I’d subtitle this one, “First, buy a stock right before it goes up…
One of my clients passed along a book for me to read: “Show Me The Money: Covered Calls and Naked Puts for a Monthly Cash Income” by Ron Groenke. It was all about the uses of covered calls and naked puts and how much money a few good stocks you have in your portfolio could make for you by selling these options to other people, essentially making money renting out the option to buy your stocks to people. What a grand idea: ignore dividends and capital appreciation, just make money because you OWN the stocks. I read it with some interest.
It goes like this: first you use your superior stock picking skills (or buy his software) to pick good stocks that are about to go up. You can tell which ones those are from their technical charts, they’re the ones currently at their 52 week lows, among other criteria.
Then you sell options at a high premium, something like 10% of the stock’s underlying value, knowing that it’s likely to expire. Apparently someone will take the other side of this trade because someone somewhere wants to pay high premiums for things that are likely to be worthless to them. Which is interesting, because every time I’ve looked at this the premiums are so low that the commissions eat a significant portion of their value. But, anyway, the way he tells it you just buy these great stocks and sell people the option to buy them from you for good money.
Then you sit back and let the money flow, putting on new covered calls every month or three on the same stocks as they keep expiring worthless, picking fruit from your money tree. (Without, of course, the premium people are willing to pay being reduced.)
The book thoughtfully takes you through a gedanken exercise where some of your stock picks go bad. After all, it happens to the best of people (although what could go wrong when you buy a stock at its 52 week low? It’s already low! It must be about to make a sine wave shape!) The author allows that maybe 15% of the time you could lose a little money. He figures that you’ll make some capital gains along the way when you have to produce a stock for an accepted call at prices above your cost, and that will more than offset any commissions you might have to pay on these calls so he discounts that in his calculation.
See, it can’t go wrong! o.O
As a tax accountant I truly hate the options markets. My clients always lose money. Always always lose money. It’s like the new Amway pyramids: someone somewhere made it work for a while and passed along a rumor that they got rich and it just sends droves of pawns into the market. Oh, there’ll be wins. Short-term capital gains wins, that is. In MA short-term capital gains are taxed at 12%, so someone in the Federal 25% bracket will pay 37% of their winnings to taxes. But, of course, they don’t have winnings over time, because options premiums are NOT priced irrationally. So eventually they slink away with their losses, leaving survivor bias to carry the banner. And they are big honking carryforward losses until they have no more portfolio left to generate any corresponding gains. In MA you can only use capital losses against investment income, which of course there isn’t any if you aren’t bringing in any dividends or interest because your money is tied up in short-term stocks. You never even USE those losses. Sigh.
I can see *MAYBE* doing a naked put if I’m sort of maybe interested in buying a stock if it goes low and I’m too lazy to keep an eye on it myself. But here’s the thing: it’s utter hubris to think that I can pick a stock. I pick stocks just about the same way I picked horses at Churchill Downs: I look over their information using my own personal training (as a CPA with a MBA for financial statements on the one hand, and as the daughter of a man who raised and raced thoroughbreds on the other) and then I listen to my hunches and make my pick. I am right just about the exact amount of time that random odds suggest I would be. Maybe I’m fooling myself about my level of ability to evaluate, maybe I’m not. The markets can stay irrational longer than I can stay solvent.
But I’m trying to understand and appreciate the wonders of options. I really am. But I just keep getting stuck on the initial premise: that you can look at history and it will tell you the future. Yes, that works in some arenas. But stock picking? Really not.
Originally published May 9, 2011 at ProsperiTeaPlanning.blogspot.com