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Dear Daily Crux reader, Today, we've got another installment of our popular "World's Greatest Investment Ideas" series. This week we're back with Porter Stansberry, founder of Stansberry & Associates Investment Research, with another one of his favorite investment ideas. This is an idea that many investors have never considered... but one that allowed Porter and his subscribers to make 50%-plus returns during the worst days of the financial crisis, with very little risk. We sat down with Porter to discuss this idea and learn how anyone can take advantage of this strategy to boost returns while dramatically reducing risk. Read on for the details... Regards, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com –––––––––––––––––––––––––––––––––––––––––– The Daily Crux Sunday Interview The World's Greatest Investment Ideas: Selling Put Options The Daily Crux: Porter, you've written a great deal about selling put options, and why it's one of the best strategies to lower risk and boost returns in the stock market. Before we get into the details, can you define the idea for us? Porter Stansberry: I'll assume readers understand what an option is, and the difference between call options and put options. If not, our colleague Steve Sjuggerud has a great primer on the subject. Now, when most people think of trading options, they think of buying them. The fact is, most options expire worthless, and most investors who buy them lose money. Of course, there are skilled traders who are able to consistently profit by buying options, but the average investor who indiscriminately buys options will inevitably lose money, give up, and write off options as "too risky." But that's not at all what we're talking about here. Try to forget for a moment that we're talking about options. What if I were to tell you there was a way to buy stocks where you can greatly increase your returns, buy them below the price you can get them in the market, and nearly eliminate the possibility of losing money? Would you be interested? That's exactly what the strategy of selling puts can do for you. You're taking advantage of the fact that most options expire worthless to swing the odds in your favor. Crux: Why is selling puts such a great idea? Stansberry: To explain why an investor should sell puts, we first need to understand why an investor buys stock. In my mind, the first rule to being a successful investor is to understand value. A smart investor only buys equity when it's attractively priced. That is something that's hard for most people to learn how to do... but if you don't, you're missing the entire game. If you don't know, for example, that an asset-based company – like a gold miner, oil company, or real estate company – is valued based on its assets and the price of the stock relative to its assets, you're not investing wisely. Likewise, with an operating company... You need to know how to figure out the real owner earnings to properly value it. I'm not talking about the earnings numbers you see on Yahoo Finance listed as part of the "P" ratios. I'm talking about the earnings that are available to the shareholders after all the capital investments have been paid... after all the other expenses that are on the cash flow statement are included. If you're not aware of what the real cash earnings are – the owner earnings as we call them – you don't truly know how to evaluate a stock, because you don't know what the stock price is relative to its real earnings. My point is... If you're going to be a stock investor, you have to know how to analyze the value of a given equity. If you do not know how to do that – or are unwilling to do so – you should never buy stocks. Now, I'm sure some readers are thinking I'm crazy for suggesting such a thing, but it's true. It's the equivalent of saying, "I don't know how to drive, but I'm going to get in my car and drive to Albuquerque." If you've never driven a car before... if you don't know how to fill it up with gas... if you don't know how to check the air in the tires... if you don't know how to fasten your seatbelt... if you don't know how to turn on the lights... the chances that you'll arrive safely are almost zero. Likewise, if you have no idea how to evaluate value and equity securities, the chances you'll be successful as an investor are almost zero. I would say the same thing applies to mutual funds. If you don't know how to evaluate securities, you can't assume that buying a mutual fund is a shortcut. It's not a shortcut. Mutual funds are just big collections of stocks. If those stocks are overpriced, you're not going to make any money. Now, assuming you've learned how to value securities, you'll quickly realize one of the biggest problems most equities investors face: What do you do when none of the stocks you analyze are cheap enough to buy safely? When I'm valuing equities, I don't want to pay more than about 10 times cash earnings for an operating business, or more than about one times book value for an asset-based business. Given those strict criteria, most people assume that means sitting in cash most of the time. Well, not necessarily... It just means that you don't buy equities until they are fairly priced. Occasionally, something will happen that will give you a chance to buy equity at a discount. For example, last summer, before its oil well blew up in the Gulf of Mexico, BP – which is a high-quality, globally integrated company – was trading around three times book value. Later in the summer, during the worst of the spill, it ended up trading all the way down below book value. That, of course, was the time to buy it... and it's now trading back at well above book value. So you will occasionally have opportunities to buy good companies at great prices. You just have to be patient... You have to be opportunistic. But what do you do when you can't? This is where selling puts comes in. Crux: So exactly how does this strategy work? ---------- Advertisement ---------- A secret website Wall Street doesn’t want anyone OVER AGE 55 logging onto This 'underground' Internet site could help you collect as much as $653 per week in extra retirement income… Without touching regular investments… And without going through brokers and money managers ever again. Click here for details. --------------------------------------- Stansberry: It's actually pretty simple. Let me just give you a quick scenario. Let's say there's a stock out there that's widely held by mutual funds and insurance companies and things like that. And let's say its shares are trading for around $100. You have done your securities analysis, and you believe the stock would be fairly purchased at $75. Obviously, if the stock is trading at $100 right now, no one is going to sell it to you for $75. But if you were to sell a $75 put option on that stock, that's essentially the deal you're getting. Again, the math behind this is very technical, but not important for our purposes. All you need to know is selling a put on a stock is the equivalent of agreeing to buy that particular stock at that specific price. In this case, you're agreeing to buy that stock for $75 at some time in the future. Since you're selling the put rather than buying, you don't have to pay the premium... it's paid to you. You can go to an options dealer and say, "Hey, I will agree to buy that stock at $75. What would you pay me for that option?" And the options dealer is going to look around at market spreads and the volatility of the stock, and he's going to quote you a price. Now, most of the time, the price you will get paid for agreeing to buy a stock that is that far out of the money – in other words, that far away from the price you're willing to pay – is not going to be much. In this example, you're agreeing to pay $75 for a $100 stock, so it's $25 out of the money. That's a lot... So the options dealer is probably going to quote you something absurd, like $0.02 or $0.04 per shares. Every call or put option represents 100 shares of the actual stock... So in this case, you're being paid $0.04 per share on 100 shares, or $4 for each put you sell. In other words, you're going to get $4 upfront in premium for agreeing to buy 100 shares at $75. And the options all have different time spans, so you can agree to do that for 30 days, 60 days, 90 days, or more. Usually you can get options quotes up to a year or two in the future depending upon how widely traded they are. Crux: So you get paid more to sell longer-dated puts, or puts with strike prices closer to where the stock is trading... Stansberry: Right... So what many people do when they first consider selling puts is go into the market and look for the biggest premiums. This is a mistake. For example, suppose we were considering selling puts on one of the recent "high-flyers"... maybe one of the new social networking stocks like LinkedIn. Let's say LinkedIn is trading at $100. For a $75 put option a few months out, you might get a $10 premium. A novice might say, "Wow, $10 on 100 shares... that's $1,000. I can get $1,000 in cash today just for agreeing to buy LinkedIn at $75 a share anytime in the next 90 days."And so they go after that premium. Unfortunately, LinkedIn intrinsically is probably only worth closer to about $5, and it's an incredibly volatile stock. Let's say the stock suddenly drops to $25. All of the sudden, they could find themselves on the other end of a contract that requires them to pay $75 for stock that is now worth much less. As a result, they take an enormous loss. They lose $50 a share on 100 shares, right? So they've lost $5,000. This is why people believe that selling puts is so dangerous. They believe that because they don't know how to value securities and they don't understand that the stocks with the biggest premiums are often the riskiest. That's not the right way to trade put options. Crux: What's the right way to trade put options? Stansberry: The right way is simple. Let's say you have determined that there's a high-quality business out there you really want to own. I'll use one of my favorite companies as an example: RadioShack. Most people have little respect for RadioShack, but it's one of the most misunderstood businesses in the world. People usually compare it to large electronics retailers like Best Buy... But in fact, RadioShack is nothing like Best Buy. It has gross margins of 45%... Best Buy's gross margins are barely above 10% RadioShack is not where you go to buy new electronics. It's where you go to buy something when your electronics are broken. It's actually much more akin to a pharmacy... a pharmacy for your electronics. It's a great business... And it has a location within five miles of 90% of the population in America. Every year, the company makes about $300 million in cash, and the stock trades in a wide range between about $10 and $30. At around $30, the stock probably trades close to 20 times cash earnings. When it gets all the way down to $10, it probably trades around six times earnings. Those aren't exact numbers, but you get the idea. RadioShack is a buy to me when you can get it for six to eight times cash earnings, and it's a sell when it trades above 15 times cash earnings, which it does on a regular basis. An investor could make this trade consistently every two or three years, and make a lot of money with it. But what happens if you miss it? Let's say the stock recently fell down to six times earnings, but it has already rebounded a good bit and is now trading back above 10 times earnings. It's not expensive, but it's also not cheap. So you don't want to buy it now, but you are confident that you want to buy the stock eventually. That's the most important part in this decision-making process. You're confident you want to want to own this stock. You're confident that you're willing to own it for two or three years. You're confident in the business. You're confident in what it's worth. You can go into the options market and look at RadioShack. There is very little volatility in the stock. This means traders are less interested in it, so there's relatively little dealing in the options... You can only really find options that are, at the most, about six months out. Let's say RadioShack's trading at $12, and I want to buy it at $10. I might be able to sell a $10 put option for $0.25 per share in premium, or $250 per option contract. It's not a home run, but it's a solid return on the capital I'm putting at risk. I'm making 4% or 5% a month selling these puts. I can also sell a new round of them each time they expire and the stock continues to trade above my buy price. So I can make a consistent 4% or 5% a month, and the only risk I'm taking is that I have to buy the stock at $10, which is exactly where I wanted to buy anyway. Crux: How often do put option sellers end up having to buy stock? ----------- Advertisement ----------- "Bucket" $625 in 60 Seconds or less If you have a brokerage account, you can collect $625 of other people’s investment losses, on 3,500 stocks... via the Internet. In fact, one of our colleagues has already "bucketed" thousands of dollars with this system from his home in Georgia. Click here to get started doing this yourself. ---------------------------------------- Stansberry: In my experience, if you're selling puts at 10% below the market price or more, you will almost never end up being forced to buy the stock. But you must always be prepared to do so... meaning you must size your positions based on how much stock you would be willing to buy. Crux: Are there any major risks to selling puts? Stansberry: Again, the critical thing is you have to know where you are willing to buy the stock. Once you know that, selling puts at that price is essentially risk-free, because you were a willing buyer of that stock at that price anyway. Therefore, all the premiums you received for agreeing to buy the stock at that price are gravy. It's just icing on the cake. If you look at selling puts that way, you will never have a problem. You're never going to have a big loss... And it will add to the discipline of your investing a great deal because it will prevent you from ever paying too much for a stock again. So the next time you want to buy a stock – once you figure out what it's worth and what price you're willing to pay – consider selling a put rather than buying the stock outright. Just be sure to choose a put option with a strike price at or preferably a little below your preferred buy price, so you have no risk when you buy. Crux: Certainly, there must be some risk? Stansberry: Well, of course, technically there is risk. There is risk in any investment you make. What I'm saying is there is no additional risk in selling a put – when done correctly – than there is in buying a stock at a great price. Am I taking a risk when I pay six or eight times earnings for shares of RadioShack? Technically, yes I am. So you can't say it is zero risk. But can you say, historically, buying the stock at that price always leads to a profit? Yes, you can. Can you say that it's unrealistic that anything bad is going to happen to that corporation in the next decade? Yes, you can say that. It's at no risk of bankruptcy, it has high cash flows, and it's been in business for 40 years. Nothing is likely to change about the need for people to go pick up doohickeys around the corner for their electronics, because it's the kind of thing that you don't want to have wait to get online through Amazon. If your cell phone isn't working because your battery died or you don't have a charger for it, you want to go get a new battery or charger for it right now. That's why pharmacies are such good businesses... and that's why RadioShack is such a good business. These are the kinds of businesses you want to buy at the right price. Selling puts is simply a way to "buy" those stocks at the price you want to pay, regardless of where the stock is actually trading, and get paid to do so. If you're going to buy stocks, you should almost always sell puts instead. Doing so allows you to pick your entry price and gives you an enormous margin of safety. Crux: Thanks for talking with us. Stansberry: My pleasure. Summary: Selling puts is a simple way to "buy" the stocks you want to own, at the exact price you want to pay, while minimizing risk and greatly increasing potential returns.