Stop Working: Here's How You Can!

[Taggart]

Some of us have had to leave the buy and hold camp, and I can understand why. However, aside from making a few minor adjustments over the last few months, I certainly haven't made any wholesale change. I still see dividend growth investing as a valid strategy, and that's the way I will continue to run the taxable account.

[2 yen]

In one way, I can understand why Foster lost his nerve. The last eight weeks have been very, very hard. I sold much of my financial dividend payers for a loss and will miss out on much of the upside in financials when a rebound occurs. The plus side is that I am now sleeping much better knowing that if the better Canadian banks do indeed cut or suspend their dividends, I can still probably retire when I want to. This is no small thing. Foster, because of his books, may have felt even more pressure to protect his "retirement", if that's what we can call it. The rather bitter irony to date is that of my holdings, only one dividend cut has happened (RUS) and one trust has decreased distributions (COS.UN). Everything else is just as it always has been. I suppose I am saying through my selling actions that the future from this point is not at all clear and with TD Bank saying half a million Canadians will lose their jobs this year, it is really hard to see where earnings are going to come from to support dividends and distributions, especially bank dividends. Maybe Foster can be cut a little slack because of the shocking crash that is happening.

[DanH]

"I think it's a terrible strategy. I think retail investors should not play with options, that's the bottom line," says Norbert Schlenker, president of Libra Investment Management in Salt Spring Island, B.C.

Sigh.

I didnt' have a stop watch going but I believe I spoke with John Heinzl for 30-45 minutes and then followed up with a long email about why naked put writing is insane IMHO. For reasons of space, it all gets distilled into that little sound bite.

That's pretty typical Norbert. Sometimes it's frustrating but the reality is that there is very limited space. After lengthy conversations with journalists, I often highlight my main takeaways to help them distill the jist of my message.

By the way, I was batting this topic around with a colleague yesterday and what my more intelligent colleague reminded me of was that Derek is not writing naked puts. He has the cash proceeds from his liquidation to back up any exercising of the puts. I agree that the strategy is fraught with risks. But you have to give the guy credit for one thing: he could have kept quiet about this and avoided the backlash he seems to get no matter what he does or says.

[OptsyEagle]

Danh wrote:

Derek is not writing naked puts. He has the cash proceeds from his liquidation to back up any exercising of the puts.

I believe naked put selling is when one is not currently short the positions that they are selling puts on.

In any event, I do not understand why a guy that is so pessimistic, looking for more downside, would want to sell puts. For a few premium dollars he has exposed his entire cash holdings to this down market (in effect he is not actually out of the market), but prevented himself from participating in any upside or dividends.

I never like this plan myself. It would work in a sideways market but that is just as difficult to predict.

[Bylo Selhi]

But you have to give the guy credit for one thing: he could have kept quiet about this and avoided the backlash he seems to get no matter what he does or says.

He, um, literally authored his own credibility misfortune when he wrote his first book under the premise that anyone could retire young while failing to warn about (or maybe even appreciate) the considerable risks he took to get there.

Ditto his current put strategy. If it works he'll be lauded even though it isn't appropriate for the vast majority of his audience. And if it fails he'll deservedly get even more backlash.

[village_idiot]

I was very happy to purchase one of these mis-priced bonds the other day on the TW Waterhouse fixed-income website.

Unfortunately for me -- it was mispriced! I got a phone call from TDW the next day cancelling my trade!

There are some very good yields on bonds - huge mispricing in the markets. for example RBC DS offered me a CIBC bond earlier this week that yeilded 9% to maturity (10 years). Similiar GofC were in the 1.8 to 2.1% range.
You woud have to assess your comfort level with the risk. But obviously someone somewhere has assigned a huge risk premium.
I didn't take it because I think I can do better over the next 10 years in equities. Eevn though I think CIBC will be around I wouldn't put much money on it.

Cheers

[Taggart]

But you have to give the guy credit for one thing: he could have kept quiet about this and avoided the backlash he seems to get no matter what he does or says.

He, um, literally authored his own credibility misfortune when he wrote his first book under the premise that anyone could retire young while failing to warn about (or maybe even appreciate) the considerable risks he took to get there.

Ditto his current put strategy. If it works he'll be lauded even though it isn't appropriate for the vast majority of his audience. And if it fails he'll deservedly get even more backlash.

I wish Foster the best of luck, but if he runs out of money he may be forced to go back to the workforce whether he likes it or not. He wants his freedom, but he now has a family to support. At least when Paul Terhorst retired with his wife Vicki at the age of 35, he said basically if worst came to worst, he could always go back to work.

[Icarus]

So why don't you post the e-mail here?

Norbert, can I second that request? I haven't read the book but the idea of writing cash-covered puts along the lines of what people have been describing is an idea that had occured to me, too. The basic idea was that if you're buying and holding with periodic purchases, your purchases are basically random anyway. I find that often when I buy I miss the market bottom (since purchases are separated by months.) I figured that you could get paid to put in bids lower than you'd take if you were buying today.

I understand the downside risk: that you may pay more than what you would pay if the market tanks. I don't understand the Black-Scholes equation well enough to analyze it, but I assume it takes this consideration into account when pricing puts.

Anyway, it was always just a thought and I was far from acting on it, but if you've written something thoughtful, why waste it?

[Chuck]

Ditto his current put strategy. If it works he'll be lauded even though it isn't appropriate for the vast majority of his audience. And if it fails he'll deservedly get even more backlash.

And if he's playing with options how are we ever going to know if it's working or not?

In total, I earned $1,150 Canadian and $2,430 US in option premiums
(less around $60 Canadian and $200 US in commissions)
In total, this works out to around $4,000 Canadian in one month.

That doesn't tell me anything. Did he get assigned the stock in any of these cases? Or is Foster going to expect me to believe he can call the direction of short term options correctly 100% of the time. I'd call BS on that no matter who said it.

So if he made $4000 in premiums but say on one position got assigned 1000 shares at $5 above market price (so on paper he has a $5000 loss) did he make any money or not? I'd say not, but I doubt we'll ever see this data.

[scomac]

Ditto his current put strategy. If it works he'll be lauded even though it isn't appropriate for the vast majority of his audience. And if it fails he'll deservedly get even more backlash.

And if he's playing with options how are we ever going to know if it's working or not?

I'm sure we'll hear all about it if he is successful.

In total, I earned $1,150 Canadian and $2,430 US in option premiums
(less around $60 Canadian and $200 US in commissions)
In total, this works out to around $4,000 Canadian in one month.

That doesn't tell me anything. Did he get assigned the stock in any of these cases? Or is Foster going to expect me to believe he can call the direction of short term options correctly 100% of the time. I'd call BS on that no matter who said it.

I guess that's my fault as I didn't provide the contract details. IIRC there were 3 Cdn. contracts and a half a dozen or so US contracts. I'm pretty sure that they all expire Mar. 20/09. Based on the strike price of the various contracts he listed, all were out-of-the-money and as such none would have been assigned to date. I should point out that the strike price on these various contracts were all well below market.

As an aside, I was looking into writing some covered call options for some Cdn. blue chip stocks that I hold and the premiums for in-the-money call options were very, very high on the securities I looked at. The sorts of premiums that Foster is getting for these puts were a fraction of what the open interest call contracts were. Perhaps adrian2 or iluvnascar might care to comment.

[steves]

Maybe a 4th book is in the works.... "Quit Work: Join the Derek Foster Class Action Lawsuit"

[Norbert Schlenker]

For Shakes and Icarus ....

[This is based on an old argument that I had with optionable68 just after FWF got underway, so it may seem familiar.]

There is a standard pitch to convince an investor that the [naked put selling] strategy is worthwhile and it is really hard for the average person to see the flaw. (Most flaws in option strategies are statistical in nature, beyond the understanding of most investors, so arguments for and against in this realm are almost never used with Joe Retail. The Joe Retail argument is usually simpler – “Well, sure, on average it won’t work but you’re not average, right?” – and carefully skates around some significant problems.) The reason I saved this particular back-and-forth is because there is only simple arithmetic involved. I never had to get into statistics or costs or Black-Scholes. I just constructed a simple example to show how a strategy where things apparently go right in every circumstance still results in underperformance.

The original argument for put writing goes as follows. This is the specific example I was presented with and the argument for why it should work. It’s brilliantly constructed and it’s not easy for the average person to see what’s wrong with it. It looks so easy, so conservative, so reasonable.

QUESTION: Why would anyone buy a highly liquid stock when they can instead sell an at-the-money-put?

Lets look at an example. Say that stock you always wanted to purchase was historically too expensive, but it finally approaches a price you are ready to buy it at, say $10.

You have 2 choices:

1. You could buy the stock and hope it rises over time,

2. Sell the 3-month $10 cash-covered put for $1 and invest the proceeds and your available cash outlay at the risk free rate. Incorporating 10% downside risk mitigation in the process.

Which would you do?

Before you reply, I would suggest you should conduct a scenario analysis of what can happen to the stock between today and option expiry.

Turn the clock to option expiry.

1. If the stock is over $10 you keep the premium, the original cash, and the interest earned (on both the premium and the original cash) at the risk free rate.

2. If the stock is $9.01-$9.99 you get put the stock at an average price of $9 and still have a gain.

3. If the stock is $9, you break even.

4. If the stock is below $9, your loss is considerably less than the loss you would have endured had you just went out and bought the stock.

That’s an exhaustive list of the scenarios that are possible and in every case it looks good. What could possibly go wrong?

We have a liquid $10 stock and a 3 month put option that can be sold for $1. We’re interested in owning the stock and the question boils down to, "Why not sell the put instead of buying the stock? Take the free dollar."

Let me show you why the scenario analysis is flawed. It's not just that the stock might never dip to $10 and then rocket off to $20, you having never gotten in. That happens to straight stock buyers with limit orders too.

The single biggest problem with the analysis is that it is an either-or example where success on one side is defined as "I lost less money than the stock buyer", while on the other side it's defined as "I made money". It's a mix of apples and oranges and is analytically meaningless.

A simplified example of why is to suppose that one is doing this with two different stocks simultaneously, call them A and B, both around $10, both with puts that can be sold for $1. I, the straight stock buyer, start with $20, and buy one share of each outright. You, the naked put writer, start with $20 too. You sell two puts, one on A and one on B.

A goes to $5, B goes to $15. Let’s review the results. On A, your analysis says, “Your loss is considerably less than the loss you would have endured had you just went out and bought the stock.” This is true. I lost $5 and you lost only $4. On B, your analysis says, “You keep the premium, the original cash, and the interest earned.” This is true too. On this position, the naked put writer made $1 in premium.

But what happened overall? Sell out all the positions in both our accounts and let's see where we ended up. Mine is simple. Sell the A for $5, the B for $15, and I have $20. I made nothing.

How about your account? You started with $20. You collected $2 in option premiums. You were put the A, paying $10 for it. You were never put the B. You end up with $12 plus the share of A, which is worth $5, i.e. $17, i.e. you lost $3.

By adding apples and oranges, you have convinced yourself that you are winning with both A and B, once relatively, once absolutely. Yet my account is flat and you’re out 15%. How did that happen? Your scenario analysis says you win always (relative to me in some circumstances, absolutely in others) and lose never, yet you have come up short.

In the end, I doubt I convinced him. Nevertheless, he was wrong. (He was even more wrong once costs are taken into account.)

Derek Foster has misled himself in exactly this way. You can see it yourself in the thread that scomac linked at CB. He's writing naked puts on a dozen different positions, total face about $400k, and thrilled to be collecting $4k in premium every month. What we don't see is the occasional time when this all goes terribly wrong. He hints at it wrt BAC but let's just estimate back of the envelope how bad it can get.

Foster started doing this last fall. BAC is in the high 30s, so he writes a naked put on 1000 shares at 35 and collects 50 cents a share in premium. Let's say he's doing it with a dozen stocks then too, but only BAC falls out of bed. Altogether he collects $4k in premium. As we all know, the wheels come off in October and BAC is $20 virtually overnight. He's lost $15k on that put. So the $4k sure thing monthly income is suddenly an $11k loss (presuming that the other 11 stocks aren't in the same boat, which isn't a good assumption recently, no?)

Am I surprised by Foster's attitude? Not really. The book is titled "Money for Nothing" and he seems to believe that's what naked put writing provides. I doubt I could convince him of it any more than I was able to convince optionable, but he is still wrong.

Underlying almost every Joe Retail's understanding of options are two very simple beliefs: My counterparty doesn't know what he's doing and (for writers) he's paying too much to lay off an inconsequential risk. Both of those beliefs are wrong and, while everything may look fine in the short run, the long run effect is to siphon money out of Joe Retail's (and Derek Foster's) pocket.

[Shakespeare]

IIRC, I sold an option once (a covered call). I got called. After thinking about it for a while, I concluded the other guys were the sharks and I was the bait. I never again dealt with options.

[scomac]

I could really use your help right now, Norbert. Instinctively, I know that Foster is discounting the amount of risk he is assuming, yet to date I haven't been able to provide an argument he will buy let alone acknowledge. It would be really great if you would join in the discussion on the CB forum if only in this one instance as you seem to be the most knowledgeable about options of all the participants. AFAIC this has become a moral hazard issue with Foster and yet he views that as a rant on may part. I don't care what happens with him one way or the other, but I am concerned that others could be hurt deeply and materially by following his course of action that is outlined in his latest book.

[deaddog]

I could really use your help right now, Norbert. Instinctively, I know that Foster is discounting the amount of risk he is assuming, yet to date I haven't been able to provide an argument he will buy let alone acknowledge. It would be really great if you would join in the discussion on the CB forum if only in this one instance as you seem to be the most knowledgeable about options of all the participants. AFAIC this has become a moral hazard issue with Foster and yet he views that as a rant on may part. I don't care what happens with him one way or the other, but I am concerned that others could be hurt deeply and materially by following his course of action that is outlined in his latest book.

What it is this CB forum???

[scomac]

What it is this CB forum???

Canadian Business.

http://forums.canadianbusiness.com/index.jspa

The discussion is taking place under the following thread:

http://forums.canadianbusiness.com/thre ... 6&tstart=0

[brad911]

I could really use your help right now, Norbert.

I'll even invite any knowledgeable investor with respect to options to help co-author a post as an update to my article on The Foster Effect.

The fact that published media (G&M, TS, etc) doesn't want to really take this issue that Foster has made out of risk seriously makes me very unnerved. I've already suggested to Scott that I would be more than willing to provide a broader outlet by publishing and submitting an article on my site & to major media sources in an effort to get out "the other side of the story."

Emotions removed, I feel this would be a very useful tool/perspective for investors not aware of the dangers that could plague them by following Foster's strategies.

Canadian Capitalist linked to my previous article on Foster's teachings and by the traffic there appears to be adequate interest in an objective view of his teachings. I think that this new "Money for Nothing" strategy is a serious danger to investors in this market especially when you consider the limited/no upside for taking unlimited downside risk

[jay]

I have an average Math background and I can understand Norbert's argument. Thanks Norbert!

brad/scomac: I think the author of Michael James on Money can present a valid mathematical argument against put selling. Reading his blog one can easily conclude the author has a thorough knowledge of Mathematical concepts related to anything in investing, including options. He also discusses Foster's strategy in one of his posts at http://michaeljamesmoney.blogspot.com/2008/11/money-for-nothing-and-your-stocks-for.html

Confession: I did think a few times about selling put options on XIU as I feel it is less risky to trade options on indexes than to do on stocks. I never had the guts to do it.

[squash500]

Thanks for all the informative posts in this thread .

Especially by Norbert, Scomac, Brad and Jay

I've certainly learned a lot .

[stopwork]

Norbert,

I respect the response you made - very practical and not a flame or rant...and you also reveal whom I'm posting with.

I already posted on the other board, but I'll cut and paste here also...\\

Your example assumes one stock rise and the other falls by $5 and I sold "at the money" puts and received a $1 premium. First off, I only sell deep "out of the money puts", but let's set that aspect aside for the time being and simply focus on your initial example.

Let's look at a few scenarios (again using simple math)

The First Scenario

Suppose stock A rises from $10 to $11 while stock B declines from $10 to $9. In this case, the investor who bought both stocks at $10 breaks even (one stock worth $9 and the other worth $11 = $20).

However, the investor who sold put options has earned a $2 premium (from your example), and owns a $9 stock and still keeps his $10 cash which was not used to buy the other stock. In total, he has $21 (plus interest earned minus commissions) for his effort.

The investor who sold put options finishes ahead of the investor who simply bought both stocks.

The Second Scenario

Suppose both stocks A and B fall in price to $9 each. In this case, the investor who bought the stocks outright now owns 2 stocks for a total of $18.

The investor who sold put options also owns 2 stocks worth $9 each (for $18). BUT he also received $2 in premiums, so he is left with $20.

Again, the investor who sold put options finishes ahead of the investor who bought the shares outright.

The Third Scenario

In this case, we assume both stocks rise by $1 each.

The investor who bought both stocks at $10 now owns 2 stocks worth $11 (or $22 total).

The investor who sold put options has his original $20 pluse the $2 in premiums he received for a total of $22.

In this case, both investors finish even.

Now we can change the numbers around to make one strategy win over another by varying the percentage losses or gains - but this is simply an example following the one you outlined on the other thread. In real life I would only sell deep "out of the money" puts, so I once again state that this reduces my upside potential (if the stock zooms higher), but also reduces the downside (similar results to the idea of Warren Buffett "waiting for the perfect pitch")

Cheers (respectfully),

Derek Foster (author "STOP WORKING", "The Lazy Investor", and "Money for Nothing")

[desk4811]

I think I read that he took out (he said) about $430,000 from the market. Now's the time, with bank dividends high and interest rates low, that he should test his theory. Which proves that it didn't work in the first place or perhaps it takes more courage to follow it through.

[NormR]

This argument might be a bit on an anathema to many here but what the heck. Norbert can rap my knuckles for it.

Isn't selling deep out-of-the-money puts essentially courting high negative momentum stocks?

That is, if the option is exercised then you'll wind up holding a collection of very poor recent performers. The negative momentum effect points to the continued decline of such stocks. At least in the short term (about a year).

Negative momentum seems to form the bulk of the well-known momentum effect. Some quant hedge funds like to go long positive momentum stocks (recent good performance) and short negative momentum stocks (recent bad performance). Most of the alpha, or return, from such strategies comes from shorting the negative momentum stocks.

(Behaviourally, people are reluctant to sell their losers which argues that stocks don't correct to the downside as fully as they should given a particular piece of bad news.)

Similarly, one put sellers can also get caught by Taleb-style black swan events.

So, the 'selling deep out-of-the-money puts' strategy is likely to move a portfolio into negative momentum stocks over time. If the stock is held for a very long period, say 5+ years, then the momentum effect should get washed out or mitigated. But if the stocks are held for shorter periods, say months or a year or two, then the approach is likely to get one perennially trapped in negative momentum hell.

Now there's an argument that you don't often hear around these parts.

Anyway, good on Derek for engaging in the debate. He's a nice guy. So, I humbly suggest everyone argue about the strategy and not the person. Let's keep things civil.

[Shakespeare]

I really don't see why a strategy with unlimited left-tail black-swan risk and capped upside should be entered into. We know that the probabilities aren't normally or log-normally distributed, and a blowup of the whole portfolio is a distinct possibility that cannot be accurately estimated but that has profoundly negative results. At least with a conventional equity/bond portfolio, the bond component caps the downside and the upside of the equity portion is uncapped.

[ghariton]

Just playing arounda bit with the algebra, and using the notation used by John Hull in his book, let S0 be the current price of a stock, ST the price of the stock at maturity T, K the strike price, and r the risk-free rate of interest.

Let q be the probability that at maturity ST > K, and (1 - q) the probability that ST < K.

Suppose two investors have a sum of money S0 at time 0. Then the expected value at time T of the position of an investor who sold a naked put for a price P, is

q times (S0 + P)exp(rT), plus

(1 - q) times K + Pexp(rT)

i.e.

q * [(S0 + P)exp(rT)] + (1 - q) * [K + Pexp(rT)].

The value of the position of an investor who merely used the S0 at time 0 to buy a share is ST.

It follows that the writer of the put is better off if

q * Pexp(rT) + (1 - q) * K + (1 - q) * [K - S0exp(rT)] > 0

If the put option is deeply out-of-the-money, then he better hope that the probability q is quite high, or that the price he receives for the option P is very high. Fooling around with Black-Scholes (imperfect since it is designed for European style puts and assumes a Weiner process, but still informative), suggests that P will be pretty small relative to S. So he is essentially placing a significant bet on the movement of the stock price.

Note that this line of argument does NOT depend on the notion that selling a put allows you to buy the stock at a discount at a future time. If you believe that the stock price will be going down, you should be selling short, which gives you more or less the same result on the downside.l What you are really doing is making a bet on the upside, i.e. that there will be no significant upside.

Indeed, in rough terms, this writing of a put reduces to selling all of the upside for the premium P on the put. That may or may not be a bet one is willing to take. But it is certainly not costless (in terms of expected returns foregone).

George

[Taggart]

Norbert:

I'm culling the following from what you wrote on the other site:

"You may not remember but we met briefly in Toronto last June where you spoke to a few people during the Moneysense makeover. I expressed skepticism then about your claims re the safety of blue chip dividends......."

That's the part I personally would be interested in, so I hope you follow through.