April 9, 2012 | 8 comments
Barron's had a recurring theme this weekend about complacency toward risk and the amount of risk that investors now appear to be taking.
As for complacency, the Striking Price column included the following; "Selling puts that are 5% or 10% below the stock price and that expire in three to six months never hurts..." Selling puts was generically a great trade in the 90s then the tech wreck came along and put sellers were crushed. Then there were a few more years of good times followed by the financial crisis which again crushed put sellers. The market is now three years from the low and put selling has generally been a great trade again. While there is no way to know when, I promise you there will be some future event that again crushes put sellers.
For anyone unfamiliar, when you buy a put you have the right to sell stock to someone (the put seller but actually early assignment is random) at the strike price of the option. Buying a put is either a hedge or a speculation that the price will decline, the seller of the put does not expect the price to drop below the strike price of the put he sells.
The context of the Barron's quote was selling puts 5-10% out of the money targeting a three-six month expiration. A great example of how this can blow up can be found with Akami (AKAM) from 2000. On March 10 of that year the stock closed at $296. A put 10% out of the money would have had a strike at $260 (if memory serves, up that high strike prices were struck every ten points) and based on the Barron's comment someone may have sold a June or July strike (I don't remember the cycle that AKAM was on back then) or maybe September or October.
By April 10, 2000 the stock was down to $133. By May 10 it was down to $77. The put sold in this example that was $35 out of the money was $183 in the money. This is likely a permanent impairment of capital when it is bought back or if the position is held until expiration resulting in assignment. The seller of the put must buy 100 shares for $26,000 when the market value is only $7,700.
The reason I think AKAM is a good example is because there was no fraud at the company, it did not fail--it actually has a very important function but it got caught up in the hype and then got crushed.
The next time selling puts becomes a bad idea there will be people short a whole bunch of puts from the "wrong sector."
The other point from Barron's (this was repeated in a couple of places) was a repeat of the idea that the Fed's interest rate policy (and the other attempts to stimulate the economy) are forcing investors into other instruments to seek a "reasonable return."
I hate this line of thinking. It would be great to get a "reasonable" rate of return from cash and treasuries but for now that is not the case. That people put what should be their low risk dollars into higher risk instruments to get a return they used to get from cash has tragic outcome written all over it. If there is another bear market before interest rates normalize there will be an avalanche of dismayed investors panic selling their dividend stocks because they thought the stocks were "safe."
There are a lot of people who have put cash and bond money into dividend stocks because dividend stocks have done well lately and either they or their advisors have become complacent about the risks of owning stocks. We all have some amount of our liquid net worth that should be in cash. For one person it might only be 2% and for someone else maybe it should be 90% but either way too much "safe" money into stocks has a high probability of ending badly. Opportunity lost is far better than actual money lost.
As a note to the dividend crowd at Seeking Alpha, this is not pointed at you, some of whom say they like it when prices drop so they can buy more and so on. If you comment regularly all over that site about dividend stocks and do what you say you do, then you are strong hands but the people above would be best thought of as weak hands. All stocks have strong and weak holders and I promise you that the weak holders will sell into the face of something bad--this is normal market behavior and has nothing to do with the merits of a stock or a strategy. I believe a client holding Philip Morris Intl (PM) is favorably viewed by the dividend crowd yet it went down 32% from when it spun off in March 2008 into the March 2009 low--weak hands not bad stock.
Track new comments on this article
I don't doubt that you are correct about weak hands selling dividend stocks during the next market panic. Since the majority of many large cap dividend stocks are held by mutual funds, most of the selling will come not from investors in individual dividend stocks but broad market investors in 401(k)s and IRAs.
But it won't be just dividend stocks. I think the much heavier sellers will be the weak holders of non-dividend stocks. 9 Apr, 11:28 AMReply! Report AbuseLike0
Roger NusbaumComments (1094)
"But it won't be just dividend stocks..."
Right but the context is trying to get yield with money that used to be in cash or bonds which makes the context here dividend stocks not names like GMCR or NFLX that pay no dividends. 9 Apr, 12:51 PMReply! Report AbuseLike0
I was reluctant to buy stocks during the recent run-up, but as a way to get into a few stocks of interest, I started looking at put-selling. At first I was not quite sure what my strategy was, but I think I have decided that
1. If I'm going to sell a future put, I must really be willing to buy the stock - today - at the strike price. So "the seller of the put does not expect the price to drop below the strike price of the put he sells." does not really apply to me. If my put is exercised and I have to buy the stock, perhaps even at an initial loss, at least my cost basis is lower and my yield is higher, due to the premium received.
2. Must be on stocks that I intend to hold long-term. I hope to be a strong hand, so no short-term trading strategies. That said, if I sell a put and its value tanks quickly, I'll buy it back and look into selling another.
3. No chasing big premiums in companies that I don't understand at least a little. Don't take action based on SA articles that offer half-baked advice like "here is a good put to sell... I rate it in the above-average category".
4. Where I'm weakest right now, is in the selection of the actual put to sell. There must be automated sites for data collection and analysis, but right now I gather data manually and use a spreadsheet to calculate things that I think mean something to me, like adjusted yield and APR of the premium. Looking at APR's of at least 15%.
5. For now this is with play money. The cash that secures the puts I am short right now, represents perhaps 10% of my total cash/fixed income stash (which is likely way too large for someone my age, and indeed failing to earn a reasonable return.) My other investing is unaffected by this. 9 Apr, 11:50 AMReply! Report AbuseLike1
Roger you make a good point about some investors view on dividends and while I am a big fan of dividend investing... it is what it is and it isnt what it isnt.
There are going to be some that see dividend investors talking about the safety of the dividend payment and translate that into risk free income similar to a bank CD. If they are taking their cash position into dividend stocks... that could turn out worse then their equity money in 2008. 9 Apr, 01:21 PMReply! Report AbuseLike0
Good afternoon Roger -- Good points well made.
[Your note to dividend-growth investors was not required...but is understandable] 9 Apr, 01:40 PMReply! Report AbuseLike1
Brad ThomasComments (1076)
How much return? 9 Apr, 04:08 PMReply! Report AbuseLike0
Global ViewComments (130)
I was holding my dividend growth stocks, and buying long calls and selling short puts on August 8, 2011. S&P 500 at 1350 to 1400 is no time to be going short puts, IMO. Short calls yes. Long puts,maybe. S&P 500 at 1100 is the time to be going short puts, but only when the market gives a solid oversold signal.
The euro risk has not gone away, the can was just kicked down the road. Our dividend growth stocks are low beta, not no beta. They will go down with a general market sell off, just not as much as high beta stocks due to their "internal shock absorber" of yield and supply liquidity (for the big caps).
GV 9 Apr, 11:17 PMReply! Report AbuseLike0
Example of selling a put that I think is okay.
Investor has $1,500,000 - none in stocks. Wants AAPL but not willing to pay current price. Sells 1 put at strike somewhere in the range $500-$600 (lower number for longer dated). If AAPL has declined below the strike, AAPL gets bought automatically - it is easier to decide to buy a 10% dip by having an order in ahead of time than to place an order to buy on a day your stock drops 6%, after dropping 4% the prior week.
Example that is not good. "Investor" has $30,000 - 80% invested in stocks with a portfolio beta of 1.60 (his average stock has a beta of 2.00 and just sold something). Sells 10 GRPN 14 puts. Premium is 7% for 2 weeks - but position does not fit portfolio. Beta unknown - stock is too new - early alpha looks negative.
If one's target beta is sensible - usually under 1.00 is okay for under age 40 - then there are several ways to get there. Beta isn't the only measure of risk - volatility is to my mind more important - but beta is easy to calculate, and for diversified portfolios is useful. Remember to calculate both with and without exercise, and assume that if you have several open options, that they may all get exercised, unless that is impossible. 10 Apr, 12:38 AMReply! Report AbuseLike0
Retirement2995[view and edit your profile]
Add Your Comment: Publish
Sent from my iPod