Buy and hold Sell covered calls

[Cruncher]

Hello all,

Been a Boglehead since before my start date on this forum. To keep this post succinct, I'll just say I'm a true believer in our ways. The only time I sell any asset, is to rebalance; which is not done very often, currently I rebalance twice a year, 1) when I fund my Roth IRAs and 2)when my company's Profit Sharing posts. I don't time the market; I don't care if the talking heads say the "signals" are bullish or bearish. When panic/fear strikes and people sell/buy, I don't care, I rebalance using the 5%/25% trigger bands. Nothing more, & nothing less; it's almost mechanical, without emotion, almost have become a contrarian investor and my new money just goes to the "laggards" in my portfolio.

Now lemme talk Covered Calls. (Something I wrote down in my Personal Investment Plan as to research in the future). Here's my research.

I own and plan to hold more or less indefinitely my ETF holdings. They are low cost, asset class indexes (VOE, VBR, EEM, ... and so forth). I'll use an example looking at today's market on EEM:

Today's price: $43.92, looking at the Jan '15 LEAPS, I'll just pick a random one, say the $55 strike price. The last premium bid was $1.18 / share. Now, say I sell 1000 shares (10 contracts), the buyer pays me $1,180 today for the option to buy 1,000 shares from me (at $55), at anytime between today and Jan '15. (sorry for the lesson, don't mean to, just my simple understanding).

I'm not going to sell the shares anyhow, the shares are just sitting in my account working for me, returning a 1.7 yield annually, waxing and waning in security price.

Now, if the buyer executes the sell and buys my 1,000 shares of EEM at $55, I would take the money as soon as it's available and re-purchase EEM back at whatever market price. Again, I don't care, I'm not a timer but a looooong term investor.

The risks I see are:

My capital could be temporarily out of the market, during the Option call & me re-buying EEM.
I could potentially miss a big swing to the upside. Again, I don't care about day-to-day fluctuations.
I tie up a considerable amount of my portfolio for long periods of time (though again, I don't sell anyway, but If I wanted to say lower my EM allocation, I really couldn't).
Time and energy of managing my Call options and re-buying the just sold securities.
I'll have to be careful during rebalancing that I don't happen to sell EEM to less than 1,000 shares.
$30 round trip through the online brokerage, plus the repurchase.
Taxes are not a consequence as these assets are in tax sheltered accounts.

What am I missing? (I can hear Jack now, "there's no free lunch")

If this has been debated (which I am sure it has), you can just direct me to the thread (my forum kung fu is weak).

Thanks for your thoughts,

Cruncher

[larryswedroe]

Cruncher, my book The Only Guide You'll Ever Need to Alternative Investments has a chapter on covered calls. While there are far worse strategies I put them in the flawed category and don't like using them. For one, their use cuts the wrong tail of the potential distribution. Then there are tax issues and trading costs.
Best wishes
Larry

[BBL]

What I don't think you are getting is that once the call purchaser goes 'in the money' they own all of the upside from then on and your position only worsens.

Use your numbers and ask yourself what happens if the share price is 100 in November 2014 and you get exercised?

How much do you have to pay to replace your 1000 shares that you want as part of your long term portfolio - that's the problem.

Assume you buy-write - buy the 1000 shares at 44 / write the calls for a total 1.2K premium.

If you got exercised at 100/share what happened to you?

You rebuy your previous 1000 shares [that you paid 44 for] for 100 a share.

The call buyer got most of your upside and all you got was a 1.2K premium.

[magician]

A covered call is a long position in the stock and a short position in a call:

covered call = stock - call

Put-call parity says that:

stock + put = call + bond

Applying a little 8th-grade algebra, we get

bond - put = stock - call = covered call

Thus, a covered call is the same as selling a put option and having enough cash (a risk-free bond) to buy the stock if the put is exercised. You'll lose money if the price of the stock drops (enough) and the best you'll do is keep the premium.

So, if you're considering a covered call, you should ask yourself if you would be happy selling put options and keeping a bunch of cash lying around. Should the answer be "No," don't sell a covered call.

[Cruncher]

Larry, Thank you for your time answering. I respect your professional knowledge you share with us (ditto a lot or you folks )

BBL, I suppose I was thinking once a Call was in the money, the holder would execute the option and purchase the stocks (from me) at the strike price (releasing my capital to invest - in my example back into EEM). I didn't delve too far into the possibility of the holder hanging onto the call option for much longer after in the money. IOW, I figured once it was in the money, they would buy it. But I can see how the purchaser would might want to hang out a little while (after their cost basis was met) to "see" how the ETF was doing. I guess I don't understand why someone would want to buy a Call X months in the future, I mean I understand what it does / how it works, but why? I guess it allows a person the option (essentially access) to a certain amount of a particular asset with little money down (the premium) - In my example $1,200 to control $55,000 worth of EEM sometime between now and Jan 2015.

Magician, I'll have to re-read your post again. I think I'll pick up Larry's book tomorrow, I don't have it, so it'll most likely add to my small library. Still very content with my buy and hold index approach! Thanks Jack!

One of the lessons I learned in life, is if I can't explain it to my 8 yo son, and have him explain it back to me, it's not for me.

Thanks again all, Cruncher

[Ranger]

Other posters have given reasons, why it is not a good strategy. I'll add one more from my perspective, writing covered call is not a good use of my capital and with volatility being so low these days, it does not make sense to write premium.

That being said, Let us go through your example.

From your example as of today (EEM price 43.92), Jan 15, 55 strike price can be sold around 1.23 or 1.22. Current 55 strike vol is priced at 19%, pretty close to 52 week low of implied volatility. (EEM options are liquid, Theoretical Option price is 1.24. It will be filled, if you give up around 1 or 2 penny. I have traded EEM, but not that far out in time. It usually fills around mid-price between bid/ask.)

When you write covered call, you pretty much are willing to give up the stock at strike price of 55. So your break even price is 55+1.22-0.03 = 56.19 ( 3 cents is for commission, btw you need to change broker, if you are trading options frequently. That is awfully expensive). I have written many times, option is all about probabilities. Assuming normal distribution of stock prices (in reality stock prices will have fat tails), probability of stock prices hitting 56.19 on Jan 15 is around 14%. So option prices are pricing that there is 84% probability, you can keep your premium. If you are comfortable with that assumption, then it is ok to write premium.

The risks I see are:

My capital could be temporarily out of the market, during the Option call & me re-buying EEM.
This is not a big issue. Assuming, your option is in the money and called away, you could always buy back shares next morning. There is no reason, option buyer will exercise, when it is out of the money

I could potentially miss a big swing to the upside. Again, I don't care about day-to-day fluctuations.
That is the problem with covered call, if the stock make big up-move you will miss it
I tie up a considerable amount of my portfolio for long periods of time (though again, I don't sell anyway, but If I wanted to say lower my EM allocation, I really couldn't).
You are not tying up anything. If you want to close the position, it is just one click. Since it is covered position and were willing to give up at 55 anyway, you don't loose anything
Time and energy of managing my Call options and re-buying the just sold securities.
I do not understand. You will be notified, if it is assigned. Next morning, just need to replace the shares, if you want it
I'll have to be careful during rebalancing that I don't happen to sell EEM to less than 1,000 shares.
This is complicated. First of all, when you write call you really don't have 1000 shares per say. Think in terms of delta (There is stock delta and portfolio beta weighted delta. Here i am talking about stock delta). 1000 shares of EEM is 1000 EEM delta. Jan 15, 55 strike is 22 delta, For 10 contracts it is 220 delta. So theoretically at the time of writing, you own only 880 EEM deltas. These deltas change, as price changes. I would forget rebalancing
$30 round trip through the online brokerage, plus the repurchase.
No round trip, unless you close the positions.
Taxes are not a consequence as these assets are in tax sheltered accounts.

What am I missing? (I can hear Jack now, "there's no free lunch")

Only thing missing is, option trader always thinks in terms of probability of risk reward. If i write that far out (Never written that far out), I would go long jan 15, 44 strike LEAP for around 5.15 and 5.20 and write 3-4 strikes out every 55-60 days our. So basically, I will have around 12-13 rolls. At the end of all rolls, i will have free call on Jan 15 and keep the money in CD till that time. There are other risks which comes along with that, but i am ok with that.

If this has been debated (which I am sure it has), you can just direct me to the thread (my forum kung fu is weak).

Thanks for your thoughts,

Cruncher

[Ranger]

I guess I don't understand why someone would want to buy a Call X months in the future, I mean I understand what it does / how it works, but why? I guess it allows a person the option (essentially access) to a certain amount of a particular asset with little money down (the premium) - In my example $1,200 to control $55,000 worth of EEM sometime between now and Jan 2015.

Thanks again all, Cruncher

I just saw your post, after I wrote mine.

Why would investor purchase that far out?

Some people like to buy lottery ticket. So this will have lottery effect for them and from probability perspective it is around 14%, they will make some money above their investment. This prob. is much better than lottery.

Another reason, is what I wrote in above post. I some time buy long dated call, and write short dated call against it. It is little riskier as long one has willingness and capital to bear short term losses.

Edit: I will add one more. Most of the option buyer spread it, instead of paying up for time premium. So in that case. assume option buyer buys Jan 15, 55/60 call vertical debit spread. Here is just buying 55 call for $1.24 and selling Jan 15, 60 call to collect $0.67 (actual theoretical prices. (it can be had at $0.68). This vertical spread costs only $0.68 cents per contract. If the EEM closes at or above $60, then the spread buyer collects entire spread profit of $433 pay-off of 1:7.5. Also now break even price reduces to $55.67.
There are many other strategies like ratio spread, where in one buys 1 of 55 strike and sells 2 of 60 strike. In that case it does not cost anything to buy that spread, but suffers loss, if the stock closes above $65. With only about 5% probability of that happening, that may be one of the best trades.

[DualIncomeNoDebt]

Let me add the emotional component to this, one who speaks from experience selling covered calls.

If you write calls on one of your winning investments, and it gets called away, it is going to piss you off, period. I've had some quality stocks called away from me, and believe me, it annoys me to no end just thinking about it. Worse, the CC strategy means you keep your "losers" while the "winners" get yanked from you, and at a cheap price.

Now, if the buyer executes the sell and buys my 1,000 shares of EEM at $55, I would take the money as soon as it's available and re-purchase EEM back at whatever market price. Again, I don't care, I'm not a timer but a looooong term investor.

Take it from one who has been there, done that. You will indeed care, quite a bit, that your nice position was called away. Forced to exit your position, now it will burn you even more when you reestablish at a higher price. Just a couple of these, and you'll know of what I speak.

It may not be sexy. Hell, it may be boring. But the basic yet solid investing strategies recommended here are truly the way to go. Less stress, no daily monitoring, and being able to ignore the financial press talking heads, it is in my opinion a vastly superior way to save and invest.

If you need yet another reason, if you are option trading from a basic brokerage account you will get reamed on the spreads. The bid/ask on calls/puts is criminal, and sitting at home, you are outmanned and outgunned by the pro traders and their computer algos. If you enjoy giving your money away to the CBOE and also enjoy getting frontrunned by the HFTers and others with direct feeds, proceed.

[magician]

Magician, I'll have to re-read your post again.

Sorry; I teach this stuff all the time, so I sometimes blast through it.

Put-call parity is pretty straightforward.

Consider two portfolios: in one (portfolio A) you own a share of stock and a put option on that stock with a given strike price, X, and in the other (portfolio B) you own a call option with the same strike price - X - and a risk-free bond that has a par value of X; the two options expire on the same day the bond matures.

At expiration, if you look at all of the possible values for the stock, you'll see that no matter what happens these two portfolios will have the same value: if the stock price is below X, the value of portfolio A is the same as the value of portfolio B; if the stock price equals X, the value of portfolio A is the same as the value of portfolio B; if the stock price is above X, the value of portfolio A is the same as the value of portfolio B. (You might want to look at these three scenarios, figure out in each whether you would exercise either option or not, and calculate the value of each portfolio; it's a useful exercise.)

Because their final payoffs are always equal, their price today has to be the same (or else there's an arbitrage opportunity). Thus,

stock + put = bond + call (where "bond" is the present value of X discounted at the risk-free rate)

Once you have that equation, you can rearrange things algebraically to suit your fancy. We're talking about a covered call (long a share of stock, short a call option), so we subtract the put option from both sides and subtract the call option from both sides, giving:

(covered call =) stock - call = bond - put

Thus, the payoff of a covered call is the same as the payoff of the bond (X) plus the payoff of a short put: you sell a put option, and at expiration have enough cash to cover the strike price in case the option is exercised.

So, if you're considering a covered call, it's the same as considering selling a put option (without owning the stock) and holding a bond (cash).

Hope that that helps.

[MN Finance]

I've used options a few times in the past. IMO, it simply seems like a lot of work for an extra couple hundred dollars a year. You have to spend *some* amount of time monitoring, then you have transaction costs and potentially involuntary changes to your portfolio when you aren't paying attention. It's far from terrible, but not a home run.

[hollowcave2]

BBL, I suppose I was thinking once a Call was in the money, the holder would execute the option and purchase the stocks (from me) at the strike price

No, this most likely will not happen until there is no time premium left. Once the call goes into the money, it will acquire an "intrinsic value" in addition to a "time value." From the perspective of a call holder who is long, it doesn't make sense to exercise the call if it still has significant time premium. That's OK, because you can still hang onto the call after it goes into the money. Your call isn't likely to be exercised until the option is near expiration, there's a major dividend ex-date coming, or the call is so far into the money that the time value is almost zero, and in that case, you'll probably be wondering why you sold it.

There's lots of options about options. If the call goes into the money, you can always trade it into a new position, but that may or may not be profitable. You can also indefinitely roll forward at the same strike and continue to collect premium.

Bottom line, the call premium you receive is not free. There's always a cost to money. When you sell a covered call, you risk limiting more upside for a known amount of premium and strike price today. Much of the time, it works out. Sometimes you will miss a large move. But if you write covered calls as a continuous process on your portfolio, that is the way to optimize the process. If you really don't want to sell the stock or ETF at all, then don't write them. You always need to be prepared to let the security go eventually.

The only way to learn for yourself is to try selling a few calls on a small position and see how you like it. Then you can see how it works for real, but only on a small position until you learn more about it. And BTW, you don't need to sell calls on the entire amount of stock shares you own. Try selling on half of the shares, for example.

Let us know how it goes.

Steve

[325e]

From my understanding, the reason the buyer would not call the in the money option is that they don't want to separate with the funds. They are using you to put up the money, leveraging your cash. They put up a couple hundred, you put up a couple thousand, and they can go into a bunch of positions with the same money you need.

I tried selling calls and a few other things before and the fees and taxes were more than the payoff was worth. It's kind of fun, but it is a big distraction and the boring good, old fashioned way will probably make just as much for most of us.

[Cruncher]

Folks,

This is exactly the kind of discussion I was looking for! There is the simple, from Larry to describing the mathematical, logical and emotional (all the others).

I thank everyone for their inputs. I can now go back to my IPS and say, this subject has been researched and I'm sticking to my boring ways. I may even copy and paste some responses and add them as footnotes in my IPS.

Cheers everyone!


Cruncher

[magician]

I may even copy and paste some responses and add them as footnotes in my IPS.

Remember to include the attributions.

[fmhealth]

Cruncher, here's another strategy you may want to consider.

1- Sell 10 1/15 55 calls ($1,500 credit)

2- Sell 10 1/15 35 puts ($2,700 credit)

So you immediately pick-up $4,200. Downside, as mentioned already, is the stock goes to $100.00 (unlikely). Or, the stock crashes & you get put the stock @ $35.00 (net is ~ $30.80).

Hitting $55 would represent a 25% increase in price. Once again possible but highly unlikely. If this did occur your net price @ call would be $59.200.

I utilize trades outlined above on a regular basis. I let the calls run & employ S/L , GTC orders on the puts. Thus giving me at least a modicum of downside protection. Schwab will email you when your GTC order expires. So you can reevaluate every 60 days.

Some of these trades implode but most work out very well. Stocks are simply commodites to buy & sell. If it goes to $100, so be it. Another trader will do well & make a nice profit. I'll just move on.

Be Well,
fmhealth

[Cruncher]

Magic,

Of course!

Thank you

[magician]

Magic,

Of course!

Thank you

My pleasure.

[rai]

Just curious, if you own a large amount of a stock, for example if you own 500 shares of Apple and are comfortable selling 100 at current value or higher, you can sell Jan 2014 at the money (today $475) for $4800, this is around 1% a month gain and you'd keep the dividends during this time which is another $795 (three quarters dividends at $2.65/share on the 100 shares).

Of course if you want to sell out of the money like $575 ($100/share gain) you can sell a Jan 2014 for $1700 (plus dividends), it would seem as if selling a call in this instance would somewhat pad a downside risk in the stock, at the risk of holding long and a risk of loss of upside.

In other words, especially selling a higher out of the money call is like gaining extra income from the stock at the risk of being long. And at the risk of paying more taxes.

Am I miss-understanding something especially if you are long in the stock and sell high side out of the money calls?

[Cruncher]

Rai,

This is exactly what some friends of mine do. They do it particularly with ESPP company stock, though others delve into the "volatile stocks." Over the years, they amassed a sizable amount, which they sell covered calls on. Now, the stock isn't as volatile as AAPL, and the premium is not nearly as much. But in their instances, they generate an extra couple percentage points per year, while keeping the dividends the stocks kick out.

I'm no longer a stock guesser, nor do I time the market. Additionally, my cash position is zero (I'm all in so to speak), so I can't nor do I want to write cash backed Puts (I know not in reference to your post). My OP was a question regarding this 1 - 2% annually (with dividends) return I have with some ETFs I have. I'm a believer in intertwined nature of risk and return; I just couldn't really wrap my hands around the risk (that enabled the extra returns).

anyway, gotta run ...

[jdilla1107]

Larry, Thank you for your time answering. I respect your professional knowledge you share with us (ditto a lot or you folks )

BBL, I suppose I was thinking once a Call was in the money, the holder would execute the option and purchase the stocks (from me) at the strike price (releasing my capital to invest - in my example back into EEM). I didn't delve too far into the possibility of the holder hanging onto the call option for much longer after in the money. IOW, I figured once it was in the money, they would buy it.

Thanks again all, Cruncher

This is wrong. It Is actually very bad for the buyer to exercise an option early as they are throwing away the time value of the option. What happens 95% of the time is your option will be traded and exercised only at expiration. You should assume that your option will only be exercised at expiration.

[magician]

Larry, Thank you for your time answering. I respect your professional knowledge you share with us (ditto a lot or you folks )

BBL, I suppose I was thinking once a Call was in the money, the holder would execute the option and purchase the stocks (from me) at the strike price (releasing my capital to invest - in my example back into EEM). I didn't delve too far into the possibility of the holder hanging onto the call option for much longer after in the money. IOW, I figured once it was in the money, they would buy it.

Thanks again all, Cruncher

This is wrong. It Is actually very bad for the buyer to exercise an option early as they are throwing away the time value of the option. What happens 95% of the time is your option will be traded and exercised only at expiration.

Generally, the only circumstances that would argue in favor of exercising an American option before expiry are:

For a call option, the stock is about to declare a dividend that will exceed the time value of the option; failure to exercise will lose more in the lost dividend than is gained in the time value.

For a put option, the option is very deep in-the-money, so there's very little upside potential, and there's a risk that the underlying price will rise and the option will lose intrinsic value; in essence, the option has negative time value.

[ourbrooks]

If buying and selling covered calls were a good way to make a few additional percentage point, you'd guess that someone would have started a mutual fund to do exactly that and, sure enough, people have! Even Vanguard has one; it's called the Market Neutral fund. (To see it in the list, include funds with a $50,000 minimum.) Vanguard can hire the best talent in the business and, with experts doing the buying and selling and with the very good rates on trades that Vanguard gets, the fund should be a shining example of how well these strategies do.

How well do these strategies do? Well, over the past 10 years, the Market Neutral fund underperformed the Admiral Money Market fund as well as every other fund for which there's 10 years of data.

[ArthurDent]

Cruncher, my book The Only Guide You'll Ever Need to Alternative Investments has a chapter on covered calls. While there are far worse strategies I put them in the flawed category and don't like using them. For one, their use cuts the wrong tail of the potential distribution.

I haven't read your book, but you might want to reconsider that blanket statement.
Over long enough periods of time, covered calls, equivalently short puts, have the same downside risk and therefore the same upside (expected return) as a long equity position. What differs is
(1) that the cash asset and the derivative assets have different cash-flow profiles, so how they achieve the expected return is wildly different, (the former makes money when stocks go up, the latter make money at all other times),
and,
(2) that the derivative assets might have higher transaction costs. (Tax and trading costs, as you mentioned)
If you can work around (2), then (1) effectively implies that put writing acts as diversification for your equity portfolio. In a risk-on/risk-off world where assets are tightly correlated, this is as close as you can get to free diversification.

Witness Buffett writing puts, and re-insuring CIGNA's variable annuity portfolio. (In a variable annuity, the insurer is effectively short a put on equities since the policyholder is more likely to exercise their account guarantee as the market goes lower; so a VA is effectively a short put position.) Of course, Buffett posts no collateral on his short puts, instead he gets to invest the premia while waiting for maturity of the puts, and he also has low to negative trading costs on his options.

[ArthurDent]

If buying and selling covered calls were a good way to make a few additional percentage point

If you believe that exposure to market risk is the source of market return, then "buying calls" has zero expectation before transaction costs. "Covered calls" or "selling puts" has the exact same expected return as "long stock", and therefore does not add additional return, but it adds diversification, see my post immediately above.

[magician]

Over long enough periods of time, covered calls, equivalently short puts, have the same downside risk and therefore the same upside (expected return) as a long equity position.

I'm not sure I understand this statement. A long equity position has an unlimited upside, whereas a covered call (or short put) has an upside capped at the option premium. Please explain how they're the same.

[DualIncomeNoDebt]

Over long enough periods of time, covered calls, equivalently short puts, have the same downside risk and therefore the same upside (expected return) as a long equity position.

Respectfully, this can't possibly be true. The time value of options (calls or puts) decays exponentially to zero. Options have time decay, even the longest of long-term equity anticipation securities are subject to theta -- and option theta is always negative, period. Equity positions do not have theta. Ergo option and equity do not "have the same downside risk."

[Ranger]

Even Vanguard has one; it's called the Market Neutral fund. (To see it in the list, include funds with a $50,000 minimum.)

It is like a clock work. Some one asks about "Covered Call", and some one else points to Vanguard Market Neutral fund.

Have you even read the prospectus?

Market neutral is a beta neutral fund, while generating alpha through security selection. So now tell me how this strategy is similar to Covered Call?

If buying and selling covered calls were a good way to make a few additional percentage point, you'd guess that someone would have started a mutual fund to do exactly that and, sure enough, people have!

You made me look. There is Covered call ETN called BWV. This is a mechanical strategy, which writes covered call on SP500 at set intervals.


As i said above in my previous post that, I don't like covered call because of its inefficient use of capital. It has performed better than SP500 during down turn and ferocious come back. Do you know why?

Vanguard can hire the best talent in the business and, with experts doing the buying and selling and with the very good rates on trades that Vanguard gets,

Vanguard core competency is cost reduction of its funds and passing the savings to its fund holders. Their core competency is not being Quant funds. Qunats are expensive and they use lot of derivatives. Vanguard is non-player in those areas.

Finally, market neutral fund is not a core fund and its bogey is T-bill. Market neutral strategy has its place, I do not believe Vanguard is the funds one looks for any quant strategies.

[Ranger]

Over long enough periods of time, covered calls, equivalently short puts, have the same downside risk and therefore the same upside (expected return) as a long equity position.

Respectfully, this can't possibly be true. The time value of options (calls or puts) decays exponentially to zero. Options have time decay, even the longest of long-term equity anticipation securities are subject to theta -- and option theta is always negative, period. Equity positions do not have theta. Ergo option and equity do not "have the same downside risk."

Theta is negative, if you are long the options otherwise it is positive and works in your favor. Only free lunch offered in the market is diversification and (in my experience) time decay.



This is from GMO paper. Their quote " It is important to note that, just like low beta, the put writing strategies above have lower volatility and smaller drawdowns than the market, while still delivering good performance. But it is clear there is no anomaly here, althoogh the simple realized risk statistics are low, put writing carries the same downside risk as the market. Put writing strategies have lower volatility because of the reduced exposure to market rallies, and they have smaller drawdowns because, in times of market stress, the premium paid to providers of insurance is very high"

[magician]

You made me look. There is Covered call ETN called BWV. This is a mechanical strategy, which writes covered call on SP500 at set intervals.

Does this follow, essentially, the BXM strategy?

I have a funny story about the BXM from a few years ago.

[Ranger]

Does this follow, essentially, the BXM strategy?

I have a funny story about the BXM from a few years ago.

Yes, BXM is the index and BWV is the actual product, which follows that index.

http://www.cboe.com/aboutcboe/showdocum ... 070523.doc

I would like to hear that funny story.

[magician]

Does this follow, essentially, the BXM strategy?

I have a funny story about the BXM from a few years ago.

Yes, BXM is the index and BWV is the actual product, which follows that index.

http://www.cboe.com/aboutcboe/showdocum ... 070523.doc

I would like to hear that funny story.

In 2007 (I think it was 2007) I attended a financial risk management conference in Huntington Beach, CA. In one of the breakout sessions there were three or four people describing the BXM and explaining how they were making a return of 200 bp above the S&P 500 with 2/3 the return volatility. They finished their talk about 20 minutes early, so there was lots of time for questions.

I asked how long they thought that they could continue with this strategy - selling overpriced call options - until someone came along and said, "I don't need to earn 200 bp over the S&P 500 with 2/3 the volatility; I'd be happy with 150 bp," and sold the calls for much cheaper, and someone else came along who only needed 100 bp over the S&P 500 and would sell calls more cheaply, and so on.

Some guy in the back replied, "You don't understand!" (Not a great way to start a conversation, thought I.) "Implied volatility is always higher than realized volatility."

Sigh.

"OK, let me rephrase the question: how long do you think you can continue this strategy until someone comes along who doesn't need the implied volatility to be twice the realized volatility . . . ?"

The gentleman sitting to my immediate left tapped me on the shoulder and said, "Stop asking."

"Why . . . ?"

"Just stop asking."

OK, fine.

As we were leaving I stopped this gentlemen - whom I'd never met before - and asked why he wanted me to stop asking what I thought were reasonable questions.

"Do you know who those people were in that room?"

"No, I've never met any of them."

"Those were the people who are earning 200 bp over the S&P 500 with 2/3 the volatility! They don't want anyone suggesting that someone could come along and sell options at fair prices and eliminate their excess profits!"

[Ranger]

"Those were the people who are earning 200 bp over the S&P 500 with 2/3 the volatility! They don't want anyone suggesting that someone could come along and sell options at fair prices and eliminate their excess profits!"

Those are all valid questions magician.

But the real data does not support option premium is becoming smaller, because of efficient markets.

From the above chart of BWV, there has been out-performance of around 150 basis points per year. From GMO data of last 15 years, put selling has out-performance of more than 4 or 5% per year. GMO's recent qtrly letter (4Q2012) says "Option premium has remained fairly stable" and were surprised to find this.

Their footnote 7 This is somewhat surprising finding, because you might have thought that expensive equity markets were particularly prone to large losses, which would make put selling a bad idea. However, our research show that, at least since 1983, call buying in an expensive market has been disastrously bad, while put selling has had returns that are largely unaffected by the starting valuation of the market

[magician]

"Those were the people who are earning 200 bp over the S&P 500 with 2/3 the volatility! They don't want anyone suggesting that someone could come along and sell options at fair prices and eliminate their excess profits!"

Those are all valid questions magician.

Thanks, Ranger. I certainly thought so.

But the real data does not support option premium is becoming smaller, because of efficient markets.

I wonder why that is.

I understand people saying that implied volatility is always (well, usually, probably) higher than realized volatility, but the question they should be asking is not whether it is, but, rather, why it is.

This finance stuff is a funny beast.

[ArthurDent]

Over long enough periods of time, covered calls, equivalently short puts, have the same downside risk and therefore the same upside (expected return) as a long equity position.

I'm not sure I understand this statement. A long equity position has an unlimited upside, whereas a covered call (or short put) has an upside capped at the option premium. Please explain how they're the same.

If you subscribe to the point of view that (upside) returns arise from exposure to (downside) risks, the risk in covered call = the risk in short put = the risk in long equity. So the returns should be identical, just the distribution of the cashflows is different.

Say you write a 6m covered call each month, buy it back next month when you write a new 6m covered call. You limit your upside on the stock, but you collect the option premia regularly. In expectation, you make no more money than the stock position outright.

Respectfully, this can't possibly be true. The time value of options (calls or puts) decays exponentially to zero. Options have time decay, even the longest of long-term equity anticipation securities are subject to theta -- and option theta is always negative, period. Equity positions do not have theta. Ergo option and equity do not "have the same downside risk."

Your premium for writing the option covers the theta.
Alternately, if you do a Monte Carlo analysis of (1) long stock, and of (2) long stock plus short at the money call option, then you will see that the average return across all of your simulated paths is identical in the two cases. This is the essence of arbitrage free option option pricing.
(I am ignoring the yield on the risk free bond here.)

The two simulations above (one considering many futures, other considering a long enough single future) also exhibit the same behavior, for more details I would refer the mathematically inclined reader to ergodic theory.

[Ranger]

But the real data does not support option premium is becoming smaller, because of efficient markets.

I wonder why that is.

I understand people saying that implied volatility is always (well, usually, probably) higher than realized volatility, but the question they should be asking is not whether it is, but, rather, why it is.

This finance stuff is a funny beast.

This is from traders perspective, who is not an academic.

The reason may be because of general aversion to drawdown from investor/trader. The market reaction is negative to rise in Vol. than slow grind down of volatility. This behavior causes investor to overpay for options, which flows to implied vol. function of option pricing models. This is especially true, if the vol. rise is sudden and unexpected. Demand for option at that time far exceeds supply.

[Ranger]

Say you write a 6m covered call each month, buy it back next month when you write a new 6m covered call. You limit your upside on the stock, but you collect the option premia regularly. In expectation, you make no more money than the stock position outright.

That may be true in indices. But single stock price distribution some times goes through Jump distribution. Like for example Heinz (HNZ) acquisition or Netflix (NLFX) prices after earnings. Most of the tail risk is because of fat tails and Jump process.

[tgskull13]

Anyone who is really serious about using covered call writing as a way of generating low-risk returns should read Alan Ellman's books on the subject. I'd recommend The Complete Encyclopedia for Covered Call Writing.