Getting Naked

Some methods of investing are so dumb that they don't deserve to be called strategies. Selling puts naked is one of these nonstrategies.

Many readers have asked me about this method, suggesting that they have had excellent luck with this. Their reasoning: If you like National Gift Wrap at 40, why not sell a $3 put struck at 35 against it where you would "create" the stock at 32? The best that happens is the put goes out worthless -- you sold it. The second-best that happens is that you have found a cheap way to buy National Gift Wrap.

What's wrong with this?

Everything.

First, a word about strategies of investing. One of the cardinal rules of good investing is that you have to define your risk, but not define your rewards. When you sell a put you are doing just the opposite.

In the example above, you can't make more than $3 -- the price of the put you sold. But how about if National Gift turns out to be using MicroStrategy's (MSTR Quote) or Waste Management's(WMI Quote) or Cendant's (CD Quote) (OK, the old Cendant's) accounting? Or let's say National Gift missed its quarterly estimate big-time!

Now the stock breaks to 15. You have sold a put to make $3. But you are out everything between 32 and 15. You risked the whole shooting match to make those lousy $3. That's just stupid.

It gets worse.

The reason I haven't written this piece before is because, as long as the market was climbing, this strategy took on a sheen of brilliance. People would write puts that would go out worthless -- month after month after month picking up income. And they thought that this method was Midas-like in its bounty.

Now we are seeing, in this downturn, the underside of this strategy. Investors who sold puts when the market was much higher are now scrambling to raise cash to be able to afford stocks they never thought they would have to buy.

Typical.

In 1987 and in 1989, brokers constantly touted this method. The '87 crash obliterated almost everyone who did this, and those who weren't erased got vaporized in the October 1989 minicrash.

Before you write a put, remember, not only is this the most super-bullish strategy imaginable, but you may not have enough money to buy all of the stocks you have contracted to buy if the market goes really sour.

Don't do this. It is wrong.

Enough said.

Random musings: With small-cap stocks collapsing, Business Week's Gene Marcial gives you a chance to exit three of them on a high: Level 8 (LVEL Quote), MarineMax (HZO Quote) and Dataram(DRAM Quote). Take that egress.