Options Trading: Why Selling Puts is a Trap

I understand the problem…

You want income. But low interest rates destroyed traditional income investments. Rates are higher now. But you’re worried that they will fall again.

When rates were low, you looked for alternative income strategies. You may have bought income stocks. But then you realized that a 3% dividend yield wasn’t enough to offset the 20% decline in the stock’s price.

You might have added REITs to your portfolio. Then you got a tax form telling you that part of your dividend was actually a nontaxable return of capital. Unless you’re a CPA, you might not have known what this meant. Basically, it meant that part of the dividend wasn’t taxable income for that year. Instead, it lowered your taxable basis in the REIT and will be taxed later, when you sell.

No one warned you that REITs could complicate your taxes, and now you’re annoyed.

So your search continued. You thought about buying an investment property. Many people do that. Some like their returns. Others find the returns never match expectations since unexpected maintenance or other expenses reduce income. Plus, there’s tax complications.

Although you learned a few things that didn’t solve your problem, you still didn’t have a solution for income. You kept searching. After reviewing preferred stocks, various types of notes and other assets, you still didn’t have the right answer.

So at this point, like many investors, you may have looked at options for income. Selling puts looked like a good idea, at first…

Why Selling Puts Is a Trap

If you followed the strategy of selling puts, you likely earned steady returns in the beginning. But then you suffered a big loss — and that single loss wiped out three months or more of income.

This is the experience of many option income traders.

Selling puts is appealing at first glance. Put options increase in value when prices fall. If you buy a put, you can profit in a down market.

Because they rise when prices fall, puts decline in value when prices rise. If you bought that put, you will lose money if the underlying stock rises.

Since stocks go up more than they go down, some investors think that selling puts seems to be more profitable than buying them. Those who sell puts are betting that the underlying stock will trade above the strike price at expiration so that the option expires worthless and they can keep the premium.

Some traders believe put selling is a high probability trading strategy. They claim it has a win rate of 75%.

Years ago, I tracked down the source of that claim. It was a study using data from 1997 to 1999. But it didn’t look at stocks.

That study looked at options on futures contracts. It found that 76.5% of options on futures held to expiration expired worthless. I’m surprised the number is so low.

Only contracts open on the expiration date were included in the study. Winners or losers closed before that day were excluded.

I went through exchange data and found that just 5.5% of all contracts traded during those three years expired worthless.

Now we know that the data shows you can’t expect a contract to expire worthless. Yet, this is the foundational belief of many traders who use this strategy.

It’s a strategy that breeds complacency. It’s not uncommon for traders to win more than 80% of the time. Then something happens — maybe it’s a pandemic that sends almost all stocks lower. Or it could be a bad earnings report for a stock you sold options against. It could be a bad earnings report for a competitor that sends the sector lower.

There are hundreds of ways these trades can go wrong. And when one of those things happens, large losses occur.

The good news is that we have ways to limit those risks. In the Trade Room, I employ a certain low-risk income strategy that has generated income of more than 40% last year. And that’s actual results, not a backtest or hypothetical trades.

Next week here in Banyan Edge, I’ll explain exactly what this strategy is and how you can use it to collect safe income in any market environment.

Regards,

Michael Carr's Signature
Michael Carr
Editor, Precision Profits

 

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