Thursday, January 19, 2006

Put Writing and the Value Investor

I found an interesting post on put writing earlier today and thought I shuld bring it to your attention.

Link to Mr Market

I agree with "Mr. Market," who incidently has put together a very worthwhile blog. The ability to buy stocks at below current market prices should not be ignored.

In some ways I view this as an insurance writing business. As a put writer, I collect a premium from the buyer who fears the risk of the stock dropping in price. When markets or individual stocks become more volatile, the premium that I collect obviously expands. As time marches on, the time value decays and ultimately, the put either fades into nothingness, or I am forced to exercise, and I own the stock at a much more attractive price than the market would have provided me initially.

Admittedly, with low volatility as evidenced by the VIX, premia have shrunk and the strategy is not as rewarding as it has been in the past.

Nevertheless, capturing a premium to allay someone elses fear is a worthwhile pursuit.

Remember, there is nothing to stop the stock in either direction. If the stock moves up from initial levels, you have simply collected a premium, you have no equity position. If the stock drops below the exercise price, you will be exercised and own the stock, but it the exercise price could well be above where the current market for the stock lies.

This is a strategy that is only suited to those with sufficent capital to absorb the necessity to purchase the underlying stock. It should not be thought of as an income strategy because ultimately, you will be put the stock.

One of the comments is that with low volatility and relatively cheap time premia, one should consider buying calls instead. I view this as a riskier strategy: you do pay a time premium rather than simply pay the current market price. This does not give you a below market entry price for the stock., and consequently, I view this as contrary to a value strategy.

A client of mine once said it best,"The only advantage in buying calls is that I know not only how much I will lose, but also when!"

Put the declining value of time premium in your wallet, sell the nervous investors insurance...write puts!


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