I spend a lot of time writing about income opportunities from options. My favorites tend to be selling naked puts against stocks I wouldn’t mind owning, or selling covered calls against stocks I own. These are great ways to generate income in addition to whatever capital gains that underlying stock may provide.
However, there’s a temptation to be mindful of when using these strategies.
Sometimes we go hunting for those juicy mega-premiums. I remember back during the Internet bubble of 1999, I would seek out these crazy high-flying stocks, buy them, and sell a covered call against it just so I could grab a $2,000 premium.
The problem was, back in those days, the underlying stock could move 40 points in a single day. I lost a lot of money holding crappy stocks with covered calls sold against them, and rode them down to almost zero.
Traps like that are still out there, so today I’m focusing on those bets you should not make using these strategies.
Netflix (NFLX). I’ve written about how I think Netflix (NFLX) is doomed, because it is ultimately the pawn of the studios, which will bleed all of its free cash flow dry over time. Its financial statements can’t mask a failing business. It has $5.7 billion worth of content obligations, of which $2.7 billion are due this year, and it has only $1 billion of cash on hand. The true believers will keep this stock afloat, but you never know when they might bail.
So it’s tempting to sell the NFLX August 205 naked put for $21, and pocket that $2,100 premium. Until, that is, Netflix finally admits it can’t pay that $2.7 billion, and you get the stock put to you at $205 when it’ll be much lower.
Likewise, if you think selling a covered call to hedge your downside is smart, such as the August 205 Call for $23, that $2,300 won’t mean much if the stock falls more than that.
On the other side of things, I think Amazon (AMZN) is a great company and will be here for the long run. The problem is that its stock is highly volatile and very much responsive to moment-to-moment perception. This baby could cut either way at the drop of a hat. If it misses a revenue number, the stock could fall by $40. That will be small consolation if you sold the August 270 naked Put for $14.
Likewise, if you sell the August 270 Call for $16, you’ll be pretty unhappy if the stock gets called away because Amazon reports a blowout quarter. Those big premiums just aren’t worth the risk.
I think if you’re in Amazon, you’re in it for the long-term, volatility be damned.
There’s a tendency for people to make big bets on companies when a CEO departs, as just happened to Lululemon Athletica (LULU). I am always watchful if a CEO or CFO departs, because unless the reasons are very obvious for the departure, I get very suspicious. The real story — if there is one beyond what’s been reported — will eventually come out. On the other hand, there might not be any more to the story. Thus, I wouldn’t make a bet either way.
So, if you think selling the September 65 naked put for $6 is a good idea, I’d be careful, in case there’s a secret we haven’t heard it about the departure. Meanwhile, selling a covered September 65 Call for $5.40 could end up being really dumb if the market’s selloff on the departure turns out to be an overreaction.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets @ichabodscranium.