The (irrational) exuberance of the dot-com era was fun – and painful.
I began trading options in 1997. At the time, the stock market was ebullient with the dot.coms, and it seemed that money was free for the taking. At first, I gingerly stepped into the water, but as my knowledge grew, so did my risk taking, and happily, my returns. Eventually the market corrected, indeed, crashed. Most of the money I had made was in NASDAQ stocks on which I had sold naked puts. This technique became my favorite, because it generated immediate cash into my account, while requiring a relatively minimal collateral. It worked well for a while. The technique itself is not at fault – I was. There are certain safeguards that one must employ in any pursuit in life, not just financial, and it is only now, in retrospect, after suffering some serious bruising, that I recognize the error of my ways.
I remember September of 2000, when Intel (INTC) came out with some bad news and cratered. The market followed, but I was unconcerned, as were many of my fellow traders. We were riding high. We were happy. “Irrational exuberance” was the phrase Alan Greenspan had used in one of his speeches a couple of years earlier. Yep. We were exuberant. I’m not sure that any of us realized that we were irrational, too. How could we be irrational, when Yahoo! (YHOO) had a one-day price rally of $84!
One of the persisting caveats of naked puts is to sell them only on stock we wish to own, because if it is “put” to you (assigned), you obligate yourself to buying it. I had a position of naked puts on YHOO expiring two years hence (the longer the time to expiration, the higher the premium was likely to be) for a strike price of $150, this, when the stock was trading around $280. A strike price below the current market price is said to be out of the money for puts, and in the money for calls. In the case of YHOO sporting a market price of $280 and climbing monstrously each day, a strike of $150 two years later seemed very reasonable indeed. And so, I stayed in my position.
My troubles began the following year. By January of 2001, YHOO had begun to decline dramatically. In fact, it declined so far that it was “put” (assigned) to me. Being the irrationally exuberant person that I was, I decided to keep the stock at its substantially discounted price and write covered calls on it. How would I pay for it? By credit card, of course! Since I had a margin account, my out-of-pocket requirements were minimal, and those could “easily” be further mitigated by the covered calls. The reasoning was intact. The technique was flawless. In retrospect, the decision to do so was not. But we all know about hindsight being 20/20, don’t we? So I was now the proud owner of 1000 shares of a plummeting stock in a plummeting market, with a bulging credit card debt. Oy!
I decided to request an extension to file my taxes, which was granted to October of 2001. By that time, unfortunately, the stock market had declined much further than the previous September with the Intel calamity. Of course, so had my YHOO shares! But my credit card balance had not! A cardinal mistake I made in those days was not put aside a certain percentage of my winnings for taxes. And when the accountant presented me with my taxes owed, I was floored. We had suffered a stock market collapse; the dot com darlings were in the dog house; Greenspan was probably rubbing his hands in a self-satisfied gloat; and the heady thrill of daily price increases were a painful nightmare. Where was I going to find the money to pay the huge bill to the IRS? My credit card was maxed out – with YHOO, no less, a diminishing asset. I finally did pay the IRS by taking out a second mortgage on my house.
Naked puts remain my favorite strategy. I now have my experience to buttress my ego. I’m also much closer to retirement, and therefore less able to swing for the fences with abandon (though that was fun!). I now put safeguards in place – and lest you should be rubbing your own hands in smug satisfaction, this story fills such a purpose precisely: to identify those very safeguards for myself, as well as my readership. Options are a financial tool, just as are CD’s and Treasury bonds. And as a tool, they can enhance your life immeasurably, but they require an understanding of all their permutations. It is my wish to impart to the reader whatever lessons I have learned the hard way, and demystify their power.