Brian Abbott's  Instablog

As a follow-up to my recent article on investing in offshore drilling companies, I next wanted to outline a strategy of writing put options on selected companies in this sector. I have also previously written on the mechanics underlying the put-selling process, so I will not review that in much depth here. The rationale for offshore drilling companies is that I invest heavily in this sector as a proxy for exposure to the oil market, and their higher than average volatility seems to make them a rich target on which to sell options.

Guidelines for Put-Selling

For simplicity, I made some rules so I could show one representative strike price of each stock. (Note that these guidelines are around the selection of expirations and strike prices, and assume that the investor has already worked through the stock selection process first, and is simply choosing among underlying stocks that he or she would like to own.)

• Selected the next lowest $5 or $10-unit strike price, targeting a 5-10% out-of-the-money strike price
• Sold one contract each
• Assume a $10 commission
• Selected an expiration close to September 2013 (mainly based on Atwood's lack of LEAP options)
• Assumes an order execution at 10 cents above the current bid on the put contract. (A price that will nearly always get executed, even if it sacrifices a potentially lower price to the put seller).
• Trade date of February 5, 2013.

Current year 5-10% OTM puts for offshore drillers

Calculating Returns using CAGR: "Return on Strike Price"

In my analysis, the compound annual growth rate is calculated as a return based on premium divided by total put exercise price, and annualized from the date of selling the put through date of expiration. It assumes that the put is held until expiration, and it actually doesn't matter whether the put expires in or out of the money (that difference merely affects whether you purchase the stock or not - the put is gone at that point, etiher way). If you look at the expanded table, you will see that under these put selling criteria, the CAGR ranges from 6 to 11%.

I have seen some option writers express the "return on margin", in which a similar calculation is used except dividing the put premium by the initial margin. The problem I have with that approach is that the margin requirement changes with time, whereas the strike price remains constant. Also, the return on margin will typically be several times higher than my return on strike. I think a focus on return on margin indicates a mindset of someone attempting to go fully leveraged, and that can be disastrous with this kind of strategy once an equity downturn inevitably hits.

The most conservative investors will stick to cash-reserved puts, in which case the CAGR that I list under my calculation more truly reflects a return on the full money at risk (i.e., the full cost of the stock at the strike price). At 6 to 11%, that's not a bad return, and in the worst case scenario it gets you in to your target stocks at prices 10% lower than what the initial stock price had been. I am somewhere in between and will use 25-50% of the available margin, which helps avoid margin calls during times that we get 5 to 10% corrections, which are always going to happen. It also helps boost my effective return beyond the indicated CAGR, but make no mistake, there is additional risk being taken in order to achieve that higher return. It is leverage and it can wipe you out if not managed well.

Hold until expiration or exercise

I have used this method for 8 years now. It is fairly rare for me to get exercised on the put options with this method, and the times it does happen, the stock will usually go up later and make a net profit for me. As I have written before, this has become the exclusive way that I acquire shares, and I dispose of them later via covered calls at higher strike prices that usually end up getting exercised eventually. The returns listed above under CAGR assume holding until expiration. Even if the contract is exercised, making you the (hopefully) proud buyer of stock, you still earned the CAGR.

Risks

No discussion about investing would be complete without a discussion of risks and what can go wrong. Probably the biggest negative headline to happen in the offshore drilling space is the BP Macondo well disaster in 2010. Not only was the environmental damage disturbing and the loss of human loss horrifying, but the business of offshore drilling was hurt as well, with a moratorium on new drilling permits in the US Gulf of Mexico waters.

An additional risk with writing naked (uncovered) put options on a margined basis, rather than cash-secured basis, is that the additional leverage can amplify your losses in a severe market downturn. Some wise investors have compared writing puts on margin to "picking up nickels in front of a steam roller." This means you might make a lot of small profits, but one big correction could come along and wipe out your gains, and then some.

Real-world example

As I have noted on several occasions, selling out of the money puts is the only way in which I acquire stocks (via occasional exercise), and selling calls is the only way I dispose of those stocks (again, via occasional exercise). In fact, it works so well that a big run-up like we've had the past month leaves me with a smaller equity position, due to positions being called away! Yes, that means my upside got limited, but keep in mind that in order to sell that stock it meant I sold an out of the money put, the stock dropped and I bought it on exercise, then sold an out of the money call (usually at a strike price higher than the put strike had been) and the stock went up and I then sold it. Plus I used leverage so did this on margin with a larger number of positions than I could have purchased on a cash basis.

My best example is Noble Corp . I have a position in NE right now that is about 5% of my total portfolio but represents my single largest stock position. I have acquired it in tranches over the past 4 years exclusively via selling OTM puts. The fact that I got exercised indicates that the stock did go down periodically. However, there have been many more puts that actually never got exercised and expired worthless - so my stock position doesn't even tell the whole story, in terms of profits. NE has always rebounded and is nearing a recent high. The whole position is now at about a 15% unrealized long term capital gain. (The fact that my cap gain is all long-term quickly tells me that my last put exercise on NE was over a year ago, by the way). I just had a big re-write of LEAP calls on the entire position, since all the covered calls just expired a few weeks ago in January 2013. Plus, it pays some dividends which I continue to collect along the way. The recent performance of NE allowed me to take the covered call strike price up a notch, which will increase my profits further if they get exercised. Because of the relative size of this position I have scaled back the puts I write against NE since I don't want to acquire too much more. However, once I sell some NE stock through covered call exercise, I will put that freed-up capital to work by selling more NE puts (at lower strike prices - meaning I will potentially get back in at a lower price than I had sold the profitable position on through covered call exercise).

Conclusions

This analysis has shown a way of selecting put contracts to write, and has used offshore drilling companies as an example of a target sector. The CAGR for the methodology I outlined is around 6-11%. The example I gave with Noble shows how the cycle of selling puts and calls can be repeated, and offers the chance to squeeze more alpha out of a stock you want to own, rather than passively just letting it sit there in your portfolio.

Thanks for reading and sharing your comments!

Disclosure: I am long NE, DO, ESV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I have a theory I plan to test on some earnings announcements and analyst reports, but in advance of that, I wanted to get it out on my instablog. The theory is that all estimates should be discounted by 30%. This number is my first guess of how to incorporate all the cognitive biases that are known to exist (overconfidence, confirmation bias, hindsight bias, and many others) into a rough estimate.

Interestingly, in my own work in biotechnology research which involve clinical trials, the discount should be much, much more than 30%. If a collaborator says a trial should take one year to complete, you can bet that it will take two. In fact, I budget it that way. If they say they can accrue 200 subjects (patients), you better start looking for a publication that will accept as few as 50. The benefit to the organization is that we control our enthusiasm and also avoid the smaller, riskier projects that probably would never have even obtained publishable results.

The theory is a way of using the research that other people perform, while applying a discounting mechanism to account for the high likelihood that even if they are directionally correct, they have a high likelihood of being numerically incorrect.

This theory also tangentially gets into value investing theory, in that a margin of safety is sought, for similar reasons: even the best analysis is still flawed in some way.

That's all for now, but I hope to write more on this once I find some good examples based on stock analyst reports and the ongoing earnings season. Who knows - maybe the discount should be 20 or 50%. Thirty percent was just my first guess at what it should be.

Disclosure: I am long INTC.

Wow. That's all I can say after reading this article in Business Week quoting the recent forecast from Goldman Sachs (GS) Private Wealth unit.

Goldman Sachs Group Inc. (GS)'s private- wealth-management unit expects hedge funds to return an average of 4 percent to 5 percent over the next five years as the industry struggles amid low interest rates.

"Everybody hopes to get the five hedge funds, all of whom are going to have 15 percent returns," Sharmin Mossavar- Rahmani, chief investment officer of Goldman Sachs Private Wealth Management's Investment Strategy Group, said at a press briefing today. "People need to be more realistic."

This is amazing. Hedge funds typically charge 2% a year for management fees, plus 20% of gains. Plus, your money gets locked up with restrictive provisions dictating specific timing and procedures required in order to get it back. So a 4 to 5% annual return for the next 5 years is extremely significant, as forecasts go.

I am going to spend some time digesting this. Maybe there are some other factors behind this forecast, such as other investments that Goldman Sachs gets more fees from, for example. I agree we're in a low return environment for a while longer, most likely. But hedge funds have a bunch of MBA's from Harvard. They're supposed to be really smart to deserve all those fees. 4 to 5% ? That makes bonds yielding a pretty safe 2 or 3% look like a pretty good deal, even with their interest rate risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.