Welcome to another edition of The Mueller Report!
This week I’m going to share what I have done and learned about buying and selling options. I’ve had a positive experience so far. My rate of return (in terms of premiums for selling options) since I began has been about 6% from when I made my first trade on Aug. 31st through Nov. 17th when the next round of options expires. The annualized rate of return is roughly 30%.
As an economist, I’ve asked myself a few questions.
TANSTAAFL – “There Ain’t No Such Thing As A Free Lunch”; or, you rarely find $20 bills on the sidewalks because they are quickly picked up. Higher than normal profit opportunities are like those $20 bills. If it sounds too good to be true, it probably is. So, is trading options a rare $20 bill on the sidewalk or something else?
There is a phrase: “penny-wise but pound-poor” to express the danger of focusing myopically on small efficiencies or gains that we neglect the opportunities of much greater magnitude. Another image used to describe this is someone picking up pennies in front of a steamroller. It looks like you are making money but compared to the risk, it’s not a good long-term activity.
So, am I picking up pennies in front of a steamroller here? I don’t think so for several reasons:
I am not selling options on random companies. I try to choose companies with decent underlying fundamentals, which means they are unlikely to go bankrupt soon (i. e. have their stock price drop to or near $0).
I can make money whether I hold cash and sell put options or hold stocks and sell call options. Making money on puts that are not exercised is free money. Making money on call options of stock holdings is a bit like paying yourself extra dividends while holding the stock. I sell the put options and the call options at the same strike price – which means that I don’t suffer realized losses whenever my options are exercised.
The major danger is that a recession or financial crisis could cause the overall stock market to crash (which is a risk of holding stocks in general, by the way). Presumably, if that were the case, all my put options would be exercised and the stocks I buy would immediately be worth less than I paid for them. And they might be worth a lot less than I paid for them over time (of course, this is a danger of buying stocks period). Although this means the return from selling call options at the original strike price diminishes as the market value of the stock falls, the return is unlikely to go to zero. So I am still paying myself dividends in addition to holding the stock of presumably solid companies that have dropped in value because of a market panic.
As long as I don’t need to sell the stocks at depressed prices, I can hold them until the market recovers.
So my strategy may become less profitable if there is significant market decline, and my position will become far less liquid as well, but there shouldn’t be much risk of suffering serious loss if the underlying companies are strong enough to recover with the economy.
Some options terminology
You can buy or sell any option. If you sell a put option, you are agreeing to purchase the shares at the strike price if the option is exercised. If you buy a put option, you are able to sell your shares at the strike price any time before the option expires.
The call option is similar. If you sell a call option, it means you agree to sell your shares at the strike price if the option is exercised. If you buy a call option, it means you have the option of buying those shares at the strike price anytime before the option expires.
When you enter into an option contract, your order is “Open” because you are opening the position. But you can also close out a position by selling your contract. This would be a “Close” order. The market value of an option changes as the price of the stock moves closer or further from the strike price.
I learned this because I accidently bought a call option instead of selling a call option on 100 shares of BIG. I was able to close out (sell) that position a couple day later (with a loss of about $20), but then turned around and sold a call option on the shares like I had originally wanted to for over $100.
Here are a couple examples of how my option trading positions have played out.
Case Study #1 – Free Money
I wrote several put options on Lending Club (LC) two weeks ago. At the time, the price of LC was about $34.40. I sold the following puts:
100 shares at a strike price of $34 for $279.33 (monthly rate)
100 shares at a strike price of $32 for $184.33 (monthly rate)
100 shares at a strike price of $31 for $149.34 (monthly rate)
100 shares at a strike price of $30 for $119.34 (monthly rate)
That means I had to set aside $3400, $3200, $3100, and $3000 respectively in case the share price of LC fell below the strike price and whoever bought the option from me wanted to exercise it. Then I would pay the strike price and receive the shares of stock.
I was paid $732.34 for these options. It turns out that will almost certainly be free money because LC released quarterly earnings well above their forecast this past week and their share price has jumped to about $44.
By the way, LC put options had some of the best premiums, not all puts pay this kind of premium as you will see in the next example.
Case Study #2 – Exercised options
I wrote a put option on a construction company TOL that was exercised (meaning the stock price fell below the strike price and I *had* to buy the shares). I then sold a call option on those 100 shares, which was also exercised. Here are the transactions:
Sold a put option on 100 shares at a strike price of $58 for $59.34 (weekly rate)
After the option was exercised, I bought the 100 shares at $58 a share for $5800
Sold a call option on 100 shares at a strike price of $58 for $47 (weekly rate)
After the option was exercised, I sold the 100 shares at $58 a share for $5800
So I ended with the $5800 in cash I used initially to write the put option, but I got $59.34 and $47 in premiums for the options I wrote.
Case Study #3 Selling calls & puts
Another company I wrote a put option on that was exercised was CRMT:
I sold a put option for 100 shares of CRMT (trading at $123.25) at a strike price of $120 for $244.33
The option was exercised so I purchased those 100 shares at $120 for $12,000.
Then I sold two options (when CRMT was trading at $112/share), one put and one call:
The call option on 100 shares of CRMT at a strike price of $120 brought a premium of $249.33
I also sold a put option on 100 shares of CRMT at a strike price of $110 for $439.33
If CRMT continued to fall in value and I had to exercise the put option and buy 100 shares at $110, my plan was to then sell call options on 200 shares at $115 – averaging the purchase at $120 and the purchase at $110 but getting greater premiums (potentially) than selling a put at $120 and a put at $110. Currently CRMT is trading around $118 so it looks like the put with a strike price of $110 is not too likely to be exercised. But this was my thinking.
Hope some of you found that interesting! Let me know if you have questions or want to chat more about any of this. I may write another newsletter on options early in the new year after I have a couple more months under my belt.
Talk to you next week!