and we are only targeting a 10-15% income return on our capital. Selling naked puts may get you a higher return in bullish markets but you can quickly lose all your capital if the market goes against you.