From FullyInformed.com, we have this interesting piece today:

Put selling remains my favorite investment strategy. Over the past 4 decades, put selling has evolved into a very profitable means of compounding my capital, annually. When I started put selling in the mid 1970′s there were only a handful of stocks that had options available. Premiums were a lot higher in the mid 1970′s and over the years as more and more stocks had options introduced, option premiums have decreased except during periods of high volatility.

But with the maturing of the options market, there are today so many more stocks with options available and good option volumes on most, that it more than makes up for the decreased premiums through the wide variety of stocks available to select from.

The author here brings up a good point. Option volume is very important. Essentially, the more people there are trading a particular option, the close the bid and the ask quotes will be. The fewer people trading an option, the farther apart the quotes will be. We always want to go with the more liquid positions. The slippage (the extra amount you end up paying due to the bid-ask spread) on illiquid options can be enormous. This is critical if you want to exit your position through buying back the option. If the spread is large, you won’t be able to buy it back for less than you got in premium when you originally sold it.

A lot of readers email me with questions about my put selling strategy of trying to earn 1% a month or 12% annually. While most weeks I receive just one or two such emails, when the market is trending higher I receive a lot more. This is because as stock markets move higher it becomes more difficult to engage in put sellingout of the money puts and still earn at least 1% a month.

If you read the article “My Strategy Explained” you’ll understand that I aim for about 1% a month in income. My goal is 12% of my entire stock portfolio a year of consistent income. But it is important to remember that some months it may be difficult on certain stocks to receive 1% in a month. The goal though is 12% annually and a year is a long time. There will be periods when earning 1% is difficult but there will also be lots of periods when I can earn more than 1% in a month. This is the trade-off when investing through put selling.

Put Selling And The 12% Goal

I have a lot of investor friends. Many make more than 1% a month and many more than 12% a year. But not every year and not every month. Often what to them seemed like a great trade turned out to be a poor trade and ends with a loss. It only takes a few losses to wipe out months of gains. It only takes one bad year to wipe out years of gains.

The 12% return is my goal in put selling because I have found through every single market, bull and bear I can consistently earn 12% and continue to compound my capital.

12% annual earnings on a $100,000 portfolio compounds to over $300,000 in just 10 years. In 20 years it will compound to over 1 million dollars. 12 percent is a terrific return if it can be done consistently while controlling risk.

Just to be clear here, the author is talking about a 12% return on his entire portfolio, not on a per-trade basis. I doubt very much that 100% of his capital is in selling puts for income. If it is, then he would need to be doing so in a cash secured strategy or with bull put spreads.

Put Selling Is About Managing Risk

It is the 12% goal I care about with put selling. While it’s nice to earn 2% or more in a month when put selling, I know that overall the goal is 12% annually. That is what it will take to grow my capital according to my plan while managing risk. Not just risk of assignment, but risk of being assigned at overvalued prices which increases the likelihood of owning stock for long periods of time. If to earn 2% or more in a month I have to assume a higher risk of assignment it is necessary to be sure the stock is not overvalued.

Buy having monthly as well as an annual goal I can concentrate on either. When, as in the last two years, I reach my goal of 12% with months left in the year, I can pull back from riskier trades and sell for even half a percent because I have already reached by goal of 12%. Having clear objectives when put selling or trading stocks, controls emotion and the risk of stepping into a bad trade.

While I understand what he is saying here, I think it is even more important to focus on the particular trade at hand. How a trade effects the returns of your overall portfolio is nice to know, but never lose focus on the stock that the trade is on! If selling a put on a particular stock for income yields you 1%, great. If it yields you 2%, great. If it yields you anything, great. The key is to make sure you come out ahead like you planned in the first place!

Netflix Stock Put Selling Losses

Netflix stock is just one of many put selling disaster examples. Earlier this year Netflix stock traded over $200 and by July it had hit an intraday high of $300.70. It was highly overvalued and had a book value of just $7.40 and was trading at 68 X its PE. In less than two months it had fallen to below $130.00. I started receiving emails in early September from put selling investors caught in the collapse of Netflix. By the end of September I had received more than 1250 emails from put selling investors who had sold puts at strikes between $275.00 and $175.00. Many had been assigned shares which they did not want and many could not afford. One poor reader had 10 contracts assigned at $270.00 but the stock was trading at $155.00. 10 puts at $270.00 is $270,000.00 of capital.

Netflix was a stock heavily promoted by analysts and talked about endlessly on business media outlets. This is typical of analysts as they basically talk about the “stock of the month” like it was a new ice cream flavor brought to market. These talking heads know nothing about fundamentals, PE, book value and balance sheets let alone earnings projection. They know nothing about true value in a stock and certainly nothing about putselling. They are filling airtime.

Look at the Netflix Stock Put Option chart below for Jan 30 2012. Today three investors emailed to tell me that they had bought to close Jan 2013 $200 and $215 puts for staggering losses. They told me they had given up on Netflix Stock and were closing their put trades for huge losses. These are puts that were sold for $18.00 and $19.00 dollars of income when they sold the puts.  Such losses can sometimes take a lifetime to recover.

Put Selling against NetFlix Stock has led to enormous losses for many investors

So why did these investors get caught? Because Netflix Stock was terribly overvalued and had been for over a year. But the constant chatter about the rise in Netflix Stock by Analysts and the lure of the enormous put premiums drew them into what became an emotion charged put selling trade. They forgot to manage risk.

At the very least as Netflix Stock rose, they might have considered a credit spread strategy of selling the higher put and buying a protective put. While they would still have had large losses, a credit spread would have assisted in limiting those losses.

Netflix stock chart begs the question why would anyone choose put selling for this stock?

The Netflix stock chart above asks the question about why anyone would consider Netflix stock for put sellingat such lofty levels? It was typical investor exuberance that pushed this stock to such lofty levels. But with so many stocks to choose from for put selling, why choose Netflix? With exceptionally high put premiums, it drew a lot of investors into put selling. Those high put premiums were a sure sign from the market that Netflix stock was overvalued and could easily fall.

Well, yes and no. It is true that you, as an investor who is selling puts for income, must be aware of reversals in trend, “overvaluation” is entirely subjective. As the popular saying goes, the market can remain irrational longer than you can remain solvent. So NFLX was overvalued for a year? Entirely possible. But it kept going high and kept making put sellers lots of money, myself included.

You must watch out for changes in trend though. NFLX was an excellent candidate for selling puts for income all through 2010. At each trough in its cycle, it provided very strong support and yielded high premiums. So far, so good. The sophisticated put seller will know to never sell puts during a period when earnings reports are released. Earnings reports have the ability to drastically move the market, and we have seen that here. Once NFLX released a report that resulted in a downward break of its trendline, NFLX was no longer a candidate for put selling.

Nobody should have lost money selling puts on NFLX. It was only stupidly aggressive traders who did. If you follow Selling Puts for Income, you know that we analyze the chart each and every time we look to enter a trade. The stock must have a strong chart to even consider selling puts.

Put Selling Is Not Free Money

Put selling is for too many investors considered free money. It is not. It is not even close. The risk when selling puts is enormous and it does not matter which stock the put selling strategy has been applied to.

Put selling against overvalued stock is a disaster waiting to happen. Investors can do well for a while selling against overvalued stocks, but in most cases when the stock turns, it moves lower so quickly that the investor has no time to buy to close for small losses. Sometimes within a day or two the loss to close the sold puts can be huge.

True, but why would you be waiting for 2 days to close a losing position?

Risk Is Risk When It Comes To Put Selling

Put selling is incredibly risky for those who do not want to own the underlying stock. It is even riskier for those who fail to do any analysis of the underlying stock but simply look at the put premiums to select the fattest premium for put selling.

With proper management and stock selection, put selling is not risky. There is risk, yes, but risk and risky are two different things.

With my strategy I have a list of large cap dividend paying stocks that I like for put selling. They each have long histories of recovering from market meltdowns. When they become overvalued I move away and look at other stocks within my stock list.  Should they fall and I cannot roll down or out, I would own them and begin selling covered calls. As well should the stock fall further than expected I have cash always available to either pick up shares at fire sale prices OR sell puts at lower strikes which moves my average cost of held shares even lower.

Certainly an option (hah!), but I don’t think there is any need to restrict your selection of stocks to dividend paying companies only. As I’m sure we are all aware, dividends represent a minority of stock positions. Is that 2-5% per year worthwhile if you are going to end up selling covered calls anyways and making much more? In my book, the added flexibility that comes from examining the entire marketplace of weekly options is worth much more than the dividends that I might get if I get assigned a stock from a losing trade.

I keep 30% of my entire portfolio in cash to take advantage of pullbacks and crashes. With a stock market crash I only need to commit the cash part of my portfolio once every so many years to make huge gains which can then be averaged out for those years when my cash sits idle waiting for stock market sales.

That seems reasonable.

Put Selling Is Not A Race And It Is Not Gambling

My goal explained in my strategy is attainable and can be consistent if applied properly. Put selling is not a race and it certainly is not gambling. I do not believe that any option seller can consistently earn 12% a year in and out while controlling risk without having in place a solid put selling strategy and being highly selective in the stocks they sell options against.

So while many investors aim for that 2% or more every month I am content to establish a goal of 12% a year for my entire portfolio and wait for the opportunities to come to me.

Fair enough. Despite the technical points of contention I raise above, I fundamentally agree with this author about using the strategy of selling puts to create income. I focus much more on maximizing each individual trade rather than the overall portfolio. To me, if each trade is as good as I can make it, then the effects on the portfolio will take care of themselves. In addition, I exclusively sell weekly options in order to reduce the risk from extreme changes  in a stock. It reduces my per-trade return, but it increases my success level and averages out to higher returns over time.