July 2005 Archives

Kopin Tan writes in this week's Barron's Magazine an interesting article The Joy of Naked Puts (subscription required). Tan discusses how Tony Elenbaas makes returns of about 25% from selling naked puts.

Now meet Tony Elenbaas, an Annapolis, Md., resident who wrings annual returns of more than 25% from his option trades. A 63-year-old software engineer by day, Elenbaas is an avid tennis player, occasional beer drinker, father of three and grandfather of seven. And when he ventures into the option market, he is a naked-put seller.

Each month, Elenbaas sells out-of-the-money puts on about a dozen stocks -- in effect setting below-market prices at which he'd be willing to buy shares and, for that commitment, getting paid option premiums. "I look for solid balance sheets and companies I wouldn't mind owning," he says.

...

These days, worryingly low option premiums have tilted the risk-reward calculus, and buying back puts can prove costly should volatility spike. But Elenbaas says put selling has worked very well for him over some 15 years. Nor is he deterred by the margins required. "If you had $127,730 and wanted to make 27% return a year," he asks, "how would you do it?"

I did not like the article because it did not discuss very well the riskiness of this strategy. By selling a put that is deep-out-of-the-money, very little premium is received, especially with the today's low implied volatility. So even though Elenbaas is willing to own a stock at a reduced price, he might not be so willing to purchase that stock if it were suddenly devalued for whatever reason. In other words, the reduced price might look attractive now. But if something were to suddenly happen that knocked the stock down quickly 10%, the stock might be destined to fall a lot more in the coming days. So that bargain might not be such a bargain after all.

Elenbaas is using a high risk strategy, one which has paid handsomely so far. It is a high risk strategy because the upside is very limited (the option premium received), but the downside is immense. As an example, let us look at Yahoo!. On Friday the stock closed at $33.34. To get a reasonable premium for our put example, let us look three months forward (October) and use a strike price of about 10% below the market, or at $30. Using Yahoo's Finance page for Yahoo Stock Options for October (note that the values will likely have changed when you view the same page) are bid $0.40 and ask $0.50. Since we want to sell our puts, we would get $0.40 per share. Viewed differently, our purchase prices, should we be forced to buy Yahoo, is $29.60 (=30.00-0.40) ignoring commissions. But what happens if Yahoo were to plummet to $25, or lower? At $25.00, the investor is now out $4.60 per share. At $20.00, the investor is out $9.60. Granted, unless something extreme such as fraud happens, Yahoo will not plummet to $20.00 or lower. But there is no law of nature saying that Yahoo cannot fall to $0.00. At $0.00, the investor is out $29.60. This trivial example shows that the maximum upside is limited to $0.40 while the maximum downside is immense at $29.60. So far Elenbaas has done well, but as I have shown it is a risky strategy.

I would not advise those at home blindly following in his footsteps. If a person were motivated to try selling naked puts, I would advise the following:

• Assume the stock suddenly lost 30% or more of its value and then determine its negative effect. In other words, quantify your risk.
• Use limit orders to define or limit your risk.
• Start very small. Knowing your potential risk above, make sure that your entire risk from your portfolio is a manageable number, one that you could live with should the stars not cooperate.
• Go slow until you better understand how the options markets work.

I am looking forward to Adam Warner's comments on his blog Daily Options Report. He provides excellent commentary on options, and I expect that he will voice an opinion early next week.

In summary, be careful out there and do not blindly follow high return strategies that you see discussed in the media. Make sure you know how the markets work because you will be competing against those who trade for a living. This does not imply you should not purchase securities. Rather it means you must do your homework before you do.

According to WSJ article Fuel Rules May Aid GM, Ford: Overhaul Could Ease Burden On Makers of Big Pickups and SUVs (subscription required) the Bush administration is considering changing the rules to assist GM and Ford.

Current rules punish companies that rely heavily on sales of the biggest pickup trucks and sport-utility vehicles -- a category that is dominated by GM, with its Yukon and Tahoe SUVs, and Ford, which sells more than 900,000 of its F-Series pickups a year. These companies are forced to sell smaller trucks at smaller profit margins, or even a loss, to make sure they sell enough of the more fuel-efficient vehicles to bring their fleetwide averages up to the government's 21-mile-per-gallon requirement.

The government now calculates auto makers' performance by averaging their entire fleets' gas mileage. A complex rewriting of the rules, expected for release by Labor Day, seems likely to change that.

Under the proposed new regime, light trucks -- a category that includes pickups, SUVs and minivans -- would be judged against other trucks of similar size, though not by weight, according to auto industry and environmental lobbyists. Smaller vehicles would be required to meet higher mileage targets than larger ones. This shift would help domestic auto makers, while causing problems for Toyota, which has had an easier time meeting the current standards.

...

Important aspects of the overhaul aren't clear and could be changed. The administration could set a relatively high mileage standard for the biggest gas guzzlers, which would thrill environmentalists but hurt U.S. auto makers. It could also tighten the definition of a "light truck," now so vague that the PT Cruiser qualifies. And it could close a loophole that exempts any truck more than 8,500 pounds -- such as the Hummer H2 -- from fuel-efficiency regulation. When the original rules were written, nobody anticipated a truck that large would be used to pick up groceries. (A separate mileage standard for cars isn't under review.)

This move will help the GM and Ford in the short-run. But the reality is that with higher prices the demand for these monsters will lessen, especially if the economy weakens as many expect. If current oil prices of about $60 per barrel are sustainable, I expect we will see a shift away from SUVs and Hummers to more economical vehicles. I just typed environmental, Hummer into Google's search engine and got 180,000 hits. This is an example of the public focus on the gas guzzlers. So although GM and Ford may be helped in the short-run, to solve their longer-term problems will require much more than a simple fiddling with a few regulations.

I continue to remain short GM shares.

The Wall Street Journal article GM to End Employee-Discount Program outlines GM's latest development.

General Motors Corp. said it plans to end its successful "employee discounts for everyone" promotion next week. The company also signaled that it will embark on a new pricing strategy for 2006 models that will attempt to focus on permanently lower sticker prices instead of big rebates.

"It is our intention to end the employee-discount program on August 1," GM spokesman Jeff Kuhlman said yesterday. After two months of strong sales, inventories of unsold GM vehicles are at such low levels that the company doesn't have enough vehicles in stock to continue the program.

We see GM is going to abandon its discount program in favor of permanent lower prices. I don't put much stock in GM's assertion that it is running out of cars. Granted, I am sure that the program lowered inventory tremendously. However, the extremely low prices were also destroying profits. So now that the inventory issue has been addressed, GM is now going to try to raise prices and, it hopes, profits. But consumers is addicted to low prices, just as crack heads are addicted to crack.

Given GM's labor situation where it must pay laid off workers till the contract expires, Wagoner has little choice but to keep the factories humming, even if at just break-even. CNN article GM to cut 25,000 jobs by '08 states:

GM's UAW contract essentially forces it to pay union employees during the life of the contract even if hourly workers are laid off and their plants are closed. But those protections only run through September 2007, when the current four-year pact with the union ends.

I expect prices to remain low as Wagoner fights for concessions from the union. And I expect profits to remain elusive as low prices continue to remain the norm.

I remain short GM shares.

I just realized today that my quote marks don't show up for those of you using Internet Explorer. I often use the code

<q lang="en-us">blah blah blah</q>

expecting that the quotation marks will properly appear. Well, they do, just not for those of you using IE. After some consideration, I have decided to not worry about it.

That might seem a bit arrogant, but it isn't meant to be. I expect Microsoft will be releasing a new version of IE soon, and then this problem ought to magically disappear.

So if you are using IE and you think there ought to be quote marks, there probably are. It is just that IE doesn't support the quote tag at present.

If you have not tried Firefox, I strongly urge you to do so. It is much superior to IE.

I urge you, if you haven't already done so, to read Dr. John Rutledge's post No Strategery Here. His comments concerning China and how it is methodically moving forward are interesting indeed.

The one possible global exception to the above is China. Chinese politicians have shown that they have a longer-term point of view that we do in the US. (They of course do not have to worry about being reelected, do they.) That viewpoint gives them the patience to wait out western governments on strategic objectives. The Hong Kong handover was an example. Taiwan will be another. A third is their multi-objective approach to Chinese energy policy, simultaneously pursuing initiatives in Russia, Iran, Venezuela, Japan (the disputed gas deposits in the Sea of Japan), the US (Unocal), and other countries.

I just discovered his blog, and it has quickly become a favorite and a must read.