covered calls

[chilliaa]

considering this is "just a side thing" for you, i would say 2.2% pcm is a great little side earner.

congrats. i wish i had your kind of capital

It was only 2.2% over three months, not per month.
Hence my questioning of the 'value' of the strategy.
Now this is only a three month time frame. So its still too short to make an informed decision.

 

[chilliaa]

Any update chilliaa? Looks like your WES won't be exercised, & rolling up/out on the banks will be a lot cheaper today.

Final update for Oct:
I changed my mind during the course of the last two days.
A major headache of having covered calls in the money is you have to 're-act' rather than 'act'. An in the investment world a person who is reacting to circumstances is at a big disadvantage.
This is another negative of writing covered calls that i'm only finding out the hard way.

Anyway, i ended up covering my options on WES by buying both back at 15c on Wednesday. The reason for this was:
1) the share price was hovering around the call price.
2) at the time of execution the DOW futures where positive implying a possible upwards movement on the ASX on thursday (option expiry day)
3) if you wait until the last couple of hours on option expiry day you get raped by the market markers, you become a forced price taker if you want to roll positions (this can add several cents to the price unnecessarily).

Now the reason i bought back both instead of rolling one and letting one potentially lapse is i needed to buy time. I was getting too stressed being forced to react and i wanted time to be able to think and act.

WES is pretty fully priced at the moment.
They have an excellent business model which i have to take into account when determining the intrinsic worth of the company ( i will pay a higher price/my model has a higher intrinsic value for a quality company than an average company).
However having said this look at the price vs earnings and near term future earnings.
They reported an 2009 result of $1.7 EPS, but this is expected to fall in 2010 due to share dilution from capital raisings (i dont understand this fully but basically quoted EPS at period end is not just divided by shares on issue, but the weighted number of shares over the period adjusted for certain things) and also from lower expected earnings from their coal division.

Anyway so we start at an PE of around ($28/$1.7) 16.5 which is not too bad based on 09 earnings. However 2010 EPS is expected to bottom at around $1.35-$1.45, hence the PE will rise during 2010, but this is bottom of the cycle earnings. So we really need to go out to 2011 where the earnings should come in around $1.8 to $2 a share.
If i take the higher value and multiply it by the 10 year average PE of around 18 times earnings i get a maximum upside potential of around $2*18=$36 share price.

So if everything goes according to plan, and if the market pays what it historically has as a multiple i get a price in 2011 of $36 which is roughly 30% higher than current prices. I also get a dividend, but this is pretty crapy at current prices being only around 6% gross over the period.
So total return is (30%+6%+6%) or 42% over a two year time frame.

BUT THAT ASSUMES EVERYTHING GOES TO PLAN.
Where is my margin of error?
What happens if i am wrong in some assumptions?
Things rarely go according to plan.

Also what alternative investments are out there?
Can i beat 42% over a two year time frame from investing in some other companies?
What about cash flow? my cost of debt will rise over the next two years as interest rates go up. My current cost of finance with a margin loan is 6.85% after the last interest rate, but this will definately go up.

So basically i want to step back and access what i should do. I cant do this whilst the shares are under a covered call contract.
At the moment i am leading towards selling a portion of the shares and keeping the rest that way i hedge my bets.

It also gives me an oppportunity to reduce the margin loan. As the market recovers i want to reduce gearing. I am definately not comfortable keeping a high degree of margin debt throughout the cycle.

 

[chilliaa]

CBA went through as above, one contract excercised, one contract rolled.
ANZ were all excercised.

 

[keithj]

Final update for Oct:

Thanks for the update chilliaa - your detailed reasoning is much appreciated.

Have you considered selling puts with a strike price you'd buy (eg) WES at, at the same time as selling the call. You'd roughly double your income, with roughly the same level of risk. At most one (either put or call) will be exercised, so you're guaranteed income from one, and you should be happy with the outcome of the other (exercised or not).

 

[Ol School Skata]

Chillia,

It is important to keep it in perspective - the way you used the covered call strategy returned 2.2% over 3 months, it is not necessarily the results that everyone else would have got - some will have got worse, some better.

The strategy is a cashflow strategy not a capital growth strategy.

A covered call strategy will underperform a strongly rising market due to the nature of capping your profit for a premium. This is clearly stated as one of the risks of the strategy in most if not all official literature discussing the strategy.

I do not believe this is the holy grail of strategies, but one of many that make up part of an overall strategy - it is one tool in a toolbox and should be used at appropriate times.

OSS

 

[Ol School Skata]

Ok now on to a bit of reflective thinking.

Whats the sought of profit potential:
Over 3 months the profit from writing covered calls was around $10,000 (before paying for purchasing back contracts on positions that were at risk of being called and for which i didnt want excercised).

Reading back over your posts, as I haven't kept up with this tread, I offer the following:

from my reading, it appears your strategy changed during these three months... you were happy to sell options over shares, but then because the share price rose, you bought them back (i would think greed) when they were in the money (some very deep in the money)- this can be very expensive, at one point i think you talked about selling an in the money call option to get back your investment to buy the previous months option back.

If you didn't want them exercised, then you shouldn't have written the call options. This is greed and does not reflect a continuous strategy. You have chopped and changed what you wanted to do.

If you sell options over shares you own, you are accepting the risk they may be sold - for this risk you get paid a premium. If you don't want the risk, don't sell the options.

It doesn't appear you set clear rules in relation to this strategy and if you did you broke them. Did you clearly think about what happens if the market continues to rise above your strike price? did you consider allowing yourself to be exercised, take your profit and look at other shares to do a buy write/covered call on?

Have you done any paper trading for a suitable continuous amount of time before committing large sum to the strategy?

I don't think the use of margin loan funds to this strategy really (and i mean really) should not be done until someone is very experienced at it.

You appear to be working on this for a lot of hours each day. I would not spend hours upon hours on this one strategy - there is too much life to live. This could be one reason to use a full service options broker who can do all the number crunching for you.

This is meant to be constructive feedback and not a personal attack ok . I say this because I have made many mistakes in a covered call strategy and probably will make some in the future. But in order to learn, you must review the reasons for your results.

OSS

 

[keithj]

If you didn't want them exercised, then you shouldn't have written the call options. This is greed and does not reflect a continuous strategy. You have chopped and changed what you wanted to do.

If you sell options over shares you own, you are accepting the risk they may be sold - for this risk you get paid a premium. If you don't want the risk, don't sell the options.

....

This is meant to be constructive feedback and not a personal attack ok

I'd disagree . If you don't want them exercised then put a strategy in place to prevent that. It's reasonable to have a roll up/out strategy if exercise looks likely. Not sure if chilliaa mentioned that earlier in the thread though ?.

 

[Ol School Skata]

I'd disagree . If you don't want them exercised then put a strategy in place to prevent that. It's reasonable to have a roll up/out strategy if exercise looks likely. Not sure if chilliaa mentioned that earlier in the thread though ?.

Ok true I accept that. It does have to be acknowledged that rolling up/out has its costs and can be expensive and this will impact on the overall results.

Personally i don't roll up/out where the costs to do so are more than the premium received. I am happy to take my profit and invest elsewhere which may include writing put options or a buy write, depending on conditions.

OSS

 

[Aaron Sice]

It was only 2.2% over three months, not per month.
Hence my questioning of the 'value' of the strategy.
Now this is only a three month time frame. So its still too short to make an informed decision.

remember, you're not as aggressive as some as well.

it'll pay your tax bill though - and it's money you didn;t have before. or you can compound it.

 

[TheAnalyst]

Yes the portfolio is geared, the level of gearing depends on
1) 'value' in the portfolio, cheaper the value higher the gearing because greater the discount to my intrinsic values
2) market stability, greater volatility lower debt
3) most importantly the size of the total portfolio relative to my total non-leveraged wealth.

I want to emphasise margin debt is bl**dy dangerous. It can more than wipe you out. I know on the grape vine a certain person who had a portfolio of $7million that was geared in 2007. Now i dont know the gearing level, but i heard the gross value of the portfolio in early 2009 was $1.5 million. In otherwords he 'blew himself up' through excessive leverage into an unforeseen downturn in the market.

Be very careful of margin debt and be very careful of a financial adviser who suggests it. That financial adviser is probably receiving a commission of around 0.5% of the value of the margin debt. A nice earner for him.

Yes i invest in properties. I have 5 at the moment, but they were all purchased at cash flow neutral or better positions (without tax effect such as depreciation, natural cash flow). Importantly they were cash flow neutral with 65% of the lending position fixed for 10 years.

I still have one business left that i spend around 20 hours a week in.
At the moment the stock market chews up around 50 hours a week, so yes its pretty much full time.
I didnt plan on this, its just that the market correction provided an opportunity that only comes around once every 20yrs or so. As discounts to intrinsic values become smaller i will take money off the table and reduce my hours.


If you are going to be an active investor you must do the homework (and homework doesnt mean watching CNBCAsia, or blindly following broker recommendations or research reports. You need to do your own homework and be comfortable why you are taking positions.
Otherwise you risk being a sheep at the slaughterhouse (being the market).

You are probably one of the best on this forum. Like your posts and keep posting. You are better than a lot of "experts"

 

[chilliaa]

Chillia,

It is important to keep it in perspective - the way you used the covered call strategy returned 2.2% over 3 months, it is not necessarily the results that everyone else would have got - some will have got worse, some better.

Yes you are correct, the other point i guess is that i may be bastidising (i cant type the correct word here as its also a swear word but not when used in this sense) the strategy to suit my own purposes which runs the risk of achieving sub-optimal returns. For example i used the strategy only over a narrow range of my suitable shares. If i had used it more broadly (for example over stocks such as ORI, CSL, QBE, TLS) it would have been more effective. However the mentioned stocks are still trading below my intrinsic values, so i definately dont want to have those stocks called on me.

The strategy is a cashflow strategy not a capital growth strategy.

Yes but what im finding is its not consistent cashflow on a single share. I was rather hoping that it could generate an income against a specific stock consistently over time. This would have enabled me to hold a lower level of dividends in the portfolio overall if it was being supported by cash flow from the covered calls.

I am finding this is not the case.

A covered call strategy will underperform a strongly rising market due to the nature of capping your profit for a premium. This is clearly stated as one of the risks of the strategy in most if not all official literature discussing the strategy.

The whole market didnt rise strongly between Aug-Sept (or is this considered a strongly rising market). I under stand the theory, but how do you ensure against margin debt. Therefore a covered call strategy is probably more 'useful' if the portfolio is ungeared.

 

[chilliaa]

Thanks for the update chilliaa - your detailed reasoning is much appreciated.

Have you considered selling puts with a strike price you'd buy (eg) WES at, at the same time as selling the call. You'd roughly double your income, with roughly the same level of risk. At most one (either put or call) will be exercised, so you're guaranteed income from one, and you should be happy with the outcome of the other (exercised or not).

The trouble with selling puts is it dramatically increases your risk profile, especially if you are already using margin debt.
If the market tanks and you have written excessive puts you risk blowing up.
Writing puts can be a good way to try to pick up shares that you otherwise would be happy to pay for otherwise but its very risky in my opinion.

Also the trouble is that sometimes the price of a stock will decline based on new market information which decreases the intrinsic value of the share. Hence you may get hit on a put merely because of the reduction in the intrinsic value of the share.
Once a stock starts to move into my buy zone i prefer to just dollar average into the mother share.

 

[chilliaa]

Reading back over your posts, as I haven't kept up with this tread, I offer the following:


Firstly let me say i appreciate your constructive negative feedback. Whilst i am very comfortable investing in shares, i am a relative newbie when it comes to writing covered calls.

from my reading, it appears your strategy changed during these three months... you were happy to sell options over shares, but then because the share price rose, you bought them back (i would think greed) when they were in the money (some very deep in the money)- this can be very expensive, at one point i think you talked about selling an in the money call option to get back your investment to buy the previous months option back.



If you didn't want them exercised, then you shouldn't have written the call options. This is greed and does not reflect a continuous strategy. You have chopped and changed what you wanted to do.

If you sell options over shares you own, you are accepting the risk they may be sold - for this risk you get paid a premium. If you don't want the risk, don't sell the options.

Yes you are quite correct. And i have learned the hard way by marking some sub-optimal decisions.

However i will comment on one thing: the value of a share is not static. It can change with new information which can effect the intrinsic value of the share.
Therefore it is not just 'greed' that makes me want to keep the share but an increase in the intrinsic value of the share. There is a difference.

It doesn't appear you set clear rules in relation to this strategy and if you did you broke them. Did you clearly think about what happens if the market continues to rise above your strike price? did you consider allowing yourself to be exercised, take your profit and look at other shares to do a buy write/covered call on?

Have you done any paper trading for a suitable continuous amount of time before committing large sum to the strategy?

No and maybe i should have. I did limit the covered calls to only a small % of the total portfolio though (around 20%)

I don't think the use of margin loan funds to this strategy really (and i mean really) should not be done until someone is very experienced at it.

Yes again you are correct.
However this does lead to another question.
Which is better running an ungeared portfolio in conjuction with a covered call strategy, or using a leveraged portfolio with straight equity investments?

Maybe the answer lies in the cycle of the market.
Early in the cycle use margin debt, later in the cycle cut the margin debt and use the covered call strategy.

You appear to be working on this for a lot of hours each day. I would not spend hours upon hours on this one strategy - there is too much life to live. This could be one reason to use a full service options broker who can do all the number crunching for you.

Part of the time is the 'learning curve'. Most of my time on though is spent on fundamental issues and market pyschology (which is important if you are holding debt).

I do use a full service broker, but at the end of the day its my money and hence my responsibility. There is no point getting angry with my broker at a future point in time if everything blows up: angry wont get my money back.
I accept viewpoints but the responsibility always lies with me, so i must fully understand the risks and opportunities.

This is meant to be constructive feedback and not a personal attack ok . I say this because I have made many mistakes in a covered call strategy and probably will make some in the future. But in order to learn, you must review the reasons for your results.

This is 100% constructive feedback and i really appreciate it.
thanks.

 

[chilliaa]

The banks are a big headache at the moment. They are now well in the money, but what are the correct values for the banking sector.
Australia's big 4 banks (+MQG) are the new play thing for international hedge funds (go long AU$ long australian banks as a trade). So there is alot of hot money in this sector at the moment.

This is exactly why i always want to act rather than react.
Ive been warning about the impact of hot international money in our markets.
International hedge funds were using the AU$ as the destination carry trade and attempting to increase their return by being long Aus big 4 banks and the major resources as a proxy EFT for commodities (we know this because BHP/RIO have been trading at higher prices on our exchanges than the UK exchanges after currency conversion)
The trade was becoming very crowded.
We are now seeing what happens to crowded markets (similar to the commodity story of 2008, not that commodities and their related shares are bad investments, only the risk of being in the same position as everyone else).
Interesting to note that our market is now falling harder than the US markets as international speculators try to unwind their positions together with everyone else.

Because i am prepared i can act now rather than react
and use this correction to top up on desired shares.

 

[willair]

Because i am prepared i can act now rather than react
and use this correction to top up on desired shares.

There is a emerging concern that there will be another big slide on Wall Street very shortly,everything that i bought into over the past 12 months
is now sold 2=3 weeks ago,and the money sitting in the BANK waiting,and the 2 properties i put up for the entry costs are now free again,for the next downturn that risk has paided very well,ALL i'm waiting for now is the signal to start buying again,and i can wait like last time,as long as Chinese investment keeps going???..imho..willair..

 

[Aaron Sice]

chilli - you MUST remember that you are writing covered calls against stock you own.

which may or may not be the best premium options around.

i TRADE options, i buy calls then on-sell them, or i sell puts then buy them back, but i never buy the underlying equity. i have generated returns of over 900% like this.

 

[chilliaa]

chilli - you MUST remember that you are writing covered calls against stock you own.

which may or may not be the best premium options around.

i TRADE options, i buy calls then on-sell them, or i sell puts then buy them back, but i never buy the underlying equity. i have generated returns of over 900% like this.

i think you may have hit the nail on the head.
I'm giving much thought to this covered call writing strategy.
Used as part of a trading strategy i think it has much merit.
However i am questioning its validity as part of an investment strategy, especially one with gearing.

 

[chilliaa]

Because i am prepared i can act now rather than react
and use this correction to top up on desired shares.

I should link this into the context of this thread.
I didnt post the above comment because i have a big head.
The point i was trying to emphasise is that its better to be proactive rather than reactive.
Now i was prepared for this correction in the markets, BUT NOT AS WELL AS I COULD HAVE BEEN.

The main reason for this is that when your shares are tied up in a covered call strategy you cant take any money off the table (ie you cant partially sell as share prices go up). Its a bit like reverse dollar averaging.
Once you think a share has fallen sufficiently below your intrinsic value you start to acquire a position. But you dont acquire your full position in one hit, rather you dollar average downwards.

The reverse applies in a rising market. You dont sell everything at once.
But as a share moves to your intrinsic valuation and then moves above it you start to take money off the table.

This is a very efficient insurance strategy and an easy way to outperform the market, but personal control and will power must be executed.

 

[redwing]

chilli - you MUST remember that you are writing covered calls against stock you own.

which may or may not be the best premium options around.

i TRADE options, i buy calls then on-sell them, or i sell puts then buy them back, but i never buy the underlying equity. i have generated returns of over 900% like this.

Does this mean you have to have your finger pretty close to the trigger though BC and monitor the market?

More reward but looks much riskier unless you know what you're doing (and at 900% I'm guessing you do).

 

[reaper@work]

Hi guys, I normally don't participate in this forum, but this topic is interesting to me, so I decided to share few thoughts with you. I've been there and made the same bad decisions as chillaa so the topic certainly reverberates with me.

In my experience rolling simple covered calls higher is not worth it. If there's a need to roll then the strike or expiration date was incorrectly chosen or the whole strategy is not right.

If you want to do a simple covered write and you don't want to be exercised then place the call very far away from the money and pick a farther expiration month to get a decent premium. Don't go for near month. You will not earn so much in premium but you will feel better.

An alternative is a backspread w. stock: Sell ATM call and buy 2 OTM calls. This way you get a decent premium even with short-dated expiry but you keep the upside as well, so you will feel good.

A twist of this is a backspread + collar. Sell ATM call, buy 2 OTM calls, buy OTM put. This is a double-feelgood strategy as you protect your downside as well. Sold ATM call will cover all the costs and some credit will be left plus you keep the upside.

There's also another twist for a triple-feelgood strategy, but I won't reveal it yet - gotta keep something up the sleeves