I’ve gotten quite a few questions recently about “income” and “buy stocks cheap” letters that are clearly veiled hints about put option selling… so I thought I’d take a look at one of them.

The ad in question today is from Karim Rahemtulla, who calls himself “The Frugal Millionaire” in this spiel and has been involved in a bunch of different Agoraplex newsletters over the years. He has pretty regularly pitched the idea of “options income”, though this particular newsletter seems new — it’s called Automatic Trading Millionaire (subtlety will get you nowhere), and he’s currently selling it for $995/year by promising that his “coupon codes” will let you buy stocks at a discount. You can see the whole ad here if you want more of the details, but if you give me a few minutes I’ll explain what he’s talking about…

Here’s a taste of the pitch, from the order form:

“Receive Your First Stocks for Up to 50% Off

“(And Over $1,500 in Instant Cash Opportunities)

“It’s time to start saving money on every stock you buy.

“Why pay full price and lose sleep over falling prices?

“With these stock market coupons, you can get the chance to pay up to 50% less than the average investor.

“You’ll receive your coupon codes within moments of completing your order.

“When you use this strategy, it…

• Makes your returns even BIGGER when stocks go up.
• Protects you from losses when stocks go down.
• Hands you thousands in instant cash income.

Going by the pitches made throughout the ad, this is clearly all about selling put options… which means you sell someone the right, at a specific price and before a specific date, to “put” their shares to you.

Here’s one example, of dozens that he runs through in the ad:

“It truly is a chance to get the stocks you want at BIG discounts to today’s prices – up to 50% off.

“You can do it with virtually any company…

“For instance… General Electric.

“It trades for $14.

“But you could offer to buy GE for $10: 28% off!

“That’s why I think of this approach as using a ‘stock market coupon.’

“The chance to get it at 20% off works instantly.”

That one includes a little graphic of a GE “coupon” for buying the shares at 28% off, but it also includes the code (GE190118P10), which is a simple put option ticker.

What does that mean? The first part of the put option ticker is the stock symbol, GE… then the next bit is the date, so 1901118 is January 18, 2019… then a “P” for a put or a “C” for a call, and the strike price. Most large companies, and some smaller ones, have options contracts available for trade, usually with a variety of prices and dates going out 6-9 months into the future (or a year or two, for LEAP options).

An option contract gives the buyer an option, and the seller a commitment. So yes, if you buy this contract you are buying the right to sell someone GE shares for $10 anytime between now and January 18… it’s a way to either bet against the stock if you think it will keep falling, or to hedge your position if you hold a lot of GE shares and don’t necessarily want to sell.

But we’re talking about taking the other side of that trade, selling this contract and agreeing to buy GE (have it “put” to you) at $10 a share until the expiration date. That’s sort of like “offering to buy at a discount” … but it’s more like “promising to buy if it falls,” with the distinction being that you can pull an “offer” anytime, but once you’ve sold an options contract you either have to live with the promise you made, or buy it back (presumably at a higher price).

Right now, that particular put option contract goes for about 40 cents — GE is down to $13 now, so when it was a little higher the price of that “insurance” put option might have been a few cents lower. So if you promise to buy 100 shares at $10 a share, putting $1,000 at risk, you’re being paid 40 cents a share, $40 in total for the 100-share contract, for that promise. Each options contract is for 100 shares, so you can scale it up in 100-share increments if you want.

How do those facts fit the order form promises?

• To some extent that is like “offering” to buy the stock at a discount… so if the stock actually falls to that level, you would buy it and pay less than it’s trading at today (though not less than it’s trading for then). If the stock doesn’t fall to $10, then you keep your 40 cents and the contract expires worthless.
• It makes your returns bigger when stocks go up only if they fall, you get the shares put to you, then they go back up. If GE falls to $9 in December, for example, and you get the shares put to you at $10, then it goes back up to $20, you made more than people who paid $13 for the shares today. Pretty tough to get that timing right, however.
• And it protects you from losses only if the losses are small… because you’re selling protection against larger losses. If GE goes to $5 in January, you’re stuck paying $10 for your shares so you’ve lost quite a bit. If it falls to $11 or $12, then it’s true that you haven’t lost anything and are better off than the folks who own the shares.
• And it can hand you thousands in instant cash income… though the amount of income is directly proportional to the amount of capital you put at risk, and to how much risk you’re willing to take. To make $1,000 from that GE put option trade, for example, you’d have to sell 25 contracts and therefore promise to buy $25,000 worth of GE stock at $10 a share.

There is, at least, some honesty in the “coupon” approach because he’s not focusing on the “income” part of the trade — he’s focusing on the fact that you’re effectively “conditionally pre-ordering” stocks at a “discount” to recent prices.

And that’s the key distinction that most folks who don’t do this kind of trading probably gloss over in the appealing “offer to buy at a discount” part of the idea: You’re not offering to buy the stock, you’re promising to buy the stock. That’s a bit more “active” than some folks might envision when they use that metaphor of the “coupon,” since a coupon for 50 cents off a gallon of milk does not, of course, commit you to buying that milk.

That doesn’t mean this is a terrible strategy, but it does mean it requires a fair amount of cash — options trade in 100-share increments, so even if you sell one put option contract for a stock that trades at, say, $60, promising to pay a “discount” of $50 a share, you’re committing $5,000… and commissions can seem pretty high if you trade only one contract.

Probably the easiest way to explain how this works, and to illuminate some of the risk, is by going through the trades that he’s actually hinting at… that GE one above was one example, but he didn’t actually say that he’s recommending that one — so let’s look at the three “Discount Opportunities” Rahemtulla is specifically pitching.

“The first company is one you’re going to love getting the chance to own at a discount.

“They had strong growth in 2017 with $21.7 billion in revenue – up 19% over the last five years.

“But here’s the part you’re really going to love…

“It’s a Warren Buffett holding. And I’ll show you how to get the chance to pay 35% LESS than the market’s price!

“Buffett would be proud of our thriftiness!

“Not only that, the coupon for this stock can add up to $700 to your account instantly.”

That one is very likely Southwest Airlines (LUV), which did have $21.7 billion in revenue in 2017, 19% growth from the $17.7 billion they reported in 2013… and a fairly substantial Berkshire Hathaway holding, along with a basket of other airline stocks.

So what’s this “buy for 35% off” deal that lets you collect “instant cash” of $700? Well, Southwest now trades at $55 a share, so that would mean you’re “offering” to buy it at $35, roughly 35% below the current price.

The income from this kind of trade, however, would be extremely limited… because most people are not terribly afraid of LUV shares falling by 35% anytime soon. So if you want to be paid to take that risk off the table for them, then you need to either accept a low return or promise the “coverage” for a longer period of time to increase the return a little bit.

Promising to buy LUV shares at $35 anytime before September option expiration, for example (about five months of “coverage”) would get you about 20 cents a share. Since one option contract is for 100 shares, that would be $20 of payment to you in exchange for risking $3,500. Now, it’s not a likely “risk of 100% loss” for that $3,500, but that’s why the cost is so low — no one thinks LUV is going bankrupt.

So how do you get to $700? You could do it by promising to buy more than 100 shares — if you are comfortable buying $122,500 worth of LUV, and setting that capital aside to meet your obligation until September, you could earn $700 for that. That’s about equivalent to putting your money in a savings account, with annualized earnings of about 1.3%.

Or you could go further out in time — if you make that promise until January 18, 2019, you can get 45 cents for promising to buy LUV at $35 a share. So to get to $700 there you have to sell about 15 contracts, committing to buy 1,500 shares and therefore tying up about $52,500 until January. That’s a somewhat better return, an annualized 1.7% or so.

Which means, yes, that when you offer to buy a stock for dramatically less than the current price, you may not get paid that much. When shares are falling, the put option pricing tends to get more appealing for put sellers because investors are worried and interested in either hedging or betting against stock prices (that’s the common definition of “volatility” using the VIX: rising prices for put options) … but even though LUV is down about 20% this year from its highs, investors are not paying much today to bet that it will fall substantially more.

The better returns typically come when you promise to pay a price that’s closer to the current price — which means, of course, that you’re taking more risk. You could make $1 a share, for example, by promising to pay $45 for LUV until September 21, much nicer income than that 20 cents you get for promising to pay $35.

What’s the next one?

“I have another stock the Oracle of Omaha is bullish on…

“It’s a bank stock you can offer to get for a whopping 24% off the current market price.

“With interest rates on the rise this year, bank stocks are going to be the new haven for safety.

“And again, this is a stock Buffett himself holds, so you’re in good company… you may even being paying LESS than he did!

“You’ll also get up to $1,000 in instant cash when you use this coupon… Money you can put in your own bank account immediately!”

Buffett’s Berkshire Hathaway owns a lot of bank stocks — Bank of America (BAC), Bank of New York Mellon (BNY), Goldman Sachs (GS), M&T Bank (MTB), Synchrony Financial (SYF), U.S. Bancorp (USB) and Wells Fargo (WFC). Throw in American Express (AXP), and that’s a lot to choose from — though Wells Fargo and Bank of America are by far the largest positions, and BNY and USB are the ones he added to most recently (not by very much).

That’s going by what Berkshire owned and did in the fourth quarter, since that’s the most recent 13F we have from Berkshire Hathaway, so the data’s pretty stale — we won’t get another update until next month (institutional investors like Berkshire, and money managers, have to report their portfolios 45 days after the end of the quarter).

And I’d bet that most of those won’t pay you much for a “buy it 24% cheaper” put option sale — Bank of America investors, for example, would pay you 40 cents for a promise to buy shares at $22 until January 18th, 2019… which would mean committing $2,200 to earn $40.

Still, that’s better than the Southwest trade, you get an annualized return 2.4% with this “offer.” Of course, to make $1,000 in “instant cash” on this one you’d have to sell 25 put contracts, which would mean committing about $55,000 to possibly buying BAC shares in order to get that “instant cash” of $1,000. You can try the same math with the others, of course, but the results are not likely to be dramatically different — BAC is not the most volatile big bank stock, but it’s jumpier than some and more placid than many… the returns for a BAC put like this are quite similar to what you’d get by promising to buy Wells Fargo (WFC), for example, a stock which is arguably much more embattled, at a 24% discount (a $40 put option, in the case of WFC).

And we do get one more, which is not specifically a Warren Buffett stock…

“My third and final company is another one I know you’re familiar with. They’re one of the most established companies in the world.

“Like I said, I recommend quality, not obscure startups.

“The company pays a 7% dividend after our discount and adjusted price.

“We’re looking to get them for 20% off the current market price.

“And of course, when you use this company’s coupon, you can get up to $780 in instant cash.”

So… if you’re offering to buy a stock at “20% off” and the yield would be 7% at that price, that implies the current yield is 5.6%. Which would mean that “one of the most established companies in the world” at that kind of dividend yield might point us to AT&T (T) or GlaxoSmithKline (GSK), among other possibilities (we don’t get any clues, but both of those match on yield… if you give a bit of a wider range for the dividend yield you might also include some big REITs, or Ford Motor (F), or a few utility stocks… the list gets long quickly),

AT&T is mired in the takeover fight of the year right now, so perhaps they’ll offer a better return for put option buyers — stocks that are volatile, with known catalysts coming, generally have higher option prices. If you promise to buy T at $28 until January 18, for example, options buyers are offering you 55 cents to take that deal — which would mean you’re risking $2,800 to earn $55, an annualized return of about 2.6%. So clearly if it’s just the income you’re after, it’s better to just buy the stock and collect your 5.6%… but if you’re convinced that the whole market is going to fall by 20%, this is one way to commit yourself to “buy the dip” and therefore get a higher effective yield in the future. IF the stock falls to $28 without the company also cutting the dividend.

So that, really, is where the nuance lies in this whole scenario — yes, you can make money by promising to buy stocks at prices well below the market… but it’s not a lot of money UNLESS the stock actually does fall to below that price and then recovers higher.

Selling put options does four things:

1. It generates income. The more risk you take on from the buyer of the puts, the more income.
2. It commits you to buy stock at a lower price. Whether this is a positive or not depends on your psychology — would you commit today to buy T at $28 no matter what? Are you a “buy the dips” person who doesn’t mind “catching a falling knife” and having some confidence that it will eventually rise again? If not, this might cause you sleepless nights. In this way, these contract sales let you make future promises based on current expectations… which can be good in the sense that it works against emotional behavior that tends to hurt our portfolios — if a stock is in the middle of falling 20%, it might not seem so appealing unless you had already decided that $28 was your buy price and made rational sense given your understanding of AT&T’s business and prospects. You can reduce the risk of committing to buy a stock that goes into freefall by also buying a put option at a lower price, but that cuts into your income.
3. It ties up money. You will have to either have cash in your account (if it’s a cash account or retirement account) or a portion of the cash plus available margin loans from your broker to cover the purchase of the underlying stock. In a margin account, you might be able to put up as little as 20-25% of the capital, which makes the income from the put sale look better, but you’re still at risk for the rest… and if you use margin, you’ll also pay interest for that margin loan, and will actually borrow that money if you are forced to fulfill your promise.
4. Your “income” return is quite limited. You do get the cash for selling the put option, no matter what, but if the stock goes up (or stays flat and pays a dividend), you do not get any other positive return.

So in Rahemtulla’s ad, he’s glossing over a few things: First, he doesn’t mention the large amounts of capital you have to put at risk to make even $1,000 in “instant cash” in most of these kinds of option sales… and he shows huge return figures that assume you will sell a put option on a stock that then falls to that level, putting the shares to you at a discount, and recovers dramatically after that to make you great profits.

That’s possible, of course, and the backtesting examples he provides are real… but finding stocks that dip by 20% or 30% and then surge much higher and make you rich is a lot easier in backtesting than it is in real life.

So the risk, as with all option sales, is that the odds of success are pretty high (he says he had a 100% success rate in 2017, which is quite likely true, since almost all stocks were rising almost all the time), but the income-per-transaction is quite low… so your returns on the capital you have at risk may well not keep up with just buying index ETFs in a bull market.

And if you’re right only nine times out of ten, it is not that hard for the one loss to eat up the nine wins — you could generate a few hundred dollars each from selling put options on a bunch of different companies, for example, and then have one holding collapse and cost you a couple thousand dollars.

What would that look like? Well, let’s just hypothesize about what could go wrong with that AT&T example… they could fail to consummate their Time Warner deal, and Verizon and Sprint could slash prices to push for market share just as DirecTV is losing customers to Netflix, and interest rates could start to spike higher toward a 10-year note rate of 4.5%, which drives up T’s borrowing costs on its massive debt and makes the dividend look less appealing… investors start to see all of this possibly happening in 2019, which makes the 5.6% yield look less compelling, so they drive the shares down… and AT&T sees their cash flow deteriorate and cuts the dividend by 25%, which scares more investors away, and before you know it the stock is at $18. You’ve committed to pay $28 for your shares, so the 55 cents you earned for selling that insurance is now costing you $10 a share, or $1,000 per contract.

That’s not the most likely scenario, of course, but it’s not impossible — so it’s important to think through those risks, because if there’s really something that could make you nervous about buying AT&T at even a 20% discount to the current price, a chance that the business would be permanently less valuable rather than a risk that it would just dip down and then recover, it’s easier to think about that now than it is when the stock is actually cratering and you’re on the hook to buy it.

If you can handle that kind of emotional whiplash, and would happily buy those shares at $28 because you’re confident they’ll be back to the $30s before too long, and it wouldn’t be eating you alive that other people are paying $18 or $20 at the time you’re forced to pay $28… then selling that put option works great, and the odds are probably in your favor over the long term, especially if the general bull market trend continues.

But a lot of people can’t easily handle that kind of trading. If you’re mostly just excited about earning that 55 cents a share in “instant cash,” then remember to weigh that 55 cent income against the $28 promise you’re making in exchange.

So there you have it … the big, bold headlines say that you’re buying stocks at a huge discount, and that you’re collecting “instant cash” of $2,480… and that’s mostly true, though you’re “promising to buy” rather than buying, and won’t be buying that stock if it doesn’t fall to your discounted price.

So what you get for that promise is the psychological benefit that you’re forcing yourself to buy a stock after it has fallen sharply… though it might hurt if you have to pay more than the then-current price… and, of course, you get that ‘instant cash’ income. Do note, however, that the “instant cash” for the lower-risk trades being teased here are lower than the dividend income you’d get from just buying the S&P 500 index fund, and not much higher than the interest from a bank account… $2,480 comes as payment for putting something in the neighborhood of $150-200,000 at risk.

Sound like fun? Think this kind of trading is the way to deal with a richly valued market? Any additional insights to share with our readers about put selling, or experience with Karim Rahemtulla’s advice you’d like to pass along? Let us know with a comment below.