Options can be a useful tool for investors willing to use them to buy and sell stocks. Selling puts with the expectation of buying a stock can provide a discount price for the shares or some income if the options aren't exercised. But they can also get you into trouble far more quickly than regular stock investing.
Mistakes in options writing were a big part of why 2011 was one of my worst years investing. Instead of making these same mistakes yourself, learn from the mistakes I made below.
Don't get too aggressive
My biggest downfall in 2011 was an options position in American Superconductor (Nasdaq: AMSC) that blew up in my face. I had followed the company for years and built a small position in the stock. Early in the year, I decided to sell put options. That would have left me with the premium if the stock went up, and I would have bought shares of the stock at a discount from the current price if the stock went down.
When the stock began to drop in March, I doubled down by selling more put options, making my bullish bet even larger. In particular, my position grew much larger than the number of shares I would have bought in the same situation. Big mistake.
Close to expiration, these options had declined in value, leaving me with a profitable position. But then, the company announced that Sinovel had refused shipments and news began to trickle out about stolen intellectual property, sending the stock plunging 50% and turning my position into a huge gamble on the company's recovery to a price nearly double where shares were trading after the drop. That turned my big options position into a big loser.
Limit your downside
One of the things I should have done to limit my downside is to purchase protection for my put position. Buying out-of-the-money puts to offset an at-the-money put position is called a bull put spread, and it can greatly limit the downside of writing puts alone. I still would have lost money, just not as much.
This can be especially useful with stocks that can be volatile and swing quickly against you. The out-of-the-money put position is far less expensive than the at-the-money put position, making protection a financially viable choice.
Know when to fold 'em
When you sell options, the price of the option price will naturally decay if the stock's underlying price doesn't change. This is because the time left on an option has value. The more time left, the more value the option has. One of my biggest mistakes with American Superconductor was not buying back options I had sold after most of this decay occurred, which would have left me with a profitable position.
I benefited from that lesson later in the year with a GT Advanced Technologies (Nasdaq: GTAT) option position that I sold for only a slight loss. When fast-expanding polysilicon maker ReneSola (NYSE: SOL) started reporting losses and seeing sales flounder, I decided to cut the cord on solar supplier GT. I realized that polysilicon prices would likely remain low for the rest of the year and GT Advanced Technologies would likely be hurt by lower demand for its products. I bought back the put options I had written for only a slight loss, and this saved me from even greater losses as the stock plunged.
Understand which stocks are worth the risk
My biggest lesson in 2011 was to stay away from options unless you know a company like the back of your hand and can quantify some sort of value. Following that advice, I used valuation and volatility to successfully trade gaming options over the past year.
When gaming stocks traded below enterprise value/EBITDA ratios of 10, I viewed this as a good risk/reward opportunity for put option sales in 2011. Both Melco Crown (Nasdaq: MPEL) and Las Vegas Sands (NYSE: LVS) reached this level during the year, so I sold put options to take a long position in the stock. Since these stocks have betas of 2.2 and 3.6, respectively, I was able to collect a higher premium than from a less-volatile stock while understanding my risk because the stock traded at a value I was comfortable with.
Foolish bottom line
If you know a company well and can reasonably bet that it is trading at a value, selling put options can be a great way to earn some extra cash in if the stock goes up while letting you buy stock at a discount if the share price falls. Just make sure you don't overextend yourself.
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