Picking up Pennies and the Steamroller

Short term gains don't always translate into long term gains. The obvious example is selling options, you sell a put every year for $1,000, adding a grand in earnings every year right up until the market tanks and you have to pay out a large sum. Some investigations have shown that put sellers make more money off the puts than put buyers do off the large, but sporadic, payouts. However, and to the surprise of many people, how much money you make is only half the game, when you make it also counts for long term investing. Lets take a hypothetical example using some historical data (and some guesses/approximations).

For example I pay $1,000 for a put option on the S&P 500 to you every year on January 1st and you turn around and stick that money in the market. Years one through five the option expires worthless, and then year 6 there is a market crash and I cash out my put for $5,000 and put that $5,000 in the market. The simplistic view is that you are currently ‘up’ $1,000 on me, as I paid you $6,000 and you paid me $5,000 out. A slightly better version is that you are “up” $1,000 plus gains from having that money in the market for 5 years. The correct answer though depends on what happened after I put the money in the market. I got a lump sum that was conditional on the market dropping a substantial amount, and there are certainly times where putting $5,000 in all at once out preforms putting $1,000 in 6 separate chunks.

Following our hypothetical you might have invested $1,000 in Jan 2003 when the S&P was around 900, 2004 at ~1,100, 2005 at 1,200, 2006 at 1250, 2007 at 1,400, and 2008 at 1,450 meaning your average purchase price is (ignoring dividends etc) a little over 1,200. I instead get $5,000 to invest at the end of 2008/early 2009 when the market is around 950. Come 2018 my $5,000 purchase in 2008 is worth a (with the S&P at 2,900) little over $15,000. The $6,000 averaged at 1,200 is worth a little over $14,500.

This shows how buying puts can, potentially, turn a profit even when it "costs" more to buy a series of puts than the total payout because the award was associated with the best market buying opportunity in recent memory.  What about the put seller?  Is he also "up" $15,000 having put none of his own money in play and was just riding off your $6,000 in capital?  Well no, he paid you $5,000 so he can't be up the $15,000, is he up $10,000 then?  Well, no.  He owes you $5,000 in 2009, not in 2018.  So is he up $1,000 compounded from 2009 to 2018?  No again. To get the $5,000 he (to make it simple) sells the exact shares he bought with the $6,000 you paid in yearly installments.  He bought when the S&P was at an average of 1,200 and $6,000 bought him 5 "shares" of the S&P, but he is selling when the market is around 950, and 5 shares of the S&P at 950 sells for $4750.  The other $250 has to come out of his own pocket, so his profit in this example is -$250, even though he got $6,000 for a payout of $5,000.

There are a lot of lessons you could glean from this example, such as don't keep your collateral in the same securities that your obligations are priced in.