I’m a naked writer. I don’t mean that I write with no clothes on, although occasionally when I can’t sleep I get up and go to my computer.
What I mean is that I sell puts on certain stocks in an effort to acquire them at below market price. Selling puts is called “writing,” and if you sell them without any hedge it is called “naked.”
I’ve been reading a lot about the housing market. Most of it is pretty negative, but recently it seems that homebuilding might be ramping up again.
Like with everything else, as I wrote last time, there is an exchange-traded fund (ETF) that is a collection of stocks involved in the homebuilding industry. The symbol for one such ETF is ITB, which is the symbol for the Dow Jones Home Construction ETF.
Now ITB has in fact been moving up. Both the price and the trading volume are moving up substantially in the past 6 months.
There has been a slight pull back in the past few days. The current price as I write this, on March 8, is around $14. But I don’t want to pay $14, I want a bargain.
So what I’ve done is to sell 10 puts of the June 15 options. Since I am selling something, someone is going to pay me money. What I am selling is a contract under which I agree to buy 1,000 shares of this ETF at a price of $15 at any time between now and the third Friday of June 2012. In exchange for my promise, some lucky buyer has paid me $1,500, or $1.50 per share.
So if this buyer elects to do so, I will buy the ETF at $15 per share, but having already collected $1.50, my net cost will be $13.50. Now that’s what I call a bargain.
Why did this buyer agree to pay me $1.50 per share? My guess is that he or she (it’s probably a hedge fund, and I never know if funds are masculine or feminine) wants to “hedge,” that is, make sure that even if the stock drops below $15, he or she can sell it for that price during this time period. Perhaps that fund already has a big profit in the stock and doesn’t want to take a chance that they will lose the profit, but is not ready to sell yet.
And what are the possible things that can happen to me? Well, if the stock does not go over $15, the holder of the put will probably “put” the stock to me and I will own it. Even if it drops like a bomb, down to, say, $5, I will have to pay $15 for it. But I don’t look at that as a risk of an option trade, because I was willing to pay $13.50 for the stock anyway. Whenever you buy a stock you take a risk that it will go down, so this risk is no greater than if I had bought the stock.
If the stock does go over $15, the holder of the put will not sell it to me, because he or she can get more by selling it in the market. In that case I will not own the stock, and just get to keep my $1,500. But that’s not so bad! To make $1,500 taking a $12,500 risk over a 90 day period (and the risk of the stock going to zero is pretty small) is over 40 percent return annualized. My bank is certainly not paying that on my savings account.
Well, OK. If you’re a coward and can’t handle being a naked writer, you could just buy the ETF and hold it. Or you might want to look at different stocks. The XHB ETF is another possibility.
Why do I suddenly like homebuilding?
When people ask me how to invest money with almost certain profits, my answer is “buy a lot and build a house on it yourself.” No bank to charge interest, no contractor to syphon off part of the profits, just build it with your own hands. Why is that so successful? Because you have created value. And that’s how to make a profit.
But if you can’t build it yourself, or can’t develop your own creative software, or sales method, etc., then you have to share with people that can. So you should look for people that know how to create value. People like Steve Jobs, the people at IBM, and homebuilders.
The opposite of that is to buy gold, or invest in corporate bonds. When you buy gold you are not investing with people creating value. You buy a pound of gold and 10 years later you are sitting with the same pound of gold. You are hoping that the fear factor or some other psychological factor has caused the price to go up. And with corporate bonds you are lucky if the small return you get matches the inflation rate.
So I’m not a fan of the diversification freaks that suggest some gold, some bonds, some foreign holdings, some of everything. I look for sectors that are not in a bubble and involve good companies that are creating value, or products (like copper) that are in short supply and are needed to manufacture products.
Homebuilding is on the upswing.
The only question for me is how to take advantage of this movement. Some like to buy and hold. I write puts.
For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.