Fructivore Investments

How many times have we heard the above advice? Usually, it gets people to burn through their savings by starting ill-fated businesses, but that is not the only thing to love. We Fructivores love buying and selling at the right price. The right price is when a security is fairly valued, since at that point there is no longer any advantage to holding it. When a security is fairly valued, sell it off and find one that is unfairly valued. We also are familiar with stocks that went up before we had the funds to buy them, or worse, we bought them, gave up, and then they went higher.

Writing options allows us to squeeze a little extra money out of both these situations. Specifically, writing covered calls and naked puts. I know, most people would advise small investors not to write naked options, or they’ll never become large investors, but there are ways. Larry McMillan, in Options as a Strategic Investment, talks about the difference between having essentially a stock strategy and using options to augment it, and having an option-based strategy. He advises the second one, but this strategy sticks with the first.

With our value investing approach, we know what our exit target is because we had to value our holdings in order to be sure that we got a discount from that price. So, if we know when we are going to sell it, we can write a covered call at that price. If the stock exceeds that price at expiration, the stock will be called away from us and we will have made the money we were going to make anyway, and also collected option premiums while we waited. A related, but riskier proposition, is writing a naked put on a stock we like but that is at too high a price. If the stock declines below the price of the put, we are forced to buy it (make sure you have ample margin), but we would have bought it anyway at that price. It is riskier because if the company deteriorates during the life of the option, the price that we thought was low enough to make it a bargain could now be hugely overpriced. However, for a company with stable operations, like Windstream, or better still, a company like CMO that can never be worth less than the government-guaranteed securities it owns, this strategy is safe and reasonable.

For example, suppose that I think Capital One is worth at least $30 a share based on my sense of its minimal earning power after the economy and the markets get sorted out. The January 2010 $30 calls are at $3.40 now, so by writing them I take in $340 less commissions per hundred shares, and expose myself to no risk other than selling when I would have sold anyway. It also removes from me the agonizing over whether I should take my profits now or hoping it will go up (If it does go up it will do so for reasons unrelated to its bargain status and therefore this is an unfruitful waiting game). If, however I did not own Capital One but wanted to, I would consider writing puts, perhaps the January 2010 $20 puts at $1.75. This takes in $175 less commissions per hundred shares, and if the stock drops below $20 I will be forced to buy a stock I would have bought anyway at a discount I chose in advance. Of course, the choice of the January options was arbitrary; my focus is on valuation, not option pricing theory, so picking the date of the options is less important to me than the strike price.

So, this fundamentals-based option strategy is a way to make other market participants pay you to take the actions you would have taken anyway, thus bringing in extra money and it also has the advantage of making decisions in advance, thus freeing up your limited investing analysis time to focus on the really important matters like valuation.

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Investing by grocca