Taking on Risk and Hoping the Strategy Doesn't Backfire
Thursday, August 25, 2016

Oh boy. There’s something new to be filed under the category of, “Well, it seemed like a good idea at the time.” It is cash secured puts on the S&P 500. According to The Wall Street Journal, pension funds in Hawaii and South Carolina are using the strategy to generate income. It is a strategy that works until the market incurs a sizeable drop. At that point, the feeling of regret will loom and the bottle of aspirin will be opened.

For those you not familiar with option strategies, a put option gives its owner the ability to sell an asset at a specified price within a certain period of time. A put contract on a stock with, say, a strike price of $50 and an expiration of December 2016 will allow the put’s owner to sell the stock at any point between now and the close of trading on December 16. (From a practical standpoint, options contracts on stocks expire on the third Friday of a calendar month). If the stock stays above $50 between now and mid-December, the contract will expire worthless since there is no reason for the put holder to exercise the contract when the stock can be sold on the open market at a higher price. If the stock were to fall to any price below $50 (e.g., $40), the owner of the put can sell the stock for $50.

One of the key things about options is that they are binding contracts. When an option is written, the writer is obligated to honor it. Furthermore, the writer of the contract has no control over when or if the contract will be exercised. The investor who purchases the contract has the sole right to exercise it. The put writer must buy the stock at the price specified in the contract (the “strike price”) no matter what the stock’s prevailing market price is. So, if a put has a strike price of $50 and the stock falls to $35, the writer of the put can be forced to buy the stock at a price of $50 per share. (It’s the opposite for a call strategy. The buyer of a call option can force the call writer to sell the stock at a below-market price.)

Writing options is profitable as long as they are not exercised. If the contract expires worthless, the option contract writer gets to keep the price of the contract (the premium), assuming this investor has not closed out the position beforehand. Should the contract come into the money—meaning it makes mathematical sense for the option buyer to exercise the contract—the buyer benefits. It is here where writing options can backfire, and the type of option written matters.

If an investor holds a stock and writes call options (a strategy referred to as covered calls), the investor gives up potential upside if the option is called. Assuming the investor wrote the contracts with a strike price above what the stock cost to acquire, a profit is made, though a smaller profit than could have been made if the contract hadn’t been written.

Conversely, all of the stock’s potential downside is taken on by the investor writing the put. Assuming the investor wrote the contracts with a strike price below what the stock cost to acquire, a profit can only be made if the premiums received and the proceeds from selling the stock exceed the loss incurred from being forced to buy the stock at a price below the put’s strike price. The fact that cash was set aside to cover the put in the event of the contract being exercised—as is the case with a cash-secured put strategy—does not change this outcome. A put writer’s only out in instances when the underlying asset falls below the strike price is to buy an offsetting call option and hope that the purchase price of the call option does not significantly exceed the proceeds received for the put option.

In blunt terms, writing puts is taking on risk and hoping the strategy doesn't backfire.

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Highlights from the AAII Journal

The Week Ahead

Just five members of the S&P 500 are scheduled to report: Brown-Forman Corp. (BF.B) and Salesforce.com (CRM) on Wednesday, and Broadcom (AVGO), Campbell Soup Co. (CPB) and H&R Block (HRB) on Thursday.

The week’s first economic report of note will be July personal income and spending, released on Monday. Tuesday will feature the June S&P Case-Shiller Home Price Index and the Conference Board’s August consumer confidence survey. The August ADP employment report, the August Purchasing Managers’ Index (PMI) and July pending home sales will be released on Wednesday. Thursday will feature August motor vehicle sales, revised second quarter productivity, the August PMI manufacturing index, the August ISM manufacturing survey and July construction spending. August jobs data—including the change in nonfarm payrolls and the unemployment rate, July international trade and July factory orders will be released on Friday.

Four Federal Reserve officials will make public appearances: Boston president Eric Rosengren and Minneapolis president Neel Kashkari on Wednesday; Cleveland president Loretta Mester on Thursday; and Richmond president Jeffrey Lacker on Friday.

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AAII Sentiment Survey

Pessimism among individual investors about the short-term direction of stock prices is at a two-month high in the latest AAII Sentiment Survey. Optimism fell to back below 30%, while neutral sentiment rebounded modestly.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 6.1 percentage points to 29.4%. Optimism was last lower on June 29, 2016. This is the 75th week out of the past 77 that optimism is below its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 2.9 percentage points to 40.9%. The rebound puts neutral sentiment above 40% for the fourth time in five weeks. It also keeps neutral sentiment above its historical average of 31.0% for the 30th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.3 percentage points to 29.6%. This is the highest reading of pessimism since June 29, 2016 (33.4%). The increase is not large enough to prevent bearish sentiment from staying below its historical average of 30.5% for the eighth consecutive week, however.

This week’s decline in optimism follows what had been a five-week high. Meanwhile, pessimism rose from what had been a five-week low. Though the major U.S. indexes were relatively unchanged over the past seven days, concerns about valuations and the presidential election continue to temper individual investors’ expectations. Also keeping some individual investors bearish or at least giving them reason to be cautious are global economic uncertainty and disappointment with corporate earnings growth. Giving other individual investors reason for optimism are this summer’s upward movement in stock prices, the perceived lack of investment alternatives, corporate earnings and sustained, albeit slow, economic growth.

This week’s special question asked AAII members how second-quarter earnings have influenced their outlook for stock prices. More than four out of 10 respondents (41%) said that quarterly corporate profits have not altered their outlook. Reasons were mixed, though some said the presidential election is having more influence, while others said short-term results do not alter their long-term outlook. Slightly more than 17% said that second-quarter earnings had a positive influence on their outlook for stock prices. About 13% described themselves as being more cautious or are otherwise pessimistic about the direction of stock prices following second-quarter earnings season.

Here is a sampling of the responses:

  • “Not earnings, the election!”
  • “Looks like lipstick on a pig for the most part. Meeting lowered expectations is not a plus.”
  • “My outlook was for very slow growth, so earnings have done nothing to change my mind.”
  • “I expected slightly lower earnings overall, but for specific stocks, earnings seem to be inconsistent.”
  • “Earnings have been better than expected, which caused me to reassess my position from bearish to neutral.”

This week’s Sentiment Survey results:

Bullish: 29.4%, down 6.1 points
Neutral: 40.9%, up 2.9 points
Bearish: 29.6%, up 3.3 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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