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Arnbjorn Ingimundarson
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Arnbjorn Ingimundarson, CFA, looks for opportunities in all asset classes and all sectors, domestic and international. His main approach is based on value investing in the spirit of Benjamin Graham, while making use of any method and instrument as his disposal. For instance using technical... More
My blog:
moneypondering.com
  • Call and Put Selling – A Follow-Up
    As promised, I am revisiting some put and calls sales I wrote about in October 2009 and May 2010. In October 2009, I advocated selling covered calls on stocks to take advantage of a market that had risen substantially in a short amount of time – little did I know that it had far higher to go. After a strong pullback in May 2010, I suggested writing puts to take advantage of a weaker market and higher implied volatilities (higher prices, in other words) in options.
    Before looking at the results, note that there was nothing particularly clever about the selection of stocks (the 12 largest stocks in the U.S. by market capitalization at the time the first article was written) or the timing (I suggested selling calls after a significant increase in the market and selling puts after a significant decrease). The following chart shows that I was not nailing any tops or bottoms.



    The table below shows strike prices of the options sold and the premiums received as well as the underlying stock prices at the time of option sales and currently:



    Half of the stocks would neither be put nor called, leaving the investor in the same position as in a passive strategy, except for the joy of pocketing the option premiums. The shares that exceeded the call strike prices at expiration and therefore being sold were WMT, AAPL, GOOG, IBM, and PG. Only BAC shares ended lower than the put strike price and would therefore leave the investor with a double dose of that troubled bank. The portfolio can obviously be rebalanced at any time.



    Even though the market may have proven my outlook at the time of writing the first article to be overly cautious, the results of the overall strategy are still quite impressive. The strategy using option sales would have returned over 23%, compared to 13% for the passive strategy, dividends excluded in both cases. Remarkably, the passive approach turned out to be better for only one stock, AAPL, and in no instance did the options strategy result in a loss, whereas the passive investor would have suffered losses on BAC and JPM.
    At the right end of the table above, breakeven points are shown. If the stock price was below the lower limit at expiration, it would have been better not to use this strategy (due to a large loss on the puts), whereas if the stock price was above the upper limit at expiration, it would have been better to simply hold the stock and not limit the upside by selling calls. It would take an extremely strong or weak market for this strategy to underperform a simple buy and hold strategy. It is really only the extremely weak market you need to worry about. For instance, having a large amount of put options outstanding from late 2008 to early 2009 could potentially have been devastating. Therefore, position sizes and risk control are key.
    Again a Good Time to Sell Covered Calls
    Since the market has had an impressive and almost uninterrupted winning streak recently, it seems prudent to sell covered calls again at this time. I will repeat the exercise in a similar way by showing the twelve largest U.S. stocks by market capitalization currently and suggesting covered calls to sell with an expiration in January 2012. Between now and then, I will look for a time of weakness to sell puts against the same stocks. The results will be shown in a year’s time.


     


    Disclosure: I am long MSFT, AAPL, JNJ, BAC, T.
    Jan 21 5:22 PM | Link | Comment!
  • My trading plan for the coming years

    Watching stock charts being drawn in real time and digesting data on a daily basis, it is easy to get distracted from your longer term views. I believe it is useful to review once in a while what those views are as it can give you a different, less myopic view on your trading. The following longer term views influence my trading plan:

    1. Markets move in long cycles. I am a believer in long market cycles, typically 16-20 years in duration. Such cycles are empirically supported by market history and there is also a certain logic to them. A bull cycle starts when valuations are very compelling and all the weak and frustrated hands have been shaken out. That cycle continues until everyone has been enticed back into the market (on margin, in many cases) and valuations apparently cease to matter. When there is no one left to be fooled into the market, the process is reversed.
       
    2. Valuations matter. Perhaps not on a daily basis, but in the long term fundamentals always catch up with stock prices. Long bull markets start from low valuations (e.g. 1982) and long bear markets start from high valuations (e.g. 2000). My favorite gauge of where the market stands valuation wise is the Cyclically Adjusted P/E ratio (CAPE), made popular by Robert Shiller in his book Irrational Exuberance. Check out Doug Short’s recent post for an excellent discussion of this topic.

    Using this framework, we are currently a little over 10 years into a secular bear market and valuations, as measured by CAPE, are higher than average (20 vs. an average of 16.4 since 1871). While it is true that low interest rates should warrant higher stock market valuations, low interest rates and relatively low stock market valuations can coexist, as was the case in the period 1930-1952. Based on market history and valuations, it therefore seems likely that a long, strong bull market is some years off.

    Get paid for waiting with options

    So how to invest until valuations are compelling again? Bonds do not present an appealing alternative to stocks as their yields are very low. Instead, my method is to use a hybrid stock/option strategy to profit from the market’s manic-depressive behavior. The simplest way to do this is to sell put options when the market dips (often with the added benefit of increased implied volatilities) and sell call options against stock positions that have risen sharply (covered calls). This way, you get paid for committing to a certain trading range and time is on your side due to the time decay of options. There are a lot of complicated things you can do with options, but such basic strategies are likely to form the backbone in my trading. This is how I will try to squeeze decent returns out of a market which I anticipate being difficult in the coming years, until stock market valuations are more compelling.

    There are reasons to believe that the current rally could continue for a few weeks more, while significant risks remain to the downside (discussed here by Charles Hugh Smith). Now could be a good time to look at your long positions for covered call opportunities.



    Disclosure: Various long and short positions with net market position near zero.
    Aug 06 12:08 PM | Link | Comment!
  • Goldman Sachs hearing exposes congress as clueless and dangerous

    My opinion of congress has been with the majority of people, which is to say low. After watching the political farce that was the Goldman Sachs hearing, it is lower still. Putting a case such as this, which consists of questionable disclosure in one transaction, at the forefront of explaining the financial crisis can not merely be called stupid. It is dishonest and disgraceful.

    During the questioning it became clear that the rather insignificant and, in my opinion, weak SEC case was just a pretext to make political points quite unrelated to the case. Goldman Sachs was generally faulted for making money during the financial crisis. It is the key element of free-market capitalism that those who allocate capital wisely stay in business and those who do not fail. In a system where the prudent are punished and the imprudent bailed out, the failure can hardly be attributed to the markets.

    More specifically, the firm was faulted for taking short positions in the mortgage market, which by one senator’s count is “betting against your country”. By the same token, buying the lowest quality mortgages, whose origination was not only allowed but encouraged by the government, would be betting for your country — how patriotic those sub-prime mortgages were. Are there really people in positions of power who do not understand that it is the inflation of the bubble, not the inevitable bursting of it, that is the problem?

    At various points, senators voiced disappointment that the GS employees being questioned did not admit to playing a role in causing the financial crisis. How ironic that this very group of people, members of congress, should be so blind to the much larger role they played themselves.

    Implications

    This is relevant to investing for the following reason: The long-term fiscal outlook for the United States is dire. If there was reason to believe that members of congress could be trusted to understand the flaws of our financial system, or economics in general, one could be hopeful that the United States would leave its current fiscal path, which will inevitably lead to disaster. Instead, there is reason to think that action will only be taken to address large and growing deficits once the seriousness of the problem becomes clear to the dullest of minds. How appealing does this make long-term treasury bonds? I’ll pass.

    Ideally, the government would look inward and see the dangers caused by the inflationary monetary and fiscal policies that have been used as a band-aid to cure all problems. Instead, members of congress have chosen to abandon intelligent and civil discourse and picked an arbitrary whipping boy.

    Disclosure: I neither have a position in nor any connection to Goldman Sachs.



    Disclosure: No position.
    Apr 30 10:20 AM | Link | Comment!
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    Jun 14, 2011
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