This blog entry is meant as an explanation of writing put options or selling put options and not meant to convey any opinion as to the suitability or prudence of investing, trading, holding, buying, or selling shares or put options in Abercrombie & Fitch or any other firm.  It is purely for illustrative purposes as to the type of transaction in which the firm or its family of companies may engage in from time to time.

Right now, shares of Abercrombie & Fitch are selling at $27.27 each, down from nearly $85+/- before this crash happened, dragging even great businesses down with it.  The company earns profits of $5+ per share, giving it a price-to-earnings ratio of 5½.  The business is beautiful.  It is one of the most profitable companies that I’ve ever seen and even though it is certain to be hit hard during a recession or depression, it has no long-term debt and could likely survive as competitors were forced out of business.

Working from headquarters, I came to the conclusion that I love Abercrombie’s stock at this price.  Even if it falls by 50% from here, it is so ridiculously cheap that in ten years, I’m going to have a lot more cash thanks to dividends and earnings.  Instead of buying the stock outright, though, I can write “insurance” on shares of Abercrombie & Fitch by promising investors that anytime between now and January 16^th, 2010, I will buy their shares from them at $25 each any time they want.  In exchange for making this promise, they pay me cash of $6.80 per share.  Each “insurance” policy I write is called a “contract” and covers 100 shares.

The Economics of Writing Put Options on the Shares

Through my broker, I could write 200 contracts on these terms.  Immediately, $136,000 in cash is deposited into my account (200 contracts x 100 shares per contract = 20,000 shares x $6.80 premium per share = $136,000).  This money is the “insurance” premium that was paid to me.  It is mine forever.

Known for its provocative annual reports, catalogs, and branding, Abercrombie & Fitch boasts one of the most impressive per store earnings figures of any retail chain on the earth as measured by profit margins and return on equity.

At the same time, it is possible that some day, without warning, I’m going to have to buy 20,000 shares of Abercrombie & Fitch at $25 per share.  That’s $500,000 that will need to be sitting in my account.  Remember, though, that I already received $136,000 in premiums so I’d only have to come up with $364,000 in fresh cash.  To protect myself, I would take the $500,000 ($364,000 in new cash and $136,000 in cash from the premiums I received) and invest in U.S. Treasury bills, the safest investment in the world because the United States Government guarantees them.  Imagine I could earn 1% on them, which isn’t great but it’s better than nothing.

So, here I am with $500,000 tied up until January 16^th, 2010.  I can’t do anything with it.  It must stay parked in the account.  However, we now have two potential outcomes:

1. If the person to whom I sold the contract never exercises the stock options, they expire and cease to exist.  In that moment, I am off the hook and will never have to buy the shares.  The $500,000 is completely unrestricted and could be used for anything I wanted – investing more, buying a house, buying hamburgers … you get the idea.  For tying up $364,000 of my money for a little more than a year, I was paid $136,000 plus the interest earned on the Treasury bills, giving me a compound annual rate of return of more than 38.36%.  That is off the charts.

1. If the put options are exercised, I buy the $500,000 worth of the stock.  However, I am still better off because I paid $25 per share but I was given $6.80 per share in insurance premium so my net cost is $18.20 per share.  Remember, I was going to buy the stock outright at the current price of $27.27 anyway, so I would have been sitting on a substantial loss had I not written the contract! Now, I own the shares at $18.20 and even if they crash to $10, I only have a loss of $8.20 per share instead of $17.27 per share.

This is important because I was going to buy the shares anyway.  If they are worth $60 or $80 in five years like I think they will be, I got to buy them all at $18.20 per share.

In either case, it is a win-win proposition.  In exchange for providing protecting to panicked investors, I get to literally mint money for a stock that I want to own at these prices anyway.  The more capital I have on my balance sheet, the more contracts that can be written.  My job is to make sure that if all of the put options we wrote on Abercrombie were exercised, the money is sitting in Treasury bills to cover the potential purchase price and that if the stock fell below the $18.20 level, I’d have no emotional problems looking at those huge paper losses for a few years until it recovered.

Last week, I wrote some contracts through one of my personal accounts and if there is time before the market corrects itself, I plan on writing a whole lot more through Mount Olympus Awards, Chenille Appeal, and some other capital under my control.  Even if we went into a depression, in ten years, it will look like I just started printing money from headquarters.

Thoughts on the Crash in General

Right now, people are selling their ownership in businesses such as McDonald’s, Wal-Mart, Coca-Cola, Abercrombie & Fitch, General Electric, U.S. Bancorp, Johnson & Johnson, Procter & Gamble, Harley-Davison, Home Depot, etc. because they are scared that the market is going to go down even further.  (It may.  It could get substantially worse and could last for some time.)  After diligently buying ownership in these businesses, they got so spooked by other people selling their shares that they immediately assume that they must not know something and begin to sell themselves.

If watching your portfolio fall in value as other people make mistakes and dump their stocks upsets you, then you don’t understand the nature of what we are doing.  Investing is buying future profits so you can sit in your home and live off the businesses. Less than one year ago, you could buy all of Abercrombie for $7.35 billion.  Today, the entire company is selling for $2.37 billion.  Yes, profits are going to be hit hard in the next year or two, but given that the firm generates $435 million in profits, even if they fall in half, isn’t that still a fantastic deal?  You’d be paying 10x earnings for one of the premier retail brands, earning 10% on your money and when things finally did recover, you’d have gotten it for 5x earnings, or a 20% yield!

Over the past year, we’ve all watched trillions of dollars in quoted market wealth melt off the balance sheets of individuals, companies, and institutions.  And I’m more excited about stocks than I have ever been in my entire life.  Now is the time to get rich.  There are extraordinary values out there.  Stocks are not squiggly lines on a computer screen that go up and down.  They are part ownership in a real business that generates real cash, and has real employees, just like our family enterprises.  The goal is to buy a stake in them so you can make money from your business rather than your labor.

What better time to buy than when people are panicked and will sell you something that only a year ago, they were scrambling to buy themselves, borrowing money to do it?  Buffett has long said the secret is to “be fearful when others are greedy and greedy when others are fearful.”

To be upset about your account falling in this environment is asinine, short sighted, and foolish.  Real businesses are being given away, and courage combined with cash is going to result in substantial wealth in less than a decade.  I would love for the market to stay at a bottom for a year or two because it will set me up for the rest of my life.