The short answer is we get someone else to take the risk, while we keep most of the gain.
The long answer
We want to expose ourselves to the positive side of luck, and shun the negative side. If a stock goes up, we want to be right there riding it up, but if it goes down, we’ll get off and let someone else take that part of the trip. But we need someone to agree to take our place before the stock starts going down, because no one is going to agree after it goes down.
The way to do this is with put options. If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.
The no loss strategy
In a nutshell, the strategy is to buy a stock, and a put on that stock with a strike price near the current price (“near” in this case is usually at least 10% higher than the stock price, and often closer to 20% or 30% higher). The put will protect our investment value from going down, and we’ll be able to wait until the expiration date to see if luck happens to take our stock up and hand us a profit.
Since we had to pay for the put, this strategy will often end up in a net loss if the stock does go down. But we don’t want to take any losses. So lets switch out the stock for a dividend stock, and have the dividends on the stock pay for the put and cover any gap between the strike price and the current price.
A stock that can pay for its own put with its dividend isn’t too easy to find. It’s kind of like looking for a needle in a haystack. But assuming we could find these stocks, let’s look at the benefits of this strategy.
Benefits of put protected stocks
So assuming we can find one of these dividend stocks that can pay for it’s own puts, we now have a one way position. We are fully exposed to positive surprises like new products, high priced buyout offers, good earnings surprises, etc. And protected from negative surprises like scandals, lawsuits, bad earnings surprises, etc.
We’re also protected from inflation in a way. If prices in general are rising because of inflation, then the price of the stock that we own will also increase. So inflation is actually working for us in this case.
Lastly if an investor is willing to sell a cheap put on a stock, one that can be covered by that stock’s dividend, then that investor is indicating that they think the stock will not go down. And since no one else is buying that put at this cheap price, they don’t think it will go down either. So we get a nice little boost in that the market seems to think that the stock we are buying is not going to go down. And as the market turns around and investors gain confidence, more and more of these opportunities will become available.
It’s always good to know the risks of an investing strategy, no matter how remote they are. So let’s go through those and see what we can do to hedge against them.
One risk is that the dividend could be reduced after we buy. If the dividend were reduced before the expiration date of the put, then we would end up paying for the put protection out of pocket rather than with the dividend.
To hedge against this risk we can concentrate on stocks with long histories of paying dividends and generally stay away from high dividends that look like they are about to be cut.
Another hedge would be to look for put options with shorter expiration dates, as those put options will be cheaper and not so painful to pay for out of pocket. But we don’t want to go too short on the expiration or we’ll be paying too much in transaction fees.
Another risk is time risk. Consider the situation where we buy a stock and put combo that has an expiration date a year in the future, and then the stock drops 50% the next day because of some scandal, and it’s pretty clear the stock is not coming back any time soon. We would still have to hold on to the stock for the rest of the year to collect the dividends to pay us back for the put. That means that all the money in that stock is basically tied up for a year and not earning anything. Again the solution here is to go for the shorter-term expiration dates.
Another risk is not being diversified enough. We are basically fishing for luck here. We have a nearly zero risk of losing money, but most of the upside. So if we put all our money in one stock, and that’s the one stock that doesn’t go up, then we’ve missed out on the opportunity to make some gains. So we want to try to spread our bets on multiple different stocks. Since put options can only be bought in contracts of 100, you’re probably going to be buying stock and options in groups of 100 shares. So that’s probably a good amount to stick on each stock. Although if you just happen to have a feeling that a particular stock is going to rocket up, there’s nothing to keep you from putting all your money on that one and protecting the downside with this strategy.
Lastly there is the systemic risk. It’s extremely unlikely, but possible that the whole financial system could crash and that the exchange that guarantees the options would not be able to cover the options in the event that the original seller is bankrupt. If this really happened, we’ve all got much bigger problems, so it’s not really something to worry about, but it is there so I mentioned it to be thorough.
Get a magnet
So we’ve got the strategy, we know the benefits, and we know the dangers. The only thing left is to figure out a way to pull those needles out of the haystack. Best way I can think of is to use a magnet. Turns out I just happen to have written one.
I recently finished writing some code to sift through the haystack of stocks and pluck out those specific needles that match this strategy. However right now the output is just a spreadsheet. And it takes a fair amount of work to go from just a spreadsheet to a full-blown subscription service. Before I go through all that work, I’d like to know if anyone is actually interested in this service (other than me).
If you are interested please let me know by emailing me at firstname.lastname@example.org. And if you could, please specify answers to the following questions:
1) Does it matter if the service is displayed in a web page, or is a downloadable spreadsheet just fine?
2) What would you expect to pay for this subscription service?
3) How often would you want the spreadsheet updated? Nightly, weekly, monthly?
4) Do you want to be notified via this email address when the service starts taking subscribers?
I’m also looking for a few readers that are willing to help me refine this service. These readers would need to understand the intent of the strategy and be able to make suggestions for improvements. For example, if there is a specific piece of data that would be helpful, but is not currently being captured, you would send me an email request to add that data. If that sounds interesting to you, please mention it when you email the answers to the above questions.
Lastly, here’s an example from the most recent output.
Stock Price: $34.59
Annual Dividend Yield: 4.86%
Option Ask: $5.80
Option Strike: $40.00
Option Expiration: 11/21/2008
Dividends Expected By Expiration: $0.42
Minimum Profit: ($40.00 + $0.42 – $34.59 – $5.80) $0.03
Max Loss Without Dividend: ($40.00 -$34.59 – $5.80) $-0.39
Percent Gain Needed For Profit: ($40.00 / $34.59 – 1) 15.6%