Selling Naked Puts Stripped This Investor of Most of His Assets

I'm 25 years old and my income has averaged $120,000 annually over the past three years. I used to put my money into rental property, but after April's crash I had to sell them. I lost about $162,000 gambling in the stock market. That was my wake-up call. I used to do nothing but sell naked puts. I listened to some investment guru who said you couldn't lose selling naked puts. I was such an idiot!

I received $65,000 last month from the sale of the last investment property. I used $19,000 of the money to pay off my credit-card debt. The interest rate on the credit cards was 19.9%. I bought shares of the Nasdaq 100 Trust(QQQ Quote) with the remaining money.

I put 6% of my annual income into my 401(k) plan. I want to retire with an annual income of $60,000. My house should be paid off in 15 years. The monthly mortgage payment is $2,300.

-- T. A.

T.A. Portfolio -- $82,782
Holding	Market Value	YTD Return
401(k) Account -- $32,474
Irwin Financial (IRWN:Nasdaq)	$9,625	-11.6%
(POVSX Quote)Putnam International Growth A	4,432	-12.5
(PNOPX Quote)Putnam New Opportunities A	7,062	-25.6
(POEGX Quote)Putnam OTC Emerging Growth A	2,669	-20.4
Putnam S&P 500 Index Fund	5,593	-6.3
(PVOYX Quote)Putnam Voyager A	3,093	-16.7
Taxable Account -- $50,309
Advanced Micro Devices (AMD:NYSE)	$1,575	6.3%
Sold: AMD Jan 2001 23 3/4 Call	(50)	n/a
Intel (INTC:Nasdaq) Jan 2000 LEAP $40 Call	1,200	n/a
JDS Uniphase (JDSU:Nasdaq) Jan 2003 LEAP $90 Call	2,413	n/a
Nasdaq100 Trust Shares (QQQ:Amex)	45,170	-23.1
Source: Morningstar (returns).

T.A.,

It sounds like you learned some hard lessons this year. You've got plenty of rebuilding years in front of you, so put that knowledge to good use. Options allow you to manage risk by hedging a position, or they can increase risk by allowing you to leverage a position. Writing covered calls like you have with your Advanced Micro Devices(AMD Quote) position is an example of hedging. Selling naked puts or buying LEAPs is an example of increasing your risk through leverage. So even though you've had a wake-up call, it looks like you hit the snooze bar and forgot to smell the coffee on options trading.

I don't recommend writing covered calls because you trade away your upside potential for a little bit of immediate cash, known in options lingo as premium . So you lose if the stock price goes up. That's not where I want to be in a long-stock position.

For the uninitiated, writing a covered call is when you own a stock and sell a call option against it. (If you did that without owning the stock, you would be writing a naked call.) You pocket the option premium (less any commission paid). If the stock price goes above the strike price of the call, what you make on the stock is offset by what you lose on the call. Investors who expect the stock to go higher than the strike price during the life of the option wouldn't sell the call. So covered-call writers are in a stock they don't have high hopes for over the life of the call option. Some investors see covered-call writing as a way to make back some of their losses in a stock. That's true enough, but you've still traded away your upside potential and held on to your downside risk to get that option premium.

LEAPs (Long-term Equity Anticipation Securities) are long-term options on select indexes and stocks. Rolling hedges can make long-term option strategies an expensive proposition. LEAPs allow investors, hedgers and speculators to extend their horizon for option strategies. Available as puts or calls, they offer long-term hedging and speculative positions.

Options are decaying assets. That means an option's time value declines as the option approaches its expiration date. LEAPs carry this to the Nth degree. Option pricing is efficient enough that you'll have to experience a dramatic shift in volatility (changes in price of the underlying security) to make substantial returns with option strategies. To date, that's worked against you with your Intel(INTC Quote) and JDS Uniphase(JDSU Quote) LEAPs positions. (For the basics on options investing, see Mirror Mirror on the Wall, Explain for Me a Put and Call . For some basics on LEAPs, see LEAPs, Calls and Spreads.)

It was a smart move paying off the credit-card debt. Getting out of a hole that you dug with a 20% shovel has to feel good. Now, keep current on those bills and don't let them get out of control again. I don't know what your credit report looks like, but if it's clean you should be able to do better than 19.9% on a credit card. You can shop credit card rates on Bankrate.com.

If you're paying loads on your Putnam funds as part of your company's 401(k) plan, it's time to start lobbying your plan administrator for some no-load choices. And with your current 401(k) balances, I don't think you need four mutual funds. That should give you a reason to transfer out of the (POEGX Quote)Putnam OTC Emerging Growth fund.

Finally, it was probably convenience that caused you to invest over half of your financial assets in the Nasdaq 100 Trust, but convenience isn't a good enough reason to keep it there. Figure out what you need as cash, and then diversify by moving some of the money out of the index. I'd recommend that the index not be more than 20% of your portfolio -- especially given the tech bent of some of your Putnam funds. To figure out how much you need to save for retirement, use a retirement calculator. Remember that the more you can invest in your 20s, the easier it'll be to meet those retirement goals.

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