Phrenzie.com

My capital allocation was always in stocks, real estate, cash and a smattering of “alternative” investments (like loans and investments in private businesses). Performance varied a lot, but still bested the S&P for the last 4 years.

But in 2004, I tried options. Horrible results, just plain bad. My approach was jacked. I didn’t understand my risk tolerance, didn’t have enough discipline, didn’t do proper due diligence, including cash flow modeling and didn’t understand options. No wonder it seemed like each option LOST money.

All of that changed and I figured out how these things can work for me (cut to the Rich Dad, Poor Dad Seminar in your area commercial, quick!).

I usually sell puts (which gives the buyer the option to acquire a short position in a stock – sell stock to me, and that I have the obligation to buy – the buyer hopes the stock will drop in price).

This does several things for me…

1. I don’t have to “use” capital to invest, which allows existing capital to earn interest (see below). If I actually bought shares (which is still do from time to time), then my opportunity cost increases, because the capital used to invest, can’t earn interest.

2. Gives me money up front that I can put into a bank account yielding more than 7 times the national average (I use Citibank’s Ultimate Savings account v. Wachovia Money Market). This is in addition to the interest earned above.

3. This is key – I don’t care what direction the stock goes, as long as it doesn’t go below the strike price. And since make the strike price so low that I think there’s little chance of the stocking going below, the trade represents high return, low risk…the best of both worlds!

The only drawback is that for each put option sold, the broker restricts a certain amount of my capital, so that I can’t use it (the broker wants to make sure that I reserve capital in case the option buyer wants me to buy the underlying stock – remember the buyer has the option to sell, which means that I have the OBLIGATION to buy).

But that doesn’t mean that the restricted capital doesn’t earn interest (if cash) or potential appreciate (if stocks). The money I get when I sell earns interest and the investment is fairly low risk.

Give you an example. In October, I wrote Google options with a strike price of $470 due October 17, 2009. The stock was trading at about $487 at the time. The price dropped to about $484.58 before ending at $549.85.

You might say, well why not buy the stock and have unlimited gains.

1. I didn’t have enough available capital to actually buy the stock, without borrowing money.

2. I didn’t want to buy it, either. In my mind, the stock could have dropped. With my approach, I really don’t care if it drops, stays the same or goes up, as long as it doesn’t go below my strike. Further, because the option expired in October, I can reuse the capital on something else after October 17, 2009. If I borrowed money to buy the stock, and Google came out with earnings less than expected, then I would be sitting on a loss position and debt, which compounds my lost (at least in the short term).

On longer term options, like LEAPS, my cash flow modeling plays a bigger role since I’m trying to understand where the stock will be in a year or more, not in the next month or so.

This approach only works for stocks appreciating or stagnate. In a down market, this doesn’t work nearly as well and, thus, risk is much higher.

So far, this has been working. Since August 31, 2009, this approach is yielding 9.25% v. S&P 500 of 6.57% through October 17, 2009.  The way I do my risk rating (flawed as it might be – my portfolio has a 2.13 out of 10, 10 being absolute risk, 0 having no risk, and S&P has 5.o0), my risk adjusted return is 7.37% and S&P is 3.35%.