Common Cents

Long/short equity, options
Common Cents
Long/short equity, options
Contributor since: 2009
I think the 4% rule was a theoretical approach that at best is a rough, simple, guideline...not a "rule".
Further, common sense seems to dictate that market conditions need to have some impact on your draw down strategy. Instead of a flat 4%, I think about as a base and bonus (like 3.5% base another 1-2 % if the market is up a little/lot). I've never done the math on that, but I suspect it works out ok.
It has the added attraction of creating a family budgeting/spending process that is similar to a base plus bonus approach many are used to from when they were drawing a pay check.
These withdrawal rate studies always make me crazy. A few thoughts
- the different results shown in the two graphs starting just 4 years apart is always very telling. Unfortunately market cycles don't align with your life cycles. The timing of when you stop earning income really makes a big difference. Everyone should be thinking about turning hobbies into small income streams.
- Why does everyone assume the future will be exactly like the past? There are really only a handful of (i.e. non statistically significant) 35 year modern periods since we have had fiat currencies. With interest rates at "zero" and a baby boom driven demographics I think it is especially important to remember "past results are not indicative of future results". Personally I expect a 60/40 mix to return less in the next decades than in the past decades. Personally I'm looking for alternative investments to have as good of a chance of generating returns in the future.
- I'm a big fan of dividend investing, but not sure I understand all the comments on living off dividends being different than a 4% withdrawal. If your investments make your withdrawal (say 4%) plus inflation (say 3% on average) you will die with the same purchasing power as you have now. Hence something like 7% is the goal. Years you don't make 7% you will be "withdrawing" purchasing power from your account. Years you make over 7% you will be adding to purchasing power. Hopefully, your purchasing power will not go to zero, but big draw downs make that a real risk.
Isn't "yield on cost" just another way of conceptualizing/visual... the magic of compounding?
Certainly holding a high quality dividend payer for a long time is one way to generate a good compounded return, but I don't see how striving explicitly for yield on cost as some new, magic, path to investing success.
Consistently writing covered calls will certainly change the performance of your portfolio. As the article suggests, equities with calls written against them will under perform when things go up, but over perform when things go down or just sideways. To me that means lower volatility and that can be a good thing.
I would suggest that it is inappropriate to compare a portfolio with lots of covered calls against just holding stocks. Instead I think a better comparison is how does a covered call portfolio compare to some mix of holdings such as 60/40 of stocks/bonds. That type of portfolio is considered "good" because holding the the bonds will likely mean the portfolio will under perform the stock market when the market is up and over perform the stock market when the market is down. That reduces volatility and is good.....wait... that kind of sounds like what covered calls will do.
Further with today's record low interest environment it seems less likely that bonds will actually provide this type of cushion to a portfolio if/when the equity market falls. Covered calls can provide another way to achieve this result.
Tom, Nice article as usual. Thanks!
I do use delta to manage options which I'm short. Specifically I cover them if they fall to 15 or rise to 85, or most of the time premium is gone. Using those type of rules I tend to enter more naked positions that are OTM than ATM spreads. I realize that entails more risk and possibly capital but I think/hope the risk is worth the reward, especially if you have the discipline to cover at some level. I usually only trade spreads around very specific events like earnings for fairly speculative stocks. After the event the spread is often either a max winner or max loser so there is not too much to manage.
More broadly, I find it "interesting" that many articles such as yours usually use just the price of the stock as a trigger to adjust the position. Perhaps that is just to keep it simple. However, I inclined to believe that if an investor is sophisticated enough to trade options they might want to be sophisticated enough to manage the position using the drivers of option price illustrated by the greeks.
Have you considered exit targets based on delta and/or other "greeks". They are designed to take in not just the movement in price but the passing of time.
I usually avoid commenting on anything that has political overtones, but ....
1). The fact that we have a large combination of very unsophisticated tax/spending changes all one-time, one month after election is really just a depressing indictment of our overall political process. (left and right)
2). I would like to know who came up with the term "fiscal cliff", and how it stuck? Why not either Fiscal Armageddon, or fiscal speed bump, or tax policy decision day, etc. I'm inclined to believe that talking heads (on the left and right) just need to have a monthly "crisis" just to try to keep their ratings higher post election.
I agree interesting, well presented, and a worthwhile strategy.
As kongen1 indicates, the harder part of this strategy is managing the position. For example, it is very likely that as the price of the underlying moves one side or the other the trade will be "challenged". Which side would you consider "taking off or rolling " first. The side that gets challenged or the side that becomes safer? I'm usually inclined to the take the "safer" side off first and hope for a reversion to the mean to get out of the other side. However, I know others think it is safer to address the side of the trade at risk first or just always take off both sides at once trying to skim a little of the theta decay. Thoughts?
Interesting article!
Was looking for a little point of clarification on exiting the position.
Specifically how the index calculates the exit of the position. Does it assume the put is held to expiration. If assigned, does it assume the assigned position is sold on the open Monday or what? For your strategy it seems like you wait to the day before expiration to make some sort of decision about options that have become ITM. Have you considered rolling the option when the delta gets to something like 10 or 90 or days to expire gets down to a few?
Lastly if this works great wouldn't doing it with weekly options make even more sense?
Thanks for the article, and I agree with the general point that covered calls add to performance in a down/flat market and take away from performance in a up market. However, I think there are a few points that also need to be considered.
1) volatility reduction - the results described above seems to certainly led to less volatility to a portfolio. Reduced volatility likely has a positive impact on compounded returns over the longer term, and also has a positive influence on an investor's mindset such that they might be less inclined to panic sell
2). How the covered calls are managed? I believe the indexes and most back testing assume that the options are held to expiration. However, I think the results would be different if an investor had some basic strategies to roll the options prior to expiration. If an investor is going to sell calls, they need to have a plan to adjust the position if/when the market moves significantly.
3). Cash flow - Some of the reason to sell calls is to generate cash for consumption on a periodic basis. Something akin to the coupons from a bond. Hence, for a person in retirement who is going to need to get some cash from their portfolio the draw downs may look different for each scenario.
Kind of depends on your objective, but 2 would get you close to delta neutral.
i.e. Long Apple has a delta of 1 and this spread probably has a delta a little less than -.5.
I only mentioned Apple in the article because it was a big part of this index. If you are really, really concerned about an Apple position it might be easier/better just to use Apple options. Maybe sell a call way above the current price and use the proceeds to by a put below. This exchanges further big moves up for insurance on the downside.
You are right there are lots of numbers that help an investor define the probabilities. In this case:
- I view 50/50 (or actual 92/108) as the odds of success because that is where the market has set the odds. I hate to use gambling terms, but the bookies (ie market makers) have defined this as the odds based on their models.
- The 67% probability of touching actually came from the options trading platform I use. Most of the options oriented trading sites do the complex math to figure that number out. I've heard people quote a rule of thumb that 2x delta is a good approximation of the probability of touching. At the end of the day that all seems very theoretical and very tied to a belief in a normal distribution of activity. I use those numbers as starting point for probability of something happening, but then try to adjust it based on my human judgment.
- Volatility. I don't put a whole lot of thought into the current IV vs HV. To me those seem to diverge/converge across the whole market at the same time. However, when I perceive IV to be low (like it is now) I'm more inclined to buy the put spread. Hoping that volatility might rise helping the direction of the trade a little. If IV was higher I might have sold a call spread instead.
Yes, an investor can use any of the indexes and accomplish the same general objective. All the indexes have some "over weight issues " to consider. Since DIA is price weighted the large priced stocks make a bigger impact. I think IBM is about 11% of the DIA and the large oil companies also make up a big chunk. SPY has a fairly large weighting in financials.
As I said, this approach can work with any of them. I chose QQQs right now because it has had such a big run up, and "hoping" for a reversion to the mean for the big tech stocks like Apple that drive this index.

I prefer to get exposure for my portfolio to gold via options. Specifically I like selling puts on the miners (GDX), and using those proceeds to buy calls on the metal (GLD). Per above, these two entities are 85% correlated, but the higher implied volatility in the miners makes this trade attractive. As described in the article below this lowers the capital requirements needed to gain gold exposure, but still provides upside exposure on a spike in gold prices.
No, I am not into the details of any real/perceived issues with the gld etf. If you prefer buying and holding physical gold, I can respect that. However, that is very capital intensive and expensive.
I would point out that if you are concerned about gld, the downside of the second trade above is related to the gdx not gld. If an issue became apparent specific to gld that might not ripple directly to the gold miners.
I also still have a Leap position in CSCO. When the stock and volatility was down in August, I rolled from the Jan 13 $10 Leap to the Jan 14 $10 Leap for only $.05 more in capital. ($6.60 was the price) That bought me another year duration to write calls against the leveraged position. While vol is still low perhaps it is a good time to roll out?
With the nice bounce up in the stock since August, I recently sold the Oct $20 calls against this position for $.41. If the stock pulls back that will be the start of a nice percentage premium collection. If the stock goes over $20....might be time to take the profits and move on. Writing calls against leaps has worked well for me on this one so far, but if the stock hits the $20s I think there might be better opportunities to do that elsewhere.
I think two key words in "MPT" are worth considering
Theory- as in "not a fact" but rather a supposition based on a set of assumptions. Assumptions such as
- market participants behave rationally - proved untrue
- results follow a "normal" distribution - proven untrue
- frictionless (not taxes, fees, govt intervention)- proven untrue
- correlations between asset classes are constant - proven untrue
Modern - as is "circa 1953". Since then there have been just a few changes in technology, communications, globalization, demographics, fiat currencies, regulations, culture/ethics, etc.
Sure seems like those things might have some impact.
I like the longer term story.
As you mentioned, this may take some time to bounce and might not be likely to rocket higher in the near term. So the question to me is not "why buy this"?, but..... "why buy now?"
The option implied volatility seems high to me given their strong balance sheet should provide some protection for the downside. Hence, I've been regularly selling puts in Met. Sometimes capturing some premium, and sometimes acquiring a few shares In general, trying to build a position over a period of time while lowering costs.
I'm not sure if Gross's assessment that returns over the next decades will be less than historical averages is true or not....but I do think investors should not put 100% faith (and 100% of their capital) in the idea that a traditional mix of stock and bonds (i.e 60/40) will generate sufficient returns to meet their needs.
Instead I'd suggest you should allocate only some portion of your capital to a 60/40 model, the other portion should try to generate returns using other vehicles and techniques (leverage, options, long/short, hard assets, etc) In that way, all your eggs are not in the basket that assumes the next 20 years will be like the last 100.
Tom, as usual good follow on analysis on a quick basis! Thanks
What bothers me is ... if that kind of "sum of the parts" analysis can be done this easily ....why are all the "brains" on wall street not doing the same math and coming up with the same conclusion?
I believe this type of story was driving a reasonable amount of hedge fund ownership of xrx awhile back. I can only assume that part of the sell off in the stock is these funds are exiting and placing their bets elsewhere. Hopefully, it is as simple as they are just not patient investors and are off chasing something more I'm hanging on.....but it does make me worry that we are overlooking something they are seeing.
Disclosure: I'm an underwater holder of these shares as well.
My key rationale for investing has been the transition to services. (I owned ACS pre merger as well). At a cursory level of review, services is now over half the revenue but I think it is 80% of the profits. A few thoughts:
- As an alternative valuation approach. Have you ever done an analysis of just the services business as it exists now? That would not be a zero growth assumption. Once you have a target price for that portion of the business you can add/subtract some amount for the old tech business. I wonder what target number that might yield.
- Is one of the concerns on the services business that too much revenue might come from government. I seem to recall that ACS had a large govt book of business. I'm not sure what the percentage of govt business might be today? Also, while govt spending is decreasing, it would seem govt might have to consider using these type of outsourcing service to be a little more efficient.
Hence I'm not sure if this trend is a tailwind or headwind.
- While XRX mgmt talks up this transition to services, I don't think the analyst /investor community seems to be buying it. At some point I think they will. When they do this stock should pop. The obvious analogy is when investors realized IBM was services/software not hardware, but recent example include ebay is now more valued on paypal, and visa as a transaction processor. Of course, I've been waiting for this transition for awhile and wrong for awhile. Maybe there does need to be an activist investor or management change to bring this to light.
I'm still holding for now, but not feeling good.
I hope/think you are right, and Google is trying to get Android to be predominate platform so they can hopefully then exploit it beyond mobile ads. For example "what if" searches on the Android technology became faster, better, cheaper than searches in iOS, "what if" video display and search from utube on Android became better, faster, cheaper than video using ios, what if documents/books were displayed better on Android than ios, what if maps were better faster, cheaper using Google maps......oh wait Apple already seems to be worried about that and is going its own direction,...etc, etc,etc..
Owning the stack of technology allows the possibility of that to happen. Hence Google's desire to get Android everywhere.
Using the combined power of all Apple's competitors (and the telecom providers) to accelerate this process may be messy but it seems like one logical way to accelerate adoptions and play catch up. Something required by Apple's current lead in the market place. That makes Apple fight a multi front war.
These is in essence how Microsoft beat Apple in the PC market.
The Mac was an innovative product, but it did not end up the dominate platform. Msft got Windows everywhere (even using monopolistic tactics as proven in courts) and then sold everything on top of it. That is why Apple is trying to put up a lot more legal barriers to Android products than they did in the pc market.
Anyway, I think Google does have a longer term view of the market, and it will reward investors...but it might take awhile.
sreeram6 - I agree
The August premium is higher because of the risk associated with the earnings release, and should be factored into selecting a strike price.
If you want to sell puts on Cisco, I'd think about selling the July strike now - hope to collect most/all of that premium. If that works and you still feel Cisco is a good candidate for a put sale at that time you can consider rolling that into the September puts near July expiration. The Sept strike should still be priced fairly attractively in a few weeks because the earnings risk still exists and it will not have had too much time decay yet. Most importantly and if the stock does tank after earnings this might time to unwind the trade to minimize the damage. I see this combination as less risk, more/similar reward.
The bucket theory makes a lot of conceptual sense to me....but
my only "issue" is when I add the buckets together I usually come back to a somewhat "normal" asset allocation model.
Hence I'm not sure that "buckets" add too much value related to investing for retirement, but it may make be a good mental aide to help people manage their assets/budgets/expecta...
Related to the point raised by a few people that stocks with high dollar value make trading options more challenging:
I believe I read/heard somewhere that there was a plan to have "mini-options" that represent 10 shares of the underlying vs. the conventional 100 shares of the underlying. Not sure if that is fact or just an internet rumor.
However, that could be helpful when trying to establish options on a small lot of stocks with high dollar values. Of course, I also suspect it is also intended to generate more commissions/fees/profits for the industry.
re - thanks for the comment.
FYI, your statement of "lower before headed higher" is a great example of the tug of war that is the cornerstone of my thesis for FB going sideways awhile. If that is true, the best strategy is playing a trading range via selling option premium.
Your suggestion of selling longer term OTM puts or calls seems like another good trade if you believe the thesis.
To me the big risk in classic diversification theory is that at some point the underlying assumptions which the theory is based on may change.
For example, choosing something like a 60/30/10 portfolio of stocks, bonds, commodities seems like a good diversification strategy based on history. However this strategy is based on a number of assumptions made years ago such as: stocks return follow a standard deviation with an 8% average return and a SD of 15%, stocks and bonds are highly negatively correlated, countries are fairly decoupled, currencies are pegged to gold not total political fiat, investors act totally unemotionally/rationally, etc, etc, etc.
To me the big risk is that it seems like none of these assumptions have held for the past decade. Perhaps things will revert to the mean and these assumptions will hold or.... perhaps we are in a new normal and these assumptions are not as valid as they once were (with apologies to PIMCO for the use of their term).
I think Markowitz would be the first to say if the underlying assumptions change the theory should change. I think it was Keynes who said .."when the facts change I change my mind...what do you do?" The financial services industry continues to push these theories developed in the 1950s about diversified investing to the public because they are "safe" for them to stand behind, not because they are state of the art. Meanwhile, the big/smart asset managers have changed their way of thinking and now often have 20-30% of their asset allocation in hedge funds. Largely, these hedge funds try to make their money by not following the normal assumptions
So I don't think the concept of diversification itself is overrated. However, I think most investors are putting all their eggs in one "basket". Let's call it the "60/30/10 asset allocation basket". It is far from certain that this type of basket will provide sufficient, stable, real returns to grow portfolios at a decent rate. I think "Steady Options" might be saying that perhaps an investor should diversify beyond 60/30/10, and their portfolio might be better served by containing large percentages of more market neutral strategies (options, hedges, etc). I agree with that wholeheartedly!
I hope you are right and that this stock can get a market multiple.
But..... they have lots of issues in core business. For example, I think I heard Whitman say on CNBC today that services will be shrinking for several years, and consumer pcs/ printers face a technological innovation shift with lots of tough competitors. Having said that, I do think Lane and Whitman are providing some adult leadership and doing the right things, Also, current valuations are certainly attractive.
Low $20s might be a good long-term buy, but in the mid and short term, I still see the best opportunity in this stock as the high option implied volatility that make any option strategy that is short premium a decent trade. For example, covered calls while you wait for the turnaround.
Wow...way to go out on a limb...$680 in two years..Really.
You do realize that according to option pricing there is over a 40% chance it will be that high by the end of the year just based on "random walk" noise in the market.
If you want to buy Google with a two year time frame, it seems you have to believe in their longer term vision to be the integrated solution to a wide number of areas beyond search such as mobile, social, video etc as discussed in my article Seems to me the are the best candidate to integrate all those disparate things. If they do that (a big if) this stock will be way past $680.
Roger, good post as usual!
Saw that CNBC segment and it aggravated me too. The talking heads want to try to generalize because it is in their interest for everyone to think it is too hard to "do it yourself".
You are spot on when you say "know thyself" .
Investing is half analytical and half emotional (Fear/greed). You need to understand if you can manage both of those aspects.
If you find you can't mange those things - buying a few index funds and take the lowest-cost market based returns can be the right approach. If you need a professional to hold you hand to stick to an allocation and even re-balance when things get rough, it is probably even worth paying someone for that emotional help.
If you find you can manage the emotion - making stock and etf selections can beat the market. IMO their are two main reason broad based funds don't beat the market. 1). they stick very close to the benchmark because it is too personally risky to the managers to deviate by too much from the benchmark. 2) they get inflows/outflows at the wrong time from their investors. I suspect 80% of the fund managers in the world were thinking it was a great time to buy in 2009, but their investor base was taking money out of funds and that forced them to be sellers of stocks at a time when they knew they should not me selling. Their client base is kind of forcing them into buy high, sell low.
Somehow these factors get turned into a overly simplistic catch phrase of ...."you can't time the market". If you are invested in broad based funds you are almost letting every other investor time the market for you, and that is what has been shown not to work.
Two European thoughts I'd appreciate your thoughts about
- Switzerland (EWL) - I realize it is not in the Eurozone. Also that Nestle is 20% of the fund (I happen to like Nestle as good, blue chip consumer staple). My basic, very general premise is it seems to me Switzerland has been a safe haven for the upper classes of Europe over the past decades. Also I suspect the Swiss Govt and Swiss banks are less at odds than in the US or other Eurozone countries. Seems like those type of macro trends might be a good foundation for some good stock market gains. What am I missing?
- Shorting Europe - it seems like something like long Asia/short Europe might be an interesting pair trade. What do you think might be a good vehicle to short Europe?