Motley Fool’s “4 Proven Options Strategies”

I’ve been reading the Motley Fool stuff on and off for more than ten years now, since they were just a forum on AOL. I like to think I learned a bit of useful information from them like how to evaluate a mutual fund based on its expense ratio rather than its historical performance, or the differences between a 401(k) a traditional IRA and a Roth IRA. Sometimes though, I just have to wonder where their heads are at. I was thoroughly dissatisfied with some of their picks in their Inside Value Investing newsletter a couple of years ago (I am no longer a subscriber), and I think they were just about as badly blind-sided by the events of 2008 as everyone else.

I thought these guys were supposed to protect the interests of us “regular guy” investors out here. Keep on investing in DRIPS, dollar-cost average down (do these guys not know what it’s like to try and catch the proverbial falling knife?) was all I heard. Over the long-term, the market has always gone up (Really? What about sector-rotation?).

That sort of thing.

Then, in early 2009 I think, they started touting and teasing their mailing list with something called “Motley Fool PRO”, some high-priced (I think it’s over $1k/year …) newsletter that advocates, among other things, options trading.

Whoa, hold the bus, Tom and Dave. What?! The supposed advocates of dollar-cost averaging, safe investing for the little guy and railing against the financial professionals who want to line their wallets by managing your money — yes, these Motley Fools — are planning to charge readers a not insubstantial sum to “advise” them how to play the options market.

Now, I’ve been growing more and more skeptical of the whole Motley Fool enterprise since they quietly disappeared their “real money” portfolio and started over-emphasizing their wins like Marvel and Iomega long after the train left the station — hey what have you done for me lately, guys? Well, they’ve come with another newsletter and they’re calling it “Motley Fool Pro”.

Gee, now how does that make all the dopes who already fronted cash for the other Motley Fool publications like Stock Advisor, Hidden Gems, Global Gains, Inside Value, Rule Breakers, Income Investor, Champion Funds, Rule Your Retirement, Ready-Made Millionaire and Million Dollar Portfolio feel? Like non-pros, maybe? Or how about chumps?

How are they selling this new service, and how do I know it’s so heavily tilted towards options? As part of the newsletter promotion, the Fools sent out an email blitz offering the usual “Special Report” teaser in exchange for signing up on their notification list. Curious as always, I signed up , thinking the special report would contain some insight to the options market. After all, it is supposed to cover “4 Proven Options Strategies to Profit in 2009 and Beyond”.

At a certain point apparently, it turned out the “Pro” offering wasn’t good enough … Tom and Dave decided to sell another service called “Motley Fool Options” in December. I think it’s supposed to have the same options trades as “Pro” but none of the other stuff like ETFs. Ostensibly, the cost for “MF Options” I think is the same as that for “MF Pro”, $1000/year, but their final offer to me was 2 years for about $800. Eh, it’s worth a shot. I’ve been subscribed to it for a couple of months and I’ll let you know what I think later.

First though, if you do not have a basic understanding of options, the greeks, and strategies with funny names like bull put spread, condor, and strangle, you have no business signing up for either newsletter and following these fools’ advice — not for $1000+ a year for “MF Pro” and not for the $800 two year plan I got for “MF Options” — because either they’re going give you a lot of hand-holding you can get for next to free by watching “Options Action” on CNBC and reading an introductory book like Guy Cohen’s Options Made Easy, or they’re going to recommend trades you won’t understand.

And trading without understanding, my friends, can only lead to tears. In the special report, David Gardner and fellow fool Jeff Fischer, introduce the concept of options to their readers and prospective subscribers. They claim that options “can generate returns in flat markets, [and] cushion the blow of down markets.”

I agree, if you know what you are doing.

Again, if you want to learn about options trading buy a couple of books from Amazon (or borrow them from the library), and open up a virtual trading account at OptionsXpress.com — don’t give these fools $1000! Oy. Not only are options part of the Motley Fool Pro strategy, but also “short positions and exchange-trade funds (ETFs).” All well and good, but you have to understand how to short and what an ETF is. I have a friend whose broker was shorting the ProShares UltraShort S&P500 ETF for her right through October 2008. She received the dreaded margin call, asked “What is a margin call?” and now has to file for bankruptcy. Now, I know that overhead, the bid-ask spread and management fees will make any leveraged ETF into a dependably losing proposition, so shorting a short as my friend’s broker did is not necessarily stupid, but you have to understand the risk you’re taking on this sort of trade — the market could tank (it did) causing this ETF to temporarily spike and increase your margin requirement. In the long run, shorting leveraged ETFs like SDS seems like a good idea, but in the short-run you could be forced to close the short at the most inopportune time. You have to understand the risk you’re taking and be prepared to cover for whenever the situation goes against you.

So, what are the four foolish option strategies? Here they are:

• Buy Calls – Well, ok. If you think a stock is going to pop why tie up capital by buying it? Just buy some cheap calls and multiply your leverage by 100. For example, if I think T, at 26.59 is headed for 30, rather than commit $2,659 for 100 shares and hope for the best, I could buy one May 09 25 call for $214. If T makes it to 30 by May 15, the call expires with a value of $500. Buying the stock yields a profit of $3000 – $2659 = $341. Buying the call yields a profit of $500 – $214 = $286. Even though the leveraged return on this trade is 133%, vs. 12.8% for the stock trade, there are still problems with just buying calls. First off, since options expire and stocks don’t the underlying stock for your call must make the move you are anticipating within a limited time-frame. Second, to break even on your call purchase, the underlying stock must increase to a value above the strike plus the premium you paid. Jim Cramer goes over a variant of this strategy, using deep-in-the-money calls, in his book “Getting Back To Even”. Also, since subscribing to the “MF Option” service I have noticed that the fools have a penchant for buying in-the-money LEAPS.
• Buy Puts – Rather than short a stock that you think will tank, and take on potentially unlimited risk if the opposite happens, you could buy puts on a stock. Stock goes down, you sell the put for profit. To tell the truth, I’d prefer to do a bear call spread than buy a plain old put … At least that way you get some cash rather than laying it out. For example, I could sell March 2010 call on Nucor (NUE) with a strike of 42, and buy one with a strike of 45. For my trouble, I net .85, risk up to 2.15 and don’t start losing money until NUE goes up beyond 42.85. With the way I pick stocks that just go sideways, that’s better than paying 1.20 for a March 2010 NUE put with a strike of 41.
• Write Puts – On this one, the fools are essentially pulling rabbits out of a hat — they troll all their other services to identify a stock they would like a position in, they determine a specific entry point, and write a put option such that the put strike minus the put price is that entry point. For example, let’s say I want to buy NVidia at a significant discount to its current price of around $16.40. I could write a September 2010 put at 15 for $1.30. Now, if NVidia goes down below 15 by the third Friday of September, it will be exercised and I will have to buy it for $15 … even if it goes down to $1. Here’s the deal, though: 1) If the stock is put to me at 15, my real cost for the stock is 15-1.30= $13.70; 2) I have to maintain funds ($1500 for 1 contract) in my account to cover the put until it expires. By September, I’m happy so long as Nvidia closes above $13.70.  If the stock is not put to me, I’ve made $130 per put; and if the stock is put to me I own 100 shares of a stock I’ve already decided I like. Yay. And, if the Nvidia situation changes any time before expiration, I can always buy back the put to close the transaction.
• Write Covered Calls - If you have 100 shares of some stock in your portfolio, you can write a covered call on those shares. I actually did this in my Roth the other day, although I would have preferred to write a put — unfortunately, writing puts are considered “too risky” for retirement accounts, which is very frustrating. Anyhow, I bought 100 shares of Nvidia at $16.50, and my intent was to immediately turn around and write a September 2010 call on NVDA with an 18 strike. I was able to sell the call for something like $1.55 — that’s an extra $155 of cash that went into my account. Now if by September NVDA goes above $18, my shares will be called away … I am obligated to sell them at $18 even if NVDA goes to $100. But you know, I am okay with that because I will have made $155 by writing the call and I will have made $18 – 16.55 x 100 = $145 by selling the stock. That’s a profit of $300 or 18% on $1650 in less than a year. And if NVDA remains unchanged, I can write another call on my shares in September and perhaps add another $150 or so to my cash balance. And if NVDA goes down to 14.95, I still haven’t lost anything. I think the fools call writing covered calls creating a supplemental dividend stream.

Like I said, I have a subscription to he Motley Fool Option newsletter. The underlying stocks are uninspired, and the fools are rather conservative in their strategies as you can see from the Write Put/Buy Stock/Write Covered Calls stream I describe above. The most sophisticated trade I saw involved maintaining a diagonal spread position. E.g., they sold April $25 call and covered it by buying a December $20 call. I think they’re definitely figuring out ways to make theta-decay work for them …

MF Options does have an “Options University”, but come on, do you really need to be paying mondo-bucks for access to it? Before you even consider following these “4 Proven Options Strategies” or getting a subscription to the MF Options service, do yourself a favor — read a couple of good books on options and make sure you understand what you’re getting into. If you got lost reading this post, you’re not ready.

Jared’s Books On Options (I’ve read these, honest):

1. Options For The Beginner And Beyond by W. Edward Olmstead
2. Options Made Easy by Guy Cohen
3. Option Volatility & Pricing by Sheldon Natenberg – This one gets way more technical than the other two, but is rigorous and assigned reading for newly hired professional options traders. Though the math you need for the other two books is nothing to sneeze at,  this one is going to be over your head unless you majored in math. And even then, it’s a tough slog.

Once you’ve read these, you’ll be ready to open up an account, and follow some of the free webinars offered by places like OptionMonster and OptionsXpress. Until then, you most likely will lose money and not understand why. At least after you read these books, you’ll understand why you’re losing money. What you do about it at that point is up to you.

Now, go away and leave me alone. I’ve got shit to do man.