Thursday, November 13, 2008

Money for Nothing and Your Stocks for Free

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.

13 comments:

  1. I love the book's title. That almost makes it worth the read. However, since you summed the book up in a couple paragraphs, there's no need.

    I've never considered using options in this way. I guess I've avoided them since Peter Lynch and Warren Buffett discourage their use. It does seem like an interesting way to trade a commitment to buy for a little cash.

    Am I to assume you borrowed the book from the library?

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  2. Hi Michael. I suppose Foster's strategy on selling put options makes sense for people who value capital gains less than the average investor, because it's the capital gains that you give up when you use this strategy. It's aimed at buy-and-hold dividend investors.

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  3. Gene: This book was an impulse pick-up from the library by my wife. She just happened to notice it and thought I might be interested.

    Patrick: It's true that this strategy gives up some potential capital gains in favour of option premiums, but I'm not sure why an investor would prefer the option premium all else being equal. I think that buy-and-hold dividend investors would be better off over the long term just buying and holding rather than delaying purchases and collecting option premiums.

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  4. Michael,

    Stock options are my specialty, as I've been a professional options trader since 1977. and an educator of individual investors since 2000 (3 books, numerous magazine articles, a blog and a website)

    1) Selling naked puts is risky - but it's less risky than buying stocks outright.

    2) This is a strategy appropriate for investors who want to own shares.

    3) True, the put seller misses out when the markets surges, but that is not a common occurrence.

    4) Using your example, any time the stock is below 49.50, the put seller is ahead of the stock buyer.
    And that's most of the time.

    5) The put seller does not collect dividends, so that's a negative. But, those dividends are priced into the options, so it's not a total loss.

    6) On the other hand, the stockholder pays interest (or fails to earn interest on money tied up in stock), when the put seller not only earns interest on the premium collected, there's also the interest on the cash 'not invested' in the stock.

    7) There are additional conservative strategies with much less market risk that are appropriate for millions of investors worldwide.

    I discuss six conservative methods, all appropriate for newcomers to the options world in my book: The Rookie's Guide to Options. Download a free, sampler version here: http://www.mdwoptions.com/freebook.pdf

    Options are not for everyone, and the hype in Foster's book should be a warning. There is no free lunch and getting to own stocks 'for free' is possible, but so is making a billion dollars in the market. Let's stick with realistic goals and honesty.

    Options reduce risk. Options provide opportunity for ample profits. It's an investment tool that should be in wider use.

    Mark
    http://blog.mdwoptions.com/options_for_rookies/

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  5. Mark: Thanks for the analysis. It's important to see all the advantages and disadvantages of a strategy (as you have done) rather than to ignore some disadvantages (as Foster did).

    I'd like to clarify your first point. We are comparing two approaches. The first is to take some available money and buy a stock. The second is to set aside this money (keeping it available if the put gets triggered) and selling naked puts on the stock. For this comparison, I agree with you that selling naked puts is less volatile than buying the stock. Some readers may misunderstand and think that we are talking about selling naked puts when you don't have the money to pay for the stock if necessary. This is risky.

    If options are priced properly, then the lower volatility of the naked put strategy should mean that the expected return is lower as well. This is a trade-off that some investors are willing to make. However, an option-based method of reducing risk should be compared to a strategy of including some percentage of fixed income investments. The high spreads in option prices and extra trading that comes with option strategies (resulting in commission costs) make it hard to beat a mixed stocks/bonds strategy using options.

    I see options as a way to achieve very specific return characteristics rather than a way to improve expected returns.

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  6. 1) Yes, I am referring to selling cash-secured naked puts. That means, as you said, having cash available to purchase shares if and when you are assigned an exercise notice.

    2)Option commissions are very cheap these days, and that should not be a consideration. You can pay less than $1 per contract, with no additional charges.

    3) If options are fairly priced then one would anticipate a zero-sum game.

    But, puts tend to be priced high - due to some people's 'need' to buy them to protect assets, and IMHO the evidence shows that writing options slightly outperforms a buy and hold strategy.

    4) Any investor who has market timing skills (that's not me) does not have to use this method all the time.

    5) I want to emphasize that selling naked puts is NOT a good method for a trader looking to earn a trading profit. Too risky. But it is appropriate only for those who want to buy, or are willing to buy, the underlying shares.

    The elevated put prices (compared with calls) tends to make put writing more profitable - if one is willing to accept the risk of owning stocks. But as with any method, no investor should adopt this method to the exclusion of all others. It can be part of a diversified portfolio. Diversified in holdings and diversified in methodology.

    I don't push this method. In fact, I much prefer selling put spreads - limited losses, limited profits, but much safer overall. For experience option traders, the sale of a put spread is equivalent in risk and reward to the 'collar' - and that's considered to be one of the safest option strategies in existence.

    6) It's very rue that option selling smooths out the volatility of a portfolio over an extended period of time and I'm glad to see you mention that. It's often ignored by option traders.

    7) Options are not a quick path to instant riches. But, appropriate methods can enhance earnings. I've taken that approach for a long time - I am willing to give up the occasional big upside (I still did very well in strongly rising markets - but not as well as the averages) when markets surge, in return for for better profits in the majority of years.

    It's a comfort zone decision and each investor knows what's suitable or him/herself.

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  7. On this site you can see what the impact would be if you missed the best days on the market between two dates. Here are the results from 1980 to 2005:

    6564 trading days
    annualized return: 12.8%
    $1000 grew to $22,841

    Omitting the 20 best days
    annualized return: 9.0%
    $1000 grew to $9,407

    http://www.moneychimp.com/articles/randomness/outliers.htm

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  8. Mark and Blitzer68: The 20 best days analysis shows what you could miss by writing puts. Of course, you'll also miss a lot of days with little activity where you'll come out ahead by writing puts. Mark asserts that puts tend to be overpriced making it attractive to sell them. I'd be interested in seeing a study on this. You'd think that if puts were priced too much above sensible values, then there would be an arbitrage opportunity, but I haven't thought about how to do this.

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  9. Arbitrage opportunity is code for a risk-free way to make money, which should be treated as you would left-over fish left out in the sun.

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  10. I liked the first book by Derek Foster. This last books seems like a get rich quick scheme. Most novice investors believe that they could buy a stock and then sell calls against it forever for 4% monthly income. This of course is not true.

    I do like the idea of having the obligation to buy stocks at a lower price and get paid for waiting, sort of like a limit order. I sometimes place limit orders to purchase stocks at prices below what they are trading for. By selling covered puts, I could theoretically get paid even if my buy price is too low compared to the current price.

    But why am I not doing it? Maybe because with an actual limit order you are more likely to buy the stock at the limit price ( or close to it) if it falls sharply down and reverses. With the option however the buyer of the put might fail to exercise their right at the time of the drop, and as the stock goes up up up to oits previous levels you are only better off by the premium..

    One other reason why I don't like the selling options mumbo-jumbo for consistent monthly cash flow is because there are some investors whose results actually show that buying puts and calls could lead to decent returns in some years such as 2008..

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  11. Dividend Growth Investor: You're right that there are some periods where selling puts is profitable. In fact, just about all investing (or gambling) strategies have some periods of time where they work well. The problem is that we don't know what will happen to stocks in the short term and therefore can't correctly choose the right gamble. The best strategies have good average performance over all types of markets.

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  12. Delayed reply:

    An arbitrage opportunity would only be available when an equivalent investment is available at a lower price. Then the arbitrageur locks in the difference.

    By 'priced too high' all I mean is that the market's performance has been less volatile than predicted by the option's price (implied volatility) and that put buyers received less market movement than they paid for.

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  13. I guess selling puts is preferable to placing a limit order at the same price. The latter is just like selling a put, but you don't pocket the premium.

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