Selling Naked Puts Stripped This Investor of Most of His Assets - TheStreet

Selling Naked Puts Stripped This Investor of Most of His Assets

Dr. Don says he needs to put that lesson to work in what's left of his portfolio.
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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) - Get Report 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.,

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) - Get Report

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) - Get Report

and

JDS Uniphase

(JDSU)

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)

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.

Send In Your Portfolio

If you would like to submit your portfolio for a makeover, send it to portfoliorx@thestreet.com. Give us enough details -- dollar values or percentages -- so we can determine how your assets are allocated. Also tell us a little about yourself and your investing goals, and let us know how we can contact you if we have further questions. Though we'll only use your initials publicly, please include your full name so we can verify your identity. Unfortunately, we cannot guarantee your portfolio will be selected for a makeover, nor can we promise to respond individually to everyone who submits a portfolio.

Dr. Don Taylor has been an investment professional for nearly 15 years, most recently as the treasurer for a nonprofit organization where he managed more than $300 million in assets. He is a chartered financial analyst, holds a Ph.D. in finance and has taught investment and personal finance courses at the University of Wisconsin and at Florida Atlantic University. Dr. Don's Portfolio Rx aims to provide general investing information. Under no circumstances does the information in this column represent arecommendation to buy or sell. Dr. Don welcomes your inquiries and feedback at

portfoliorx@thestreet.com.