Covered Calls and Cash Secured Puts (Part 12)

I ended discussion in my last post with a suggestion that purchasing stock outright or trading the CC comes down to a matter of probabilities.

Purchasing the stock involves betting on a more improbable event to occur.  Looking at the current option chain, suppose I purchase 100 shares of AAPL stock at $519.80 and sell a December (29) 530 call (20% implied volatility) for $7.40. The long stock will outperform the CC if AAPL rallies over $530 + $7.40 = $537.40 in 29 days. How likely is this to occur?

Let’s do some math based on the definition of implied volatility (IV):

1 standard deviation (SD) = Stock Price * IV * sqrt [ # days / 365]

1 SD = $519.80 * 0.20 * sqrt (29 / 365)

1 SD = $29.30

In this instance, AAPL must move $537.40 – $519.80 = $17.60 for the stock to outperform the CC.

# SD = $17.60 / $29.30 = 0.6 SD

How likely is this to occur?

Looking at the graph I can see the chance of AAPL moving up at least 0.6 SD is under 30%.

If you are experienced with options then the rest of this post will be review.

To better understand this analysis, recall that it began with the option IV.  IV describes how expensive an option is and how much the marketplace expects the stock to move over the next year (any time interval may be calculated by manipulating the equation).  If traders believe an option is cheap then they will buy it and option price will increase.  If traders believe an option is expensive then they will sell it and option price will decrease.  People might think an option is cheap (expensive) if they expect the stock to move more (less) than IV suggests.

AAPL is among the most liquid of option markets and the more liquid the market, the more people (trading capital) are predicting the move.  If you think you know more than the hundreds of millions of dollars (at least!) predicting the market, which include money managers, fund managers, professional advisors, analysts, big firms, etc., then just be careful.

I will continue this discussion in the next post.

Covered Calls and Cash Secured Puts (Part 11)

In my last post, I showed graphical comparison of CCs ($BXM) and outright stock (S&P 500 index) over three different time intervals. One reason I believe more investors do not implement CCs is because they underperform in strongly bullish market environments.

To better understand this, I need look no further than the third graph from my last post:

Since mid-2012, S&P 500 (blue) is clearly outperforming $BXM (red).  This happens in strong bull markets because shareholder profit goes parabolic (seemingly unlimited) along with the stock.  In contrast, CC/CSP traders capture a maximal profit on every trade.

Human nature is to be dissatisfied when others are winning even if I am profiting, too.  This is an emotional response.

Emotions are sometimes illogical and I believe this is such an instance.  What we are currently experiencing is a bull market of historic proportions.  Barry Ritholtz lists the strongest bull markets since 1929 in this article:

Extrapolating from these data, the current bull market is up 164.27%, which ranks this as the fourth strongest bull market since 1929.  This is a very unlikely occurrence!  Is it logical to be dissatisfied when losing to a stroke of luck?

The nature of any game is that unlikely things sometimes happen.  People do occasionally hit the jackpot on slot machines.  Although few and far between, people do win the lottery.  People do root for the underdog because the underdog does sometimes win.  These are examples of good luck.  Long stock investors taking credit for luck falling their way hints at the “fooled by randomness” argument, which is beyond the scope of today’s writing.

For now, I will summarize by saying one reason more investors don’t trade CC/CSPs is probably because of the potential to underperform when the masses seem to be celebrating.  Those who do trade CC/CSPs in a raging bull market environment like this may be tempted to become “fully invested,” which can mean closing the short option and holding long stock outright.

I will continue this discussion in the next post.

Covered Calls and Cash Secured Puts (Part 10)

In the last post, I discussed volatility of returns. This is a measure of risk and the lower the volatility, the larger a position size I can feel comfortable trading.  This seems to be the biggest benefit to trading CCs and CSPs especially when comparisons are done over different time intervals.

Taken from the Ibbotson study mentioned in my last post, the following graph shows performance between 1985 and 2003:

Here, $BXM (CCs on S&P 500) matches S&P 500 as measured by absolute returns and outperforms with regard to volatility.  Volatility is harder to see on the graph but notice where the index goes way up in 2000 and then bottoms in 2002, $BXM didn’t go as far up and bottomed in the same place.  This is lower volatility.

Below is a shorter time interval from 2006 to 2011:

Here, $BXM outperforms S&P 500 in terms of absolute returns and volatility.  Once again, volatility is harder to see but notice how $BXM was lower than the index in 2007 and dropped less to its bottom in 2009.  This is lower volatility.

Finally, the following graph from 2002 to recent times shows something different:

Here, $BXM outperforms with regard to volatility and underperforms as measured by total return.  From a similar level in 2007, $BXM dropped less through 2009 and then rallied less through 2013 as the market reached all-time highs.  This is lower volatility.  Investors cheer the greater S&P volatility in this case because it is upside volatility.

While investors like upside volatility and despise downside volatility, we really don’t get to choose.   Times like the present make it feel like we get to choose and like we are making the right investing choices but this is the “fooled by randomness” argument that I can take up in a future post.

Today’s post shows three different time intervals for comparison between S&P 500 and $BXM.  While CCs tend to post equal to lower returns during bullish market environments, they display a lower volatility of returns in all market environments.

Covered Calls and Cash Secured Puts (Part 8)

Aside from being less risky than stock, the $BXM is another reason I am biased to believe in CCs and CSPs.

When the stock market is in a bullish phase, success trading CCs and CSPs is reported a thousand different ways by investment newsletters, services, and retail traders seen in forums and mailing lists over the Internet.  While everyone has their own particular way of doing this, I want to know how it all shakes out on average.  Is there any true Edge?

The Chicago Board Options Exchange along with Standard & Poor’s created a benchmark index that tracks performance of a hypothetical CC strategy on the S&P 500 index.  Known as the $BXM, this index was created in 2002.  The index is designed as follows:

• Hypothetically purchase the S&P 500 index [e.g. using spot SPX price]
• Sell a one-month slightly out-of-the-money (OTM) [SPX] option
• Hold until expiration Friday and then cash-settled
• Sell a new one-month slightly OTM call

 
In 2004, Ibbotson Associates performed a 16-year backtest on $BXM.  The backtest ran from June 1, 1988, through March 31, 2004.  The compound annual return of the $BXM was 12.39% vs. 12.20% for the S&P 500.  Volatility of the $BXM was only about two-thirds that of the S&P 500, though.  This makes for higher risk-adjusted performance:  0.22 vs. 0.16 (Stutzer index) in favor of the $BXM.

In 2006, Callan Associates performed an 18-year backtest on $BXM to extend the research done by Ibbotson.  The backtest ran from June 1, 1988, through August 31, 2006.  The compound annual return of the $BXM was 11.77% vs. 11.67% for the S&P 500.  Again, volatility of the $BXM was only about two-thirds that of the S&P 500, which again makes for higher risk-adjusted performance:  0.20 vs. 0.15 (Stutzer index).

Both studies noted $BXM outperformance in down markets and underperformance in bull markets due to limited upside profit potential.

I will continue this discussion in my next post.

Covered Calls and Cash Secured Puts (Part 7)

In my last post, I discussed conflicts of interest that potentially compromise the credibility of commentators cited in part 5 of this blog series.

The general conflict of interest principle suggests that whether or not those commentators believe option trading to be a worthwhile pursuit, they stand to profit by representing it that way.  Regardless of whether you, as a trader, make or lose money, they can profit by getting you to take interest, buy books, subscribe to services, and/or trade options.  More likely than not, the commentators do believe the positivity they spread because in the future there is potential profit to be had through “word of mouth.”  In other words, if they represent option trading positively and if I have success with it, then I may speak highly of the commentators to other people, which can generate additional referrals for them.

Whether the additional referrals occur, however, the commentators’ consistent positivity will generate some immediate revenue.  This alone makes it worthwhile for them.

If the commentators are sociopathic in nature then their external positivity toward the subject matter will be offset by internal skepticism.  This is often hard, if not impossible, for the critical thinker to judge.

Conflict of interest is always something to be on the lookout for in any discipline, field of inquiry, or business transaction.  In some cases it is blatant and egregious and in other cases it’s a moot point.  Does the last post deserve membership in my optionScam.com category?  Probably not because as discussed in part 3, CC/CSPs are less risky than outright stock ownership.  A great many people are willing to own stock.  At least as many people should be willing to trade CC/CSPs.

Another reason I am biased in favor of CC/CSPs is because of $BXM, which I will discuss in my next post.

Covered Calls and Cash Secured Puts (Part 5)

In part 3 of this blog series, I discussed why CC and CSPs are less risky than outright stock.  Why don’t more investors make use of them?  I believe an inherent fear of options within the retail trading community has capped their use.

I have spoken with a number of stock investors over the years who have bulked at the mention of option trading.

The fact that brokerages have historically limited or disallowed option trading in retirement accounts has probably biased some traders against them.

Searching the Internet for “option myths,” I found a few articles that address the fear.  Here is one:

> If you received or read a disclosure from your broker about options
> trading stating that trading options is dangerous and you may lose
> money, do not believe it. If you know what you are doing and what
> to expect from options, they can be very safe and they actually can
> be less dangerous than trading stocks themselves.

In this second article, Michael Sincere discusses it:

> Myth #1: Options are too risky
> …
> Myth #2: Options are difficult to understand
> …
> Myth #5: Options are the cause of stock market crashes

Here is a third article that also addresses the fear of trading options:

> Myth #1: Options trading is only for professional traders with
> years of experience.
> …
> Myth #3: Option trade execution is a rip-off.
> …
> Myth #5: Option trading is for older and wiser investors only.
> …
> Myth #6: Option trades are difficult to execute and should
> only be handled by professionals.
> …
> Myth #8: You have to spend thousands of dollars to get a good
> options trading education.

I would recommend reading the second and third articles in full as they cover some really good informational content.

Bottom line for today:  some apprehension toward option trading and therefore toward CC/CSPs does persist.  This may help to explain why more traders don’t use them.

In my next post, I will offer an opposing viewpoint.

Covered Calls and Cash Secured Puts (Part 4)

In the last post, I argued that CCs and CSPs are less risky than owning stock outright. People are often surprised by this because some brokerages suggest otherwise.

Certain brokerages in the past did not allow CSPs or any option trading in retirement accounts.  I found a number of links on-line devoted to the subject.  This article from a few years ago talks about Scottrade.

This article is from 2013 and describes trading restrictions in an IRA.  The article writes:

> The only universal restriction is tied to IRS rules that do not allow
> borrowing from an IRA account.  This restriction blocks short
> selling, leverage using margin, and the sale of naked put or call
> options.

Since CCs and CSPs are less risky than outright stock, why should they not be allowed in retirement accounts if long stock is?  They should.

This article discusses some possible reasons for the illogic.

> The higher suitability standards in an IRA makes the firm concerned
> that even though the strategy is safer than buying the stock, it’s more
> complex, and the duty to ensure that the client understands the
> risks… makes it not worth offering.
>
> The firm’s systems can’t differentiate between cash-secured put
> writing and other types of put writing that are not appropriate for
> IRAs (naked put writing, covered put writing against short stock,
> etc.)
>
> The firm’s permitted options strategies for IRAs have not been
> changed in many years. This is the most common one. Most firms
> established covered calls, or covered calls and protective puts as
> the only strategies they’d allow when they first became IRA
> custodians, and simply haven’t changed them since.

In my opinion, the tide seems to be changing as time goes by and this is good news for traders/investors.  TradeKing was a holdout that did begin to allow CSP Trading in IRA accounts a couple years ago.

Covered Calls and Cash Secured Puts (Part 3)

In this blog series, I’m detailing different aspects of the CC/CSP trade in an attempt to develop some trading guidelines for future use.  Today I want to explain why a CSP is less risky than owning stock outright.

Yes a CSP, or naked put, is less risky than owning stock.  Why this is counterintuitive to many is something I will discuss in a future post.  The first step to understanding it is to recall that a CSP and CC are synthetically equivalent.

Saying that a CC is less risky than owning stock outright may feel more comfortable because CCs have long been touted as a “conservative [option] strategy.”

Risk management is about limiting potential loss.  With a CC, I buy the stock and sell a call.  Selling the call puts money in my pocket.  The CC is therefore cheaper than the stock.  If the stock goes to zero then I lose less money with the CC than I do the stock because I already put money in my pocket.  The CC is therefore less risky than the stock because I cannot lose as much money.  The CSP is also less risky than the stock for the same reason.

The following graph plots the PnL of AAPL stock (blue line) and CC position (purple line) 365 days after trade inception.  The option expires on that day.  Stock dividends ($1,040) are included:

The vertical, dotted line shows breakeven for the stock position if the stock price falls.  At this zero profit level, the CC shows a profit of $5,600, which is the profit from selling the call at trade inception.  The stock is more risky than the CC.

Viewed another way, for the CC (green line, below) to be at breakeven after one year, the stock would have to fall to 432.74, which is more than $55 lower than breakeven for the stock position (purple line, below) alone:

Either way you look at it, the stock is more risky than the CC.