Getting Paid to Invest in Stocks by Trading Sell to Open Put Options

In my latest blog entry, I told you how we were sitting at headquarters, purchasing as many equities as we could reasonably afford as Wall Street degenerated into a total meltdown. Having seen the greatest slide since the 1933 stock market crash, we were deliriously happy with the bargains we were finding. Throughout the far-flung reaches of my various enterprises, and personal accounts of certain family members, we were acquiring at a furious pace.

Today, I'm going to discuss one strategy that we've been using lately to generate such high levels of profitability that we joke that we are minting money at headquarters. Each morning, I show up and bring in massive sums of cash by simply engaging in transactions that I would have, anyway, due to lower stock prices. This strategy is not for beginners. It is not appropriate for most people. Given the intellectual curiosity that many of my long-time readers have displayed in their comments and emails, I thought it would be cool to give you a glimpse into how we are earning 30%, 40% and higher returns on unleveraged equity in these extremely volatile markets as pricing for risks in some assets has lost all connection to rationality. Put plainly, do not try this at home. It is simply for your own edification and an understanding of how you can sometimes find extreme values by exploiting the knowledge you've built up about various businesses through your years of studying their annual reports, 10k's, and other SEC filings.

An Example of The Sell Open Put Strategy

One of my private corporations is a stockholder of Tiffany & Company. We'll choose them to explain this concept because they are a brand that most people understand, have some experience with in their daily lives, and the business itself is simple.

As of the close of markets on October 14, 2008, shares of Tiffany & Company are selling at $29.09 each, down from a high of $57.32 prior to the crash on Wall Street. Investors are panicked that the retail environment is going to fall apart and that high end jewelry is going to be one of the first things to go because consumers aren't going to buy expensive watches, diamond rings, and housewares when they can't pay their mortgage. Yet, what if you had long wanted to own part of the business, and had been waiting for just such an opportunity? Sure, you realize the stock could very well fall another twenty, thirty, fifty percent or more, but you are looking to profit from your equity ownership of the jewelry store for the next ten or twenty years. Could there be a way to take advantage of the situation and generate higher returns for your portfolio?

You could just call or login to your broker and buy the shares outright, pay cash, and let them sit in your account with dividends reinvesting. Over time, if two hundred years of history has been any guide, you should experience a comparable rate of return to the performance of the underlying business. Thus, if you wanted to buy 1,000 shares, you could take around $29,090 of your own money plus $10 for a commission, and use the $29,100 to buy the stock.

There is a more interesting, and perhaps even more profitable, way to put your capital to work. Using a special type of stock option, you can actually write "insurance" protection for other investors who are panicked that Tiffany & Company will crash.

Sell Open Put Options on Tiffany & Company

Right now, for instance, investors are willing to pay you an "insurance" premium of $5.80 per share if you agree to buy their stock from them at $20.00 per share.

As of today (October 14th, 2008) you could write a "contract" covering 100 shares of Tiffany & Company stock in which you agree to sell another investor the right to force you to buy their shares at $20.00 each any time they choose between now and the close of trading on Friday, January 15th, 2010. In exchange for writing this "insurance" that protects them from a total catastrophe in the price of the jewelry store shares, they are willing to pay you $5.80 per share. This "insurance" premium is yours forever, whether or not the contract is exercised (that is, they force you to buy the stock).

It might be easier to understand giving you an actual scenario. Here's how it would work:

• Imagine that I took the $29,100 that I would have invested in the stock by buying shares outright and instead agreed to "sell open" put options (that is, write insurance for other investors) on Tiffany & Company shares with an expiration date of the close of trading on Friday, January 15th, 2010, at a $20.00 "strike price" (that is the price at which they can force me to buy the stock from them).

• I call my broker and place such a trade for 20 contracts. Recall that each contract includes "insurance" for 100 shares, so I'm covering a total of 2,000 shares of Tiffany & Company stock.

• The moment the trade is executed, $11,600 of cash, less a small commission, will be deposited into my brokerage account. It's my money forever. It represents the premium the other investors paid me to protect them from a drop in Tiffany's stock price.

• If the stock price falls below $20 per share between now and the expiration date, I might be required to purchase 2,000 shares at $20 per share for a total of $40,000. On the upside, I've already received $11,600 in premiums. I can take that money and add it to the cash I was going to invest in Tiffany & Company common stock ($40,000 total potential commitment - $11,600 in cash received from investors = $28,400 potential capital I'll need to come up with to cover the purchase price if the option is exercised. Since I was going to spend $29,100 buying 1,000 shares of Tiffany & Company, that's fine).

• I immediately take the $40,000 and park it in United States Treasury Bills or other cash equivalents of comparable quality that generate interest income. This reserve is there until the end of the option contract.

  Here's how this position could work out for my account (click on the next page to continue reading):