Thoughts of a mechanical engineer turned programmer turned statistical investor. Here to save you from making mistakes I made at the beginning of my investing career.

Using short puts to open a position

Even though apple is trading at 170$, did you know someone is willing to pay you a thousand dollars if you are willing to buy apple stock for 120$?

Wait.. what?? Does that even make sense? Why would someone pay me to buy apple at 120$ when its currently at 170$? That sounds suspicious.

So let me explain. People are willing to pay you thousands of dollars if you are willing to buy apple for 120$, any time in the next 2 years. How does that sound to you? Suddenly not so sure? Maybe apple will tank next month (or any time in the next 2 years) down to 100$ (or maybe even down to 50$), and then you are forced to buy them for 120$, even though you could buy them on the open market for 100$. So thats exactly why people are willing to pay you thousands of dollars to buy apple at 120$. Because there is a chance apple will go below 120$ some time in the future, and then they can “put” the stock to you for 120$ and buy it for 100$ (for example), making 20$ in profit (minus whatever they paid you for the option).

But is agreeing to buy apple for 120$ any time in the next 2 years, assuming you get paid for it so bad? Lets think through this for a second.

Lets say you have 17,000$ you want to invest, and apple is trading at 170. You can buy 100 shares of apple. If apple goes down to 120$ you just lost 5k$, and if apple goes up to 220$ you just made 5k. This is the simplest stock investment strategy, buying stock of a company with the plan to hold it.

But what else can you do with that $17k? I will run through a couple of possibilities, its a bit technical but its literally the basis of investing, so take a couple focused minutes and stay with me.

You can dollar cost average into an apple position. Depending on what apple does in the subsequent time, this could work out better or worse than just buying the stock today, but probability says that this strategy has a higher rate of success than just buying today, over the long run. So if apple goes down to 120$ over the next 2 years and you dollar cost averaged you will have an average entry point of around 145$, and then with apple at 120$ at the end of 2 years you only lost 2,500$ instead of the 5k$ in the previous example. But in this case you still have 2500$ left over at the end of the 2 years, and with apple at 120$ you can buy another 20 shares, lowering your average cost more, and also when apple does go back up in the future (assuming you are planning to hold), you now hold 120 shares instead of the 100, so 20% more, for the same initial 17k$ sum, meaning that as apple goes up in the future, you hold a bigger piece. If apple had gone up from when you bough it, the same thing happens – you will make less than the 5k, and you will hold slighly fewer shares, but still you will make money. So dollar cost averaging sortof dampens the gains and losses, but in the case of losses it enables you to lower your average purchase price, and buy more shares. But without a doubt, especially when you’re starting your investment journey, its better to lose less money at the expense of missing out on higher potential gains.

But heres another option: you can promise to buy apple any time in the next 2 years for 120$, and someone will pay you say 1000$. This is called selling a put. 120$ is ~30% below what apple is trading at today. Lets look at the graph of apple for the past 10 years:

NO MATTER what point on the graph above you choose, 2 years later apple was higher. This means that if you had chosen this strategy during any of the past 10 years, you would have kept the 1000$ and continued on your way. So that strategy had a 100% success rate over the last 10 years.

In fact, instead of selling 120$ puts, you could have sole 170$ puts, gotten paid a lot (like several times more, like several thousand!) more for that option, and still had a 100% rate of success over the last 10 years.

1000$ is ~6% of 17,000$, so you earned 6% on you’re money over the last 2 years, or 3%/year. Now, 3% per year doesn’t sound very good, but lets go through a couple other possibilities.

Lets say apple over the next 2 years went up 10% each year.

  1. If you had bought the stock at the beginning, you would have made 10% each year. A lot better than the 3% you made selling the put.
  2. If you had dollar cost averaged in over the next 2 years, you would have made lets call it 5% each year. Still better than the 3% selling the put.

If apple went up more than 10% each of the following 2 years, obviously the differences in performance will be even stronger in favor of the other strategies.

But considering the economic environment we are in today, do you feel there is a high probability of apple (or the market in general) will go up 10% in each of the following years? Who knows, right? Thats because we’re in the present, and looking forward from here everything is unknown. We can only go by probabilities. Its easy to look back and say apple went up almost 1000% over 10 years, just buy it, but we don’t actually know, do we? We never do. So lets go over a couple other possible outcomes.

And seeing as its more important to not lose money than it is to gain more money, especially at the beginning (but also always), lets think about the some possibilities other than apple flying higher.

Lets say apple went up and down a bit throughout the next 2 years, and ended at 170$. If you had bought the stock or dollar cost averaged in, you would have made $0. With the put strategy, you still made the 3%.

And even worse still, lets say apple went down to $130 over the next 2 years, if you had bought the stock you would be down 23%, whereas if you sold the put YOU WOULD STILL BE UP 3% (because they paid you 1G), beating the pure stock strategy by 26% (!). And you would still have 18,000$ (cash), which you could now use to buy apple at 130$/share, instead of 170$/share. So you could buy 138 shares, or 38% more shares than if you had bought 2 years ago at 170. This means that for every dollar apple goes up from 130, you make 138$, instead of the 100$ you would have made for every dollar apple went above 170 if you had bought the stock 2 years ago. So its obvious that if the stock stays the same or goes down (even a significant amount), the put strategy is much (!) more successful.

And what if apple went down to 100$. If you had bought the stock, you would have lost 41% of your money (!!!). If you had dollar cost averaged, you also would have lost a significant amount of your money (most likely somewhere around 20%), depending on when apple went down. If you had sold the put, you would be forced to buy 100 shares of apple at 120$ (12,000$, this is called getting excecised, or getting “put” the stock), but you would still have 6000$ left over, and apple is at 100$ so you could buy another 60 shares. So you would own 160 shares of apple, for an average cost of 112$ ($18,000/160 shares). So if apple went up 6$ (from 100), you would already be even (ie back to a value of your original $17k). Whereas if you had bought the stock for 170$ you would have a lot (!) of waiting to do, possibly several years of waiting before you got back to a value of 17,000$. And you would only be holding 100 shares, vs the 130 or 160 you could be holding in the short put strategy.

So also in the case apple goes down a lot (here were talking about a drawdown of 41%), its much (!!!) more successful to use the short put position.

So what do you do? How do you choose a strategy?

For me, when analysing an investment strategy, the most important thing isn’t whether or not the strategy made money for a specific outcome. The important thing is how the strategy would perform in all the range of probable/possible outcomes, and if I’m comfortable with that performance.

Because No one knows what the market will do. Some people will speak with confidence, and they will be right some of the time, but also they will be wrong some of the time. And if the market (or a specific stock) went up 10% in a year, just like it went up 10% it could have gone down 10%. Or if it went down 10%, it could have gone up 10%. Or more in either direction. And then the question is how would the strategy have performed? If it performs decently in most/all probable outcomes, then its a good strategy.

Because in order to make a lot of money, its more important to get decent returns, consistently, than to get inconsistent returns. And the reason for that is the magic of compounding.

Morgan Housel, wrote an AMAZING article about the magic of compounding in his blog on the collaborative fund. In general I highly recommend reading everything Housel writes, hes insightful like very few people I’ve read, not just about the stock market but about philosophy, econonmics, and life in general.

So each person needs to decide for themselves how to weigh each of the possible/probable outcomes, based on where they are in life, their comfort with risk, their financial situation, etc. For example, younger investers may be more interested in capturing potential upside, at the risk of losing significant portions of their money, because they know they have a lot of time to make it back, and anyways most of their earning potential is in the future. Someone close to retirement who already saved enough money to retire may be focused first and formost of not losing any significant amounts of money, and because they already saved up so much, maybe they can live off of 3-4% returns, so they would rather get 3-4% returns with very low risk, than risk losing 10% of their money as that would ruin their retirement.

For me, personally, especially in the current global environment, I am much more comfortable making 3-6%/year in most probable outcomes, except for a situation where the markets tank more than 40%, and even then still drastically outperform the buy and hold strategy, at the expense of missing out on potentially better returns if the market goes up more than 3-6%/year.

NOTE: I wrote in the last paragraph 3-6%/year and not 3% because the 3% is the return using purely the short put strategy. Its possible to significantly improve that using slightly more sophisticated strategies, but thats for a different post.

In this post, I show my full portfolio, which is made up of several short put positions, and a couple of other strategies. Have a look, and leave any questions in the comments, I would be happy to answer.

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