After experiencing middling success with building a portfolio stuffed with income trusts, Derek Foster is trying out a new strategy of selling puts on stocks on his watch list and collecting the premiums. In online forums such as Canadian Business and Financial Webring and media interviews Derek has claimed that he is receiving “money for nothing” and marketing his half-baked ideas in a new book. I’ll show why selling puts is not the free lunch Derek claims it to be – something readers of his new book might want to keep in mind.

If you are already familiar with Derek’s strategy of selling puts, you may want to skip this section. Let’s say Derek thinks that shares of ABC Corp. (Ticker: ABC), which is currently trading at $50, would be interesting at $45. He would like to purchase 1,000 shares and finds that put options on ABC at a strike price of $45 can be sold for $2 per share. So, he sells put options on ABC, collects a premium of $2,000 and sets aside $45,000 in a cash account to cover the contingency that ABC falls in price to $45 or below and the option is exercised by the buyer (He could buy back the option but for the purposes of this discussion, the costs will be the same).

As it turns out, I think ABC would be interesting at $45 as well and would like to purchase 1,000 shares. But, unlike Derek, I didn’t know enough to earn premium income by selling puts or know enough to stay clear. Either way, I have the cash sitting in a brokerage account.

Now, let’s see why Derek claims his strategy is “money for nothing”. There are two possibilities with ABC stock. It never reaches $45 and both Derek and I did not get to enjoy any upside. Or, the stock reaches $45 and both Derek and I now own the stock. It keeps falling to $40 and both Derek and I have experienced a loss but Derek’s loss is smaller because he collected $2,000 in option premiums. How’s that for financial alchemy?

It seems like a very clever argument but if you had a nagging feeling that there has to be catch, you’d be right. Here is the key difference: I have the intention of buying the stock at $45; Derek might have the obligation to do so. There is a world of difference between the two.

Consider the following scenario now: With the stock trading at $47, ABC’s CEO has suddenly resigned. Rumours are swirling that he has written a letter to the board admitting to cooking the books and all hell has broken lose. The trading on the stock has been halted pending a news conference.

What would I do? I would be foolish to think that the stock is still interesting at $45. Most likely, I’ll decide that ABC isn’t worth the trouble after all and abandon my intention to buy. At the very least, I would want to wait for the dust to settle and more clarity to emerge. And I have my capital intact.

Derek has no such luxury. He has a contract to buy the stock at $45. If the stock hits $25 when trading resumes, he is looking at a $18,000 loss – substantially higher than the $2,000 premiums he collected.

Investors tempted to speculate in the options market should remember that options are a zero-sum game before commissions and expenses. The buyers of the puts Derek is selling are not giving away free money out of the goodness of their hearts. They are paying the seller to assume some risks they are not willing to bear and it would be wise to assume that the premiums reflect the risks involved. Only fools rush in where angels fear to tread.

This article has 57 comments

  1. Pingback: Let’s talk Options, sell PUTS, and you’ll have none when its exercised. | Investorial

  2. You basically summed up my concerns/issues with what Foster is proposing. I’m still debating doing a follow up post to The Foster Effect on these recent developments, but in one way its just “more of the same” from an individual who’s more interested in profiting for himself rather than helping others profit for themselves.

  3. I personally think options are a good strategy in certain circumstances, but following any strategy without really understanding it would be a foolish strategy for any investor.

  4. This article doesn’t make any sense to me. So you are saying the big “catch” is that at the exact moment the stock dips below the strike price of the puts that it’s going continue to fall so fast that you can’t sell your newly acquired shares fast enough?

    That seems like the perfect storm of unlikely circumstance to even worry about it? Can’t you just put in a stop loss for your newly acquired shares and sell them once it falls to some percentage below your strike price? This argument seems to come down to the mechanics of timing?

  5. What CC is pointing out is that with the suggest strategy which foster calls “money for nothing” there is more risk associated than foster talks about. Because you are obligated to purchase the shares at the strike price, you could be in a situation where you are forced to buy it and loose money, which defeats the idea of “money for nothing”.

    Foster is making it look like it’s free money, which it is not.

  6. There are 17 books on this topic at Amazon already. What in the world does Derek think he has to offer in a book that hasn’t already been written?

  7. Ray 2: The issue with selling put options is that more than likely the option won’t be exercised until the day (or day before) the option expires (mostly because the option can be traded instead of the underlying stock). It is quite possible that a stock could make a big move well before the option expires. In that case the only way to protect yourself from actually having to buy the stock is to either buy back the option (and pay more than you sold it for) or short the actual stock. Either case isn’t great.

  8. I’m not an options expert by any means, but if the put options seller suspected that there would be a large drop in value of the underlying security, couldn’t he/she simply buy back the option?

  9. MDJ: Yes, an option seller could buy the put option back but it would cost more to buy it back than they sold it for (if the stock had dropped since they sold the put option) so at the end of the day they would have lost money, although buying back the option could be less expensive than having to buy the underlying shares.

  10. The shortfall in this strategy is that you are only buying stocks which are showing weakness. In a strong market you will miss on potential gains, because you are only buying a stock that has fallen below your strike price and thus there’s no guarantee that that you will receive the lower cost basis. In weak markets you will be able to buy your stock at a lower price, but you will see your stock dive further down. Thus you might have been better off postponing your buy.

  11. Several have mentioned the idea of immediately buying back your puts or immediately getting exercised at $45 and then selling that back into the market if you don’t want the stock….this is not how things work.

    The price of an option consists of, basically, two portions: one portion which is the intrinsic value of the option (ie: Put struck at 45 while the stock is at 40 has an intrinsic value of 5), plus the time value of the option (Options have some kind of expiry date, and there is a value associated with the amount of time until that expiry).

    Obviously at the beginning of CCs example, the intrinsic value is zero as the stock trades above the strike. But the value of the option is not zero: obviously selling someone the option for them to short at $45 must have a nonzero price. Insurance companies for example do not give you free car insurance just because you aren’t calling from the scene of your own accident.

    Similarly, the intrinsic value is also zero when the strike and the stock price are equal, ie at $45. But again the option still has nonzero value.

    So back to the example. Say the stock drops to $40. What can the buyer do? They can exercise and make the $5 difference (usually this is unlikely). They could continue to hold it and hope that the stock drops further. Or they could sell the option back on to someone else (possibly to a hypothetical Mr. Foster). But in any case, the value of the option here is generally more than $5 (unless of course the option is expiring today).

    Early exercise is generally not optimal (its like canceling a fully paid insurance policy when you can instead sell it onward to someone else).

    oxCC: buying back the option cannot be cheaper than getting exercised, as the time value must be positive. But this is moot as nobody would exercise against you anyways.
    The value of the option can actually decay as it moves in the money if the implied volatility (this is analogous to a “risk factor” – think “car insurance bracket”) decreases. In this case the intrinsic value increases but the time value actually decreases to offset that. Generally this does not happen, however.

  12. Hmm, I was so busy writing that that I forgot to comment on Mr. Foster.

    Admittedly I do not know the full history of his writings and activities but it does not appear that he is a particularly astute investor. More likely he made a bundle of money on a highly leveraged bet during the Good Old Days, figured he was awesome, and wrote a book about it.

    I suspect he will have trouble going forward as it is difficult to make enough income on $472k to cover for one’s expenses as well as inflation. Another bad year and he is toast. Hence the new book. 🙂

  13. CC, thanks for the mention. Any time someone suggests a way to make money for nothing, we should all be suspicious. If I ever find a way to make substantial risk-free returns, you can bet that I won’t write a book about it.

  14. Sodium. You are “right on the money” concerning how Foster made his money…

    My own version of “money for nothing” is more from a taxation standpoint. If you buy certain REITs using leverage, then the interest on your leverage is tax deductible and for most REITs, at least some portion of your distribution is classified as “Return of Capital” and not taxed unless you sell that security for a profit later on…

    Especially right now that interest rates are at record lows and REIT yields are high, it’s like getting cash every month AND it’s a nice income tax return when you file…

  15. I have nothing to do with short selling, options and puts. It has always seemed like nothing more than gambling- except the dealers wear three piece suits and not casino issued vests.

    Foster’s strategy is no different than the rest of the financial industry: pitch a simple strategy and then tell everyone to promptly abandon the first strategy as soon as people have bought into it, telling them that this new (much more complicated strategy) is easy and risk free and that all the cool kids are doing it then tell them you have to put no work and no money to get rich.

    And, presto, you have 2002-2007 all over again- with most likely the same end result.

    For someone who preaches a DIY solution, it sure sounds like and smells like a Wall Street solution and all know how that ended up (Money for Nothing is very Madoff-esque).

  16. Charles in Vancouver

    @Phil S: The portion of your REIT income which counts as “return of capital” will reduce your loan’s tax-deductibility unless you reinvest it. It is treated the same as if you had sold some of the investment. Careful!

  17. Canadian Capitalist

    Brad: I think you should do a follow-up post on The Foster Effect. Frankly, Derek has become a danger to retail investors by suggesting half-baked ideas that he himself only vaguely understands.

    Ray: I don’t disagree that options could provide risk management opportunities for certain investors. But risk and reward are still related and there is still no free lunch.

    Ray2: No, I’m saying that a stock trading at $50 could gently fall to $47 and then gap down at $30 due to some new information. An investor who was simply planning to buy has no loss and the capital is still intact. Derek has sold a put option and will have to pay at least the difference between the strike price and the current price to buy it back as the puts are now in the money.

    MDJ: Yes, Derek can buy back the option. But the cost would be at least the difference between the strike price and current price. The put option is now in the money.

    sodium: Thanks for your explanation. I’ve never purchased options; probably never will and know enough to avoid it. I doubt Derek has a deep understanding of it either and even someone who has only the basic grasp of options can see the holes in his strategy. It is plain irresponsible to suggest this to other investors.

    Phil: Yes, REITs have been killed in the past year. Wish I had waited for these prices but I did have to purchase into them to bring it back to target.

  18. Not only does selling puts add to your risk, it also adds complication to investing. Like you said in your example, I’d rather be the one that can make a decision on any given day than be committed to my choice in advance.

  19. Options (and other derivatives) are not bad, contrary to Mr. Buffet, they’re just another financial product that can be a double edged sword. Same with pricing models, etc.

    Know the limitations, assumptions, and complications, or you’re likely to get burned.

    As we love to say: “User error.”

  20. This is why I like this blog (as well as the other ones in the community). Frank discussions about risk and investments. Nobody tries to sell you snake oil. No bullshit 100% fool-proof strategies to make you the next Bill Gates.

    At this point Foster is simply unethical. I wasn’t really feeling his dividend stock strategy. Living off of 100% stock (worth only 500k$) portfolio for up to 50 years strikes me as naive. The simple fact is that even ‘stable’ blue-chip companies fluctuate in value and go out of business (or at least cut their dividends), and severe bear markets now seem like they happen every 30-40 years (30s, 70s, and now late 2000s). But at least it was a somewhat reasonable (albeit risky) strategy (although it’s clear now Derek didn’t really believe in this strategy anyway as he bailed at the first sign of trouble).

    This latest book however, is nothing but a gambler’s manual. I can bet you somebody will pickup Derek’s latest book, believe what he’s selling and lose a lot of money he can’t afford to lose following Derek’s ‘sage’ advice.

    I like this quote:
    >The buyers of the puts Derek is selling are not giving away free money out of the goodness of their heart.

    Seems like Derek thinks they are.

    And as was mentioned in another post:
    >Frankly, Derek has become a danger to retail investors by suggesting half-baked ideas that he himself only vaguely understands.

    100% in agreement.

  21. To Charles in Vancouver. I didn’t see any of that information in the tax information package from the CCRA, but it seems reasonable that it would be in there. Last year around this time, I was feeling like we were going to hit an economic rough patch, so I sold off just enough equities in order to completely de-leverage myself, so that tax complication won’t affect me at the present time. Unfortunately, I wasn’t smart enough to see how bad things were really going to get – with hindsight 20/20, I should have sold and dumped everything. Oh well!

    • Canadian Capitalist

      Phil: Charles is right. Interest on the portion that is return of capital is not deductible going forward.

      gene: I have no problem with saying that selling puts has some benefits as well as some drawbacks. But it is made out to be a “free lunch” or “money for nothing” scheme. That’s why I carefully constructed a scenario that shows a significant capital loss. My problem is simply with the marketing of the scheme as having no risk and always better than waiting in cash.

  22. I don’t know, it just doesn’t seem all that riskier than buying the common stock. Say I like a stock, I buy it, then it drops 50%. It’s happened a few times to me this last year. This result isn’t that different than if you’d sold the covered puts and the stock drops 50%. The example in the blog post is a special situation where the investor is lucky enough to be considering a purchase, but hasn’t yet pulled the trigger.

    Also, if he’s got cash built up, he can sell the stock short if it’s way below the strike price, and be forced to buy when the option holder cashes out, leaving a net zero position.

    I agree, it’s not free money, and I wouldn’t want to bother with the aggravation myself, but buying equities is risky anyway, so buying and selling options on equities is also risky.

  23. The worst part of the whole Foster thing is his book was basically advocating/bragging about his method of early retirement. It was supposed to be something any novice/intermediate investor could do.

    Now that he is using puts/options etc. he is going against what he previously done and in a league that no beginner/intermediate investor should touch.

    To me, he has proven himself wrong and provided nothing but discredit to his book (“never sell!”)

  24. Quite right, CC. I can see why the “Money for Nothing” phrase bugs you. Derek Foster is no Mark Knopfler (of Dire Straits). Thanks for the response.

  25. It sounds to me like the seller of put assumes all of the risk of investing in equities, but only gets the return associated with a fixed income investment. (ie. the buyer of the put is the only one who benefits from an increase in stock price before the exercise date?)

    On the other hand, if you buy common stock you assume a lot of risk, but you also get all of the upside. Which is of course why we invest in stocks… because we know that there is (or should be) a relationship between risk and return.

  26. I’m still confused. That’s why I don’t bother. Don’t invest in something you don’t understand according to Buffett.

  27. Foster is good at selling books and nothing else.

  28. I have used options, or trading equity options for over 10 years, probably closer to 15 years. I believe they can be used by investors to increase or protect returns. however it is not an easy subject, and most of what I have learned besides from reading is from my own mistakes.
    started with covered call writing and then did calls and puts. hopefully this book will create more interest in this topic, and people read more books before beginning.

  29. I agree options can increase your profits or provide some insurance, and its a complicated strategy but I am there are many other books that can provide very valuable information on Options than Fosters book with misleading concept of “money for nothing”

  30. Dave from GP: Right on the money there, dont invest in things you dont understand!

  31. people should understand investors. listened to a radio show in the US (no longer on air) with two option traders. why did these people not protect their portfolios.
    during the bull market put options premiums were very low…ie. insurance was cheap.
    I bet many investors wish they bought some insurance on their bank stocks, not a bad idea.
    or should you hold a stock without a return for five years.

  32. by the way buffet has used options, and pretty sure he understand them.
    liked the article, however more people should learn about options.

  33. Why does the average joe has the option to buy into crap like derivatives? Why aren’t they limited only to businesses that could pay out losses with cash? They just seem so dangerous for average person to be able to purchase them.

    • Canadian Capitalist

      Matt: I’m pretty sure discount brokers don’t allow every retail investor to trade options automatically. I think you have to go through an approval process of some sort. Not entirely certain of this though; never been interested in dabbling in options.

  34. I enjoyed the post. I thing options are important as they provide ways to hedge a perceived risk without having to liquidate a position that you want to keep in the long term. But as discussed – no – it feels like pure gambling.

  35. A book on gambling your future.
    Just like going to the horse races, rather than betting on which horse is going to win or lose, you bet on which company is going to win or lose…. all the same stuff.

  36. I recently upgraded my online brokerage account so I could write uncovered options. The approval process took a couple of days and I had to answer some questions about the risk associated with different variations of uncovered option trading. The questions weren’t hard but if some one didn’t understand the basics of how options work they wouldn’t be able to answer them correctly.

    I have just started playing around with options and as sodium pointed out I’m not totally up to speed yet but I think I learn more by doing than observing. The funny thing is that right now it is the covered calls I wrote that are underwater and the uncovered puts look like they will expire worthless (and I’ll get to keep the cash I got for writing them). I expected the market to go the other way so I’m currently paying for my option writing education. 😉

  37. most discount brokerages, allow options, most will allow covered calls, some will allow naked calls, and puts, though many are very difficult to get…td watershouse I have allows, though CIBC, BMO often do not.
    options trading is a tool, and should not be compared to gambling, I have made great and dumb trades and you learn over time. it is a great benefit to some traders, sometimes.
    during this bull rally might as well be long however during a flat market covered calls are good, and during a run buying options would be good insurance. also selling puts and uncovered calls might be good depends on the time of the market.
    note: compare a covered call startegy to just holding equities and the covered call on probably outperforms and has less volatilty.

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  39. I don’t think you got Derek’s point. He is basically arguing against buy and hold. For example, if the stock price is $50, a buy and hold investor will buy it for $50 and hold it until it drops to $0. He will not sell because some CEO quit or the bank cooked its book or the government took over the bank. He basically would buy it and forget it. Derek is basically saying instead of doing that, you can get $2 right now and sell the obligation to buy it 2 month from now. The risk is basically you could sell in these 2 month, but he couldn’t (well he could too, but let’s ignore that for a minute). However, you are not going to sell since you are a buy and hold buyer. Therefore, he will never have more risk than you. The problem is he might miss a huge jump of the stock in those two month, that’s why he said it’s only opportunity cost.

    Of course, all these coming from some guy who made a lot of money selling the buy and hold idea, I wonder why somebody would ever buy his book anymore.

  40. Also, I agree with you, Derek doesn’t know what he is talking about. This strategy will only work if you really want to buy the stock at $50 no matter what. It seems he never had that conviction. The option simply lowered his guard and I heard he lost a ton doing this.

    Shepherd, I don’t think options will ever change the risk adjusted return. They are great to adjust the risk profile, but you always give something back in exchange.

  41. Archanfel: CC got Derek’s point. I think you missed CC’s point. To the extent that the market gets pricing right, the stock will only get put to you if the company turns out to be worse than you thought it was. If the company turns out to have a better future than is believed right now, you are less likely to purchase it (as a result of someone else exercising the put). This is a real cost. Any suggestion that writing puts is free money is wrong.

    • Canadian Capitalist

      Archanfel: There are two alternatives that are discussed to selling puts: (1) Buying a stock outright. (2) Wanting to buy a stock at a lesser price. Derek does have a bit of protection with (1) on the downside but no upside at all. Derek likes to say that (2) is “money for nothing”. It isn’t. You can change your mind about your intention to buy but Derek can’t. He has already sold the put. Frankly, I don’t care what Derek does with his money; selling this idea to others is irresponsible, IMO.

  42. Selling puts is an okay strategy – but ONLY when your intention is to accumulate shares if the stock moves lower.

    Bullish investors can find much less risky option strategies (sell put spread, for example) if they merely want to earn a profit if the stock does not decline.

    Mark
    The Rookie’s Guide to Options

  43. This is a really interesting discussion. I hadn’t really considered how selling puts limits the upside if the stock (which you supposedly wouldn’t mind owning) goes up in price.

    Some books I’ve read go as far as saying don’t even bother with limit orders. If something looks good, don’t worry about a nickel in spread, or wait for a slightly better price. Those books argue you might never actually acquire a position, as you watch the stock double or triple. Admittedly, these are pretty bullish books.

  44. It’s only one of a zillion half baked strategies out there with a zillion what ifs and you happened to come up with this one doomsday scenario. Even bonds are risky my friend. Do your homework before you invest in anything.

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  47. What is being promoted as money for nothing is really quite a dangerous game. I hope this book doesn’t get too popular or a lot of people will lose a lot of money.

  48. Pingback: Selling Puts is NOT Free Money | OneMint

  49. Hi Guys,

    Great board. Just wanted to say I think selling put options are fairly straight forward and not as ‘risky’ and foolish as the tone of this article and most the comments speak too. If one wants to buy the stock anyway and it’s part of porfolio trading strategy, it is less risky to follow the autors suggestion, than simply buying the stock outright. A nightmare can come with any buy and hold strategy, leveraging Reits or simply doing nothing. The main ‘catch’ is if one cannot write a cheque to cover their put writing obligations and must buy the offsetting call option instead to clear the trade, is where the losses pile up quickly and how options get a bad name. Option losses are quickly made into coffee time banter and twisted into fear mongering. For me, ensuring you want the stock anyway, being able to write a cheque if you get called out as opposed to buying the call options to ‘get out’, and trading a stock that has both liquidity in its stock and underlying options chain is really a no brainer. Selling puts is not a get rich quick scheme, as you must be able to write the cheque if called out….. which presumes you have the cash to begin with 🙂

  50. Who is still buying Derek Foster’s books? I guess there is truly a sucker born every min.

    To be fair I think Derek’s first idea is still his best – Come up with some corny varation of a sound investment strategy, write a book about it, give the book a simple yet cleaver title and then watch the “income” roll in. When the strategy fails – reapeat the process.

    Why do I have a feeling Derek has his money in a well diversified portfolio, or, better yet – GICs.

    Can’t wait for his next book – selling bridges in brookland.

  51. Brian Donaldosn

    To hedge your position when selling puts is you short the stock at the in the money price. So if you sold 10 puts at $45 then just short the stock with 1000 shares so when it hits $40.00 you want to buy back with $5.00 gain. Sell Short at $45.00 ($45000) Buy back at $40 ($40000) equaling $5000 minus premium $2000
    Come out with $3000 gain.

  52. Does anyone realize that the “risk profile” of selling naked puts is IDENTICAL to that of covered calls? I’m always amused how selling covered calls is promoted as such a low risk, conservative strategy while selling naked puts is shunned as an outrageous risk when in fact these are mathematically equivalent. The problem comes when people over-leverage (e.g. sell a huge # of naked puts) and get blown up by a modest drop…

  53. Any strategy in the stock market involves the risk of losing money. Period. Some important elements of Foster’s strategy that weren’t mentioned is what type of company you would be selecting and why, your intention with said company is to buy and hold to collect dividends (so immediate flucuations in the market are meaningless) and finally you only sell puts on companies you intended to buy at the stated price already. I also would like to mention that Foster does erg caution to his readers. We all know Money for Nothing doesn’t exist, but when you understand the whole message you see where Foster is coming from

    • Bosco, I could not agree more. I started selling puts and it is the most conservative low risk strategy I have ever found. Selling puts pays you to forego any bug upside potential but allows one to collect a premium. Plus each day that passes the option prices drifts closer to zero so if your options sold have a term of a month or less in most cases it can be bought back for less as profitable low risk exit strategy.