Thursday, August 2, 2007
On October 19, 1987, the United States stock market plummeted more than 500 points. On October 20, I started selling.
But I wasn't selling stocks. I was selling puts. And it was the smartest thing I did that year.
Most people who trade options know that puts give the buyer the right to sell a stock at a specified price by a specified date. So most option traders buy puts to either bet on the downside of a stock or to hedge a stock they already own.
But there's a lesser-known strategy that actually uses put options to bet on a potential bullish move in stocks. It involves selling puts, and the current market environment is just about perfect for doing it.
Let me explain…
The crash in 1987 freaked out a lot of investors. Those investors were clamoring for some way to protect their portfolios from further declines, and they were willing to pay up for the protection. So they rushed into the option market and bought whatever puts they could get their hands on.
And they paid double, triple, even four times fair value for the options.
Imagine being able to sell an asset for two, three, and four times its inherent value. When the demand for an asset is that strong, you'd have to be crazy not to sell.
But there's a catch…
Sellers of puts are obligated to buy the underlying stock at the agreed upon price (the strike price). So, since there was a chance I might end up having to buy these stocks, I only sold puts on the stocks I wanted to own and at the strike prices for which I was willing to pay.
For example, if I remember correctly, United Technologies (UTX) was trading around $50 per share after the market crashed in 1987. The UTX November 40 puts were selling for something like $3.
I would have been more than happy to buy UTX at $40 per share – at that price it would have been trading for about eight times earnings. So I sold the puts and got paid $3 per share for the obligation to buy UTX $10 cheaper than where it was trading at the time.
Of course, I never had to buy UTX at $40. The market stabilized and moved higher over the next month. UTX never traded anywhere near $40. The options expired worthless, and I got to keep the $3 per share premium I received for selling the puts.
The crash of 1987 made many stocks genuine bargains. Investors were panicking and were willing to pay anything for a little downside insurance. And, if you had the courage to sell some of that insurance, then you made some pretty easy money.
Now, let's fast forward to today…
The stock market hasn't crashed. But the action over the past several sessions has sparked an awful lot of fear, and it's created a number of good blue-chip bargains.
Option premiums, in general, are about 50%-60% higher than where they were one week ago. The only way option buyers are going to make money in this situation is if volatility increases even more than what we've seen over the past week.
That's a tough bet.
A far better strategy at this point is to search for a handful of blue-chip value companies that you would love to own if the market pulls back even more. Decide what you'd be willing to pay for those stocks. Then sell August or September puts at those strike prices.
If the market falls further, then you'll have to buy those bargain stocks at those bargain prices – which you wanted to do anyway. And, if the market goes up from here, then your short puts will expire worthless and you'll pocket the option premium.
It's a good deal either way.
Best regards and good trading,
The destruction continues… mortgage firms Countrywide Financial, Washington Mutual, Freddie Mac, Luminent, Newcastle, and loads more scraping new lows.
Big drug companies Pfizer and Amgen at new lows.
Big banks Wachovia, JPMorgan Chase, Citigroup, Lehman Brothers, and Bear Stearns at 52-week lows.