In his book Money for Nothing and Your Stocks for Free, author Derek Foster offers two strategies for boosting investment returns: selling put options and leveraging your house. Let’s examine these strategies.
1. Selling Put Options
Foster suggests finding a good dividend-paying stock that you’d like to own. However, instead of just buying the stock, he wants you to sell put options on the stock. How this works is best explained with an example. I’ll use some actual (approximate) figures for Royal Bank stock (ticker: RY).
Let’s say you’d like to own 200 shares of RY that are currently trading for about $46 each. You could just buy the stock for about $9200 right now, or you could sell put options on 200 shares. Royal Trust December put options at $44 have a premium of about $3.50. This means that someone is willing to pay you $3.50 for the option to sell you a share of RY for $44 any time between now and the third Friday in December.
Based on 200 shares, you can collect $700 now as long as you are willing to pay $8800 for 200 RY shares. Of course, the option buyer will only force you to buy the shares if RY shares drop below $44 each. If this happens, your net price for 200 RY shares will be $8100 (much better than the $9200 you would have paid if you just bought the shares). If the price of RY doesn’t drop, then you get to pocket the $700 from selling the put options.
According to Foster, whether you are forced to buy the shares or not, you win; it’s a “free lunch.” If this sounds suspicious, it’s because there is a catch. What if RY shares go up to $55? If you had bought the 200 shares for $9200, you’d be ahead $1800 instead of only pocketing the $700 option premium. You are giving up potential upside to take a guaranteed small amount right now.
The only way that Foster’s strategy can be profitable is if put options are routinely overpriced. If Foster thinks this is true, then he needs to justify it. Otherwise I’d have to assume that because stock options are a negative-sum game due to commissions and spreads, his strategy over the long term will prove to be worse than just buying stock.
2. Leveraging Your Home
The dangers of borrowing to invest are well known. While gains get magnified, so do losses, and you have to pay interest on the loan. Foster does a good job of explaining the risks of leverage when buying stocks on margin and concludes “never borrow on margin; it’s simply too risky.”
Foster is much more positive about borrowing against your house to invest. However, leveraging your house has all the same risks as using margin. Foster sees the critical difference as being that there are no margin calls when leveraging your house. This allows you to ride out bad periods for stocks without being forced to sell your stocks.
However, margin calls force an investor to reduce risk. The leveraged homeowner just has more rope to hang himself. Trying to ride out a downturn in stock prices could turn out well, or it could lead to complete disaster if stocks continue to drop.
Overall, this is a clearly-written book requiring little investment knowledge to understand. But readers should think carefully and tread cautiously if they plan to follow Foster’s advice.