(Today’s blog post will be a bit more advanced if you’re not familiar with stock options. However, if you want to learn more, I have a video series you can subscribe to on my company’s website.)
With the uncertainty over the debt ceiling, I wanted to talk about the importance of cash in a portfolio and how you can manage risk around events like this while still making money. I think the bulk of advisors underestimate the importance of cash in a portfolio. Most do because they follow static models that don’t adjust as market conditions change and claim that cash doesn’t earn a return and is therefore a drag on performance. What these people miss is the utility value that cash provides for risk management (cash doesn’t lose value when asset prices fall) and the ability to capture opportunities by purchasing assets at lower prices.
The saying “cash is king” exists for a reason. To make my point, I only need to note one example: Warren Buffett. In his annual letters to shareholders, he routinely points out the reasons he holds cash, namely what I mentioned above (Berkshire Hathaway’s current policy is to hold no less than $20 billion of cash equivalents). During the crash in 2008, guess who was able to step in and lend to ailing banks? Warren Buffet and Berkshire Hathaway. He purchased preferred stock from Bank of America and lent $5 billion to Goldman Sachs in exchange for warrants on the stock. Goldman Sachs repaid the original $5 billion plus a one-time preferred dividend of $1.64 billion back in Apirl and the warrants will net him close to another $2 billion – an opportunity that would have been missed without the cash on hand.
As for the argument that cash doesn’t earn you a return – well that’s just nonsense. But aren’t interest rates extremely low, to the point that interest is virtually nonexistent? Yep. This is where selling put options comes into play. You can use your cash as collateral to sell put options for income thus earning a return on your cash as you wait.
The gist of selling a put option is that you are creating a liability where you could be forced to purchase the underlying stock at a predetermined price, called the strike price. For this liability, you are paid money – the premium you collect for selling the option contract. Since you might be forced to buy a stock, you only want to sell put options against stocks that you’re willing to buy. Additionally, I almost always sell put options with a strike price that is below the current stock price, meaning the stock would have to fall before I’m at risk of being forced to purchase it. If the stock doesn’t fall, the put option will eventually expire and I’ll get to keep the premium. I’ll either be purchasing a stock I want to own at a lower price than it trades today, or I make a little money on my cash (I usually shoot for 1% per month) from selling the put option. That’s what I call a win-win!
This week was a textbook example of a great time to sell put options because 1) we still have another week of uncertainty until we hit the debt ceiling, so stocks could continue falling, and 2) expected volatility is high.
When stocks fall, expected volatility rises, as you can see in the two charts below. The top chart is the S&P 500 and the bottom chart shows the CBOE Volatility Index (more commonly known as the VIX).
S&P 500 (top) & Volatility Index (VIX – bottom) – 6 months
Volatility is one of the components factored into the price of an option. Higher volatility means higher option premiums, which means if you’re selling options, you sell them for a higher price – higher income!
This brings us to today’s current debt ceiling dilemma. Will Congress raise the debt limit in time? Or will politics screw it up? I don’t know the answer but I can tell you that I feel a lot more comfortable about having cash on hand in case stocks fall. I’ve also already selected most of the stocks that I’ll purchase and have synthetically placed a limit order to buy them at lower prices by selling put options. If they don’t fall, I’ll still make money on my cash because the put options will expire and I’ll keep the premium.
Selling options is a great way to reduce risk and boost income when done properly, and it’s something I do for many of my clients. However, I need to state that options involve risk and may not be suitable for all investors. Simply put, do your research so you understand what you’re doing when trading options or find a qualified professional to handle it for you (shameless plug for myself).
Thanks for following!
-Nick