Worst Case Scenario of Pledge-Sell-Farm
"High conviction =/= high returns because hey, even the best investors make mistakes. In fact, it's the high conviction ideas that you get wrong which kill your portfolio (i.e. It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so).
And if one is that certain that the company will definitely do well (nothing is definite though, investing is after all just a handicapping game), then just buying LEAPs on those companies will make you way more than writing puts and reinvesting the premiums in blue chips.
Also, the strategy is what I call picking pennies in front of steamroller strategy (just like all naked option writing strategies and their variants). Your hit rate will be high, but when you do make a mistake, the damage is immense.
Imagine this scenario:
1) your high conviction idea turns out to be wrong - APPS is now $20, and with volatility expanding, the puts you wrote are now 2300 bucks each, or 11200 bucks in total (IV of 100%).
2) Meanwhile your pledged portfolio also crashed (and why not? since it's highly likely your high conviction idea and your pledged portfolio are highly correlated with one another and with the market). Just when you don't want to liquidate your pledged portfolio, as the crash resulted in extremely low valuations, you are forced to liquidate to meet margin calls for your written puts.
3) Your blue chip portfolio which you bought for the yield, did relatively better since they are more defensive by nature. But they still had a 10-15% correction, and the capital loss more than wiped out whatever dividends you collected.
Basically, what I don't like about the strategy is that it kills you right at the moment you don't want it to kill you (pro-cyclical strategy). Ideally, we want strategies that make our portfolio less fragile during market crashes, but this put option writing and invest premium in blue chips don't exactly do that. Using this strategy, you get a nice yield enchancer during smooth and good times (which last very long, since markets by nature go up over the long run), then you get complacent because of the "easy money" and fail to appreciate the tail risks. But right when the market crashes, and that's the moment when you really need the cash/strong returns, this strategy will kick you when you are down and rub salt on your wound."
I am posting his comments here, not because I am upset. Rather I like to thank him for his comments because it reminded me of the significant tailwind that the strategy post. I view it probably as a summary of the worst case scenario of the strategy.
That is why I reproduced his comments as an individual post because it is important to understand and know the risks of every strategy one make.
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