Selling naked puts can be extremely profitable but what happens when a true Black Swan type event occurs. What does an investor do when they are selling puts against a wide number of stocks and the stock market collapses? A recent question from an investor brings a full discussion of how I handle a true Black Swan event.
From reading your articles it seems that you like to only do naked puts on stock you don’t mind eventually owning. So if a 9/11 event occurs and there is no way to rescue your trades, you will own stock which you’ve already determined you want in your portfolio. Am I understanding you correctly on this point? – Dorothy
Handling A True Black Swan Event
Since starting investing in 1973, the year of the Arab oil embargo, I would say that the only true Black Swan event was the tragic 9/11 attack. The collapse of a stock market due to a true such black swan event is difficult to manage when holding naked puts on individual stocks. Your example was a 9/11 type event. Fortunately those types of events are extremely rare and by and large you cannot prepare yourself for such a collapse. Interestingly, the 9/11 attacks occurred when the market was already in a bear market and the indexes were trading below the 50, 100 and 200 day moving averages so some investors may have had protection in place against the bear market not realizing that an event like 9/11 was about to occur.
Most other events, including the flash crash of 2010 can be spotted in advance. This article discusses these types of market collapses and what warning signs to look for but an event like 9/11 cannot be predicted or actually prepared for.
The Advantage of Doing Spreads
For comfort and protection put credit spreads are definitely better than sell puts naked, if an investor worries about catastrophic events. While the actual dollar capital earned will not be as good, the protection level is much higher.
Real Protection Against Black Swan Events
I believe the best protection against black swan events are understanding the stocks or asset classes you are trading in. For example I do not worry ever about black swan events. I trade almost exclusively in large cap stocks in everything from Coca Cola to Clorox. Basically I trade within stocks that should such an event occur, I know that my stocks will recover and I will be able to continue to generate income during such an event.
Not All Stocks Are Created Equal
It is important to understand that not ALL stocks are the same. Johnson and Johnson Stock for example collapsed in the days after the 9/11 catastrophe hitting a low of $50.20 on September 21 2011. Within three weeks the stock was back trading higher than it was before the 9/11 event. In this regard the collapse was actually an opportunity, despite the tragic event of 9/11.
Microsoft Stock is another good example. This stock fell after the 9/11 attacks to a low of $24.00 on September 27 2001 and then commenced to recover back to pre-attack levels within less than two weeks. Analysts and investors love to trash-talk Microsoft but it is important as an investor to acknowledge differing opinions but study the actual stock being traded. Microsoft is a highly diversified company and not just a “Windows PC” based entity. The stock offers tremendous trading values for those selling puts and trading the stock on bounces. Once again the collapse of 9/11 despite the tragedy surrounding it, proved to be an opportunity for adding additional profits to a portfolio.
Understanding Risk and Stocks
Stock collapses are tough emotionally. The 9/11 attacks were horrific. There are no adequate words which can be used to describe this tragedy.
As an investor it is imperative to acknowledge that you are trading in risky assets. Nothing is guaranteed in stocks. This is absolutely why I stay with stocks that have proven their value.
What We Learn From BlackBerry and Apple
BlackBerry for example was a company not well diversified. Apple on the other hand is far more diversified than BlackBerry was or is. This is why two years ago I wrote a number of articles complaining that management at BlackBerry were changing their focus from expanding their business to bringing a hockey team to Hamilton Ontario Canada and when that failed, trying to secure a basketball franchise. When management loses focus, companies like BlackBerry are bound to collapse. When a company grows it has little choice but to become more competitive, expand product offerings, buy up weaker rivals, secure control of their market place, lock in customers, offer products and services that cannot be had elsewhere and expand into related fields that work toward a stronger balance sheet and growing revenue. If they don’t, they will face an eroding customer base and declining revenues. In short, they begin to die.
BlackBerry did not do this and even today with all their rumors about change and news releases about upbeat outlooks, they are still not doing this. Apple on the other hand is not sitting back and continues to innovate, expand, lure in customers, buy out rivals and much more.
What We Learn from Bill Gates
When Microsoft was building their company CEO Bill Gates was focused on his product offerings. The company continued to expand beyond Windows For Workgroups and moved into Microsoft Office product lines, server products, database software and dabbled in a variety of hardware products before coming to terms with X-Box. All of this was during the days of Bill Gates. But when Gates’ turned his attention to philanthropy he left his position behind for others to fill and continue to lead the company. In other words, unlike those who were head of Research In Motion, now known as BlackBerry, Gates realized that he could not divide his attention. He knew that Microsoft would suffer and it was time for others to lead. Recently CEO Steve Ballmer has done the same, stepping down to let someone else lead. This is the type of company I want to stay with.
The Best Protection Against Black Swan Events
Therefore it is important to understand that while it is perhaps next to impossible to protect your portfolio against an unexpected market collapse such as 9/11, the best protection I have found is trading within those companies that can withstand such events and will recover. These are the companies that when investors flee in such a collapse or in severe bear markets, they can be bought for greatly reduced prices. I call this a fire-sale event.
Profiting From Fire-Sale Events
Another good example is Clorox Stock. All the major bear markets of the past 14 years and the 9/11 event are just history for many large cap quality companies. Below you can see the various events and low points for Clorox stock. Each of these events proved to be periods to add to positions rather than dump shares. These were terrific bargains which a lot of investors failed to take advantage of. Even the low in Clorox Stock after 9/11 of $34.80 which happened late in September 2001, is now a distant memory.
Keeping Cash Available
To sum up then, it comes down to you as an investor. For myself I have many strategies which I employ and would use in a true black swan event. I always keep some cash aside which I can bring out to trade in such an event. But there are other more simple strategies including everything from selling deep in the money naked puts which is one of my favorite to rolling naked puts sideways in market collapses. When a stock collapses such as you saw above in Clorox Stock, I am happy to sell in the money naked puts and pick up the huge premiums on such a collapse. For example in March 2009 with Clorox Stock trading below $46 I sold a string of naked puts at the $50.00 put strike all the way out to January 2010 for exceptional profits. I believed the stock would recover and eventually my naked puts would be out of the money.
Staying Ahead of Assignment
Remember too that following a black swan type event, the aftermath may actually be worse than the event itself, such as was the case with 9/11. But a black swan event does not meant that I will be immediately assigned shares against all the naked puts that may end up deep in the money. Often I can delay assignment for months to years by rolling far out in time and by staying well ahead of the expiring month when rolling forward. I can also use other strategies to reduce my average cost lower and keep rolling down some of the put contracts sold and once again stay ahead of assignment. So even in a black swan type event I may well end up not being assigned against the naked puts I sold prior to the event itself.
By and large, do-it-yourself investing is a somewhat lonely undertaking. Part of the reason I developed my website is to show other investors that it is possible to be successful at do-it-yourself investing. That while we may trade alone we are still part of a larger group of investors who believe there is a better way to build wealth and be successful in managing our own capital. I continue to believe that through sites like mine, do-it-yourself investors have a place to come and see what others are doing. They have a place to seek comfort, learn strategies, witness results both good and bad and learn ways to stay profitable. They learn to keep emotions at bay and withstand the market gyrations that come with investing in what are often the riskiest of assets – stocks.
The Best Protection Available
The best protection to a true “black swan” type event such as 9/11 is to be aware of what stocks you are trading in. Understand fully the product lines they sell. Stay within leaders of industry that are diversified and focused on their bottom line. Look to the past and see what the history charts show for the companies you are trading in. All of this is what helps me not worry about a “black swan” event.