It's Options Expiration Day: How I Did This Month/Year

by: Honne Capital

Most money managers calculate their performance at the end of a month or the end of a quarter or the end of a year. Since I have been trading options so much, I think a good time to calculate my performance is every options expiration day. This is always an exciting day for me because I get to see my realized gains and losses. I don’t always have gains for the month, but it’s exciting to see my scorecard once a lot of positions have been closed out. It’s relieving. (Of course the following Monday is even better, because I always get a huge surge in buying power.)

I have written a few times about my strategy of selling puts on underpriced stocks and calls on overpriced stocks. I call it: “Selling insurance and lottery tickets” (another Stableboy Selections trademark by the way). Despite Fischer Black’s criticism of writing covered calls (economically equivalent to selling puts), I think the strategy is very intelligent during periods of market turbulence. I don’t think Black ever approached the market with the view of a fundamental investor. HE WAS TOO GOOD AT MATH TO BE GOOD AT ART.

I set up our “insurance/lottery company” in mid-August right after the market tanked and our portfolio along with it. The gross results since then have been impressive: September +9.5%, October +6.2%, November -5.8%, December +9%.

These abnormal returns deserve explanation.

In September, the S&P 500 dropped 7%. Our 16.5% outperformance was due to a single short position in YRC Worldwide (NASDAQ:YRCW). I think our position in the common plus the notional value of our short calls was more than 30% of the portfolio. So we really got paid when the stock dropped 90%. A smaller short, Netflix (NASDAQ:NFLX), fell into a death spiral. Also, we bought some volatility as it went parabolic into the end of the month.

October was really frustrating from the beginning. Our short Apple (NASDAQ:AAPL) puts shot up the day after Steve Jobs died. I sold off our volatility position gradually as it kept dropping. All of our puts expired worthless, but our calls went up a lot. I bought back some calls after watching our large profits from the previous month evaporate. USG (NYSE:USG), Cheniere (NYSEMKT:LNG), Silvercorp (SVM) … all of these pieces of shit kept going up. I specifically covered all of our short positions in Chinese frauds because I sensed a broad short squeeze coming. One of the most frustrating mistakes was that I did not buy Foxconn (FXTCF.PK) or Boyd Gaming (NYSE:BYD) before they surged. (I felt intuitively that they HAD TO.) Unlike some other fundamental investors, I hate lagging the market even if we do make money.

November was another frustrating month where we lagged the market significantly, even though it was flat. Actually everything went well going into options expiration. Our big short put positions in Western Digital (NYSE:WDC), Seagate (NASDAQ:STX), Yahoo (NASDAQ:YHOO), and Sprint (NYSE:S) all expired worthless. We had collected really big premiums by selling Sprint puts because the market freaked out after the investor meeting. Our dead-cat bounce short put trades in ATPG and RMBS tacked on about one percent of performance each. Our small short call positions in ZSL and GLL also expired worthless as metals surged. LinkedIn (NYSE:LNKD) and Active Network (NYSE:ACTV) dropped like rocks. I felt like a genius.

Then our short December put position in Ship Finance International (NYSE:SFL) surged as the market feared that Frontline would default. Worse, our largest position – short Clearwire (CLWR) puts – went parabolic as the media reported that Clearwire might miss an interest payment due December 1. All of this was crazy. I put aside all emotions and decided not to buy back anything. It was little consolation that we had also sold calls on CLWR that looked worthless.

December has been fantastic because the market is flat and we are up around 9%. Our short puts in CLWR got crushed on the first day of the month, as the company got savior funding from Sprint. Clearwire’s implied volatility jumped up on the news and I took the opportunity to sell MORE calls and puts, this time with January 2012 expiry. These premiums have since collapsed. Then I discovered (belatedly) that Kyle Bass’ fund had purchased 4.9% of Magic Software (NASDAQ:MGIC). I immediately shorted puts expiring in January before the stock jumped above $3.20, making it the largest position in the portfolio. We added a large short position in HDY calls that have dropped 61% as the stock has dropped by a third. After significant earnings disappointments, we took sizable short put positions in Best Buy (NYSE:BBY) and Research In Motion (RIMM). I think that whoever is buying these puts is miscalculating their odds. We have a small workout position short The Talbots (NYSE:TLB) puts. Our largest short position is Mattress Firm (NASDAQ:MFRM), which I think will drop at least 30% if my information about J.W. Childs is correct.

In conclusion, I think selling puts and calls is a really good idea when premiums shoot up and you have decent training in fundamental value. If you think the spot price of an asset is cheap, how could selling a put not make sense? Similarly, if you the the spot price of an asset is expensive, how could selling a call not make sense? When implied volatility is high, the investor gets huge margins of safety from market participants who don’t pay attention to fundamentals. One warning is that you need to be conscious of notional exposures when trading options. Always ask, “How much am I liable for if the guy on the other side exercises?”.

One thing I am worried about is the drop in volatility we have seen in December. Option premiums are no longer as attractive as they were just a few weeks ago, and it may be time to shut down the insurance/lottery business. I will prefer to buy illiquid stocks from forced sellers. A small hedge fund in New York is getting hit with redemptions, and I have to give them liquidity.