Question

Today Tom T. states, “I have been selling puts as a means to generate income for about 18 months. Most months, I have made money, but in the months I have lost money, I have lost big – even though I try to limit losses by buying back puts when the price of the underlying stock drops below a pre-determined level. In my losing months, there are usually a small number of stocks that drop very quickly (this past month was brutal) and these small-in-number/large-in-value losses wipe out my large-in-number/small-in-value gains. Please help.”

Answer

Tom’s situation is not uncommon. In general, selling strategies tend to be consistent with many small winners and a few big losers. Premium buying strategies tend to have many losers, but a few really big winners. Here are a few considerations that might help.

The first take-away from your comments is that you are a “one trick pony”. You are only using one strategy – put selling. There is not a one size fits all strategy that works all of the time. The problem with put selling is that you are always bullish and you only see one side of the market. The only way you can be bearish is to be in cash. You must be mindful of the overall conditions. Over the last year implied volatilities (IV’s) have been at historic lows and you were not properly compensated for the risks you took. Premium buying strategies were actually more efficient from a risk/reward standpoint (provided that you used the same number of contracts).

The second concern is that you tried to buy-in the puts and still you were taking large losses. This tells me you were exposed to big moves (gaps). When you are selling puts, it is imperative to do extensive research on the underlying both technically and fundamentally. Technically the stock should be above long-term support and it should be in a long-term up trend. The puts should be sold below that support so that you have time (even if it is momentary) to buy them in when the stock rests there. Fundamentally, you must know the company because you are in essence long the stock past a certain point. You have to know when the earnings are “due”. I usually like to sell puts after the earnings are out even if it means missing some gains. If the IV’s are high in the stock, an extreme amount of caution must be used. The “rich” premiums are not there by mistake, something is about to happen.

The third issue deals with the fact that you are buying in the puts. When I sell puts I have drawn a line in the sand and I have stated, “I hope I get a chance to buy this stock at this level.” I put half of the strike price in reserve and I plan on buying the shares. It puts me in a different mind set. In these cases I need to know the company. If the stock has broken down because of a material change, I must buy in my puts. If the stock has drifted lower because of a market move, this strategy forces me to “buy low”. Do I have to take assignment on all the positions I sell puts on? No, but I should have a firm enough conviction to buy most of them. The other possibility is that you don’t have the capital to buy the shares and that is why you are buying in the puts. In that case, you are over-leveraged and “scared money never wins”. Very often, you will see a stock dip below the strike near expiration, you buy in the put and you are left holding the bag as the stock takes off. I’m not advocating taking huge losses or marrying a stock, but there are times when you have to trust your research and take a some heat.

Put writing is a great strategy, but it has its place. I have found it to be most effective when the market has sold off (like now), the fear is high (relatively rich IV’s) and the “baby has been thrown out with the bath water” (good companies have been sold off in sympathy). I like to scale into positions. I assume that I have not picked a bottom and I will probably have a chance to sell more puts at higher prices. Scaling in also helps me keep my emotions in check if the initial positions move against me. I know that if the market finds support, these prices won’t be there long and I have to at least start a small position. The bottom line is that I want to own the stock and I view this as a stock buying strategy with a “cushion”. At an extreme, this tactic might comprise 40% of my portfolio under the right conditions.

If you have had a similar experience or you have a unique approach to put writing, please share it.

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