Geoff Considine

Opportunities in Options Markets, Summer 2009

John:

Thanks for the comments. Obviously one can sell puts vs. selling covered calls--one is just the synthetic of the other. The issue comes down to how confident you are in future volatility--the cost of rolling the strategy forward through time.

I agree that Bodie's strategy is far more conservative than what I am proposing.

I have been focusing on selling long-dated options--like what I use in my examples.

Geoff



On Jul 02 02:46 AM ikkyu wrote:

> Greetings Geoff,
>
> Nice to see the evolution of your thoughts about monte-carlo and
> options pricing. I think this is the most interesting stuff you have
> done to date.
>
> Please let me ask a few questions, if you don't mind.
>
> Not sure why underpriced options would suggest buying calls rather
> than buying puts (or more reasonably straddles) in the short run
> (<3 years). Serial correlation can be positive with a negative price
> trend, can it not?
>
> Also, are you talking about buying OTM calls on EBAY? While stock
> markets tend to go produce positive results over long periods, you
> have to have to inherently predict the magnitude of the move when
> buying options.
>
> Which options are you talking about selling? The long dated LEAPs
> or the front month? You would have interest rate risk on the LEAP,
> far lower gamma initially, and wider bid-ask spreads. I usually divide
> the time value by the number of days till expiry to get a better
> idea of the decay per day.
>
> Also, why sell covered calls at all? Naked puts would be the risk
> equivalent and would simplify things. If you get exercised, you could
> then start selling calls on the underlying.
>
> While i like your plan, it is clearly not an equivalent for Bodie's
> conservative methods. Bodie's plan seems like it would work better
> with a call spreads. It would be like your own index annuity. <br/>
>
> Just some thought. Nice piece of work. Seems like you are definitely
> thinking out of the box.
>
> Cheers from Osaka,
> john
>

Opportunities in Options Markets, Summer 2009

This is just using QPP's projected volatilities for each ticker and the rest of the tabel is other data. Or did I miss your question?


On Jul 02 02:54 PM gasem wrote:

> How do you use QPP to generate the above table?
>
> thanks

Profiting from Risk Aversion

Update:

www.reuters.com/articl...

Profiting from Risk Aversion

AlexR:

Selling options that are not covered is, in general, riskier than selling covered positions. If you keep enough cash handy in your account, you can avoid margin calls as you say, but that has a cost too. Perhaps I misunderstood your point?

Profiting from Risk Aversion

To Greg Harris:

Yes, being net long the call (whether you are long the stock or just the call) allows you to grow when the broader economy makes money. You don't need to believe that there are no trends--i.e. that the market is a pure random walk to make my case here. BUT, when market volatility becomes irrationally high, I will believe that the call value exceeds the true growth potential for certain stocks---THAT is my whole point. This does not detract or even bear on put-call parity. The long-term expected return for the S&P500 is positive over the long-term---but the implied vol is SO high on some stocks that this is priced in.

Profiting from Risk Aversion

To "You're Kidding":

On a number of points, we agree. A long view makes most people better investors. On the other hand, there is considerable evidence that a long view of investing can be enhanced with fundamentals. Investing at low P/E ratios leads to higher long-term returns. Why? Reversion to The Mean (RTM). You sound like you would subscribe to a lot of Bogle's tenets--and RTM is a core theme of his. Selling select covered calls as I discuss in this article is simply another form of RTM--betting that extreme volatility will settle back towards the mean. The math can get a bit esoteric, but thats really all thats going on. Similarly, I wrote for years before 2008 that volatility was likely to revert upwards--again RTM. RTM is one of the most conservative things to bet on in the long-term--whether you are looking at the equity risk premium, P/E ratios, or volatility.

Profiting from Risk Aversion

Augustus:

Your approach to this strategy would be a more aggressive way to play this, but it could certainly work...the challenge is managing your margin. Bigger players can easily do risk netting..and that makes inst. approaches to this much more efficient.

Profiting from Risk Aversion

Glenn:

First off, the implied vol is sort of a beast unto itself--a reference point. QPP and other tools use different models but by any measure, the price of call options on a range of stocks already captures much of the upside potential. If you expect 8% return on a stock like PG and you can "monetize" 12% and still keep another 10% of potential gain, that is pretty amazing when you think about it. You may be right that there is more upside, but my approach is to be like the house and your approach is to be the gambler---I am betting the odds across a bunch of positions. If I can monetize 12% on a stock with an expected return of 85 and lower risk, I am going to do this--it may not be exciting, but it all depends on your risk tolerance. The market is certainly betting on a lot of upside potential--thats why the options are so expensive--and that is why it is a good time to let the market take its bets.

Profiting from Risk Aversion

BTW: I just found a nice follow-up stat that I would have liked to include in this article:

seekingalpha.com/artic...

This post shows volatility over the history of the S&P500 and shows that short-term volatility has never been this high. When things hit extremes like this, it is most often a good time to bet Reversion to th Mean (RTM). My point goes even further. Even if you accept that this level of vol is rational for the S&P500, it still seems too high for some low correlation sectors...

Profiting from Risk Aversion

To "You're Kidding"

Your comments suggest that you have not understood my core premise. I am not one of those people who believes that simply buying stocks and selling covered calls will generate a higher risk adjusted return. To the contrary--in most market conditions, all selling covered calls will acheive is to lower the return of the portfolio, as well as lowering the downside due to premium received. In this market--an extremely risk averse market--it can make sense. Think of it this way. Lets say I ask you to sell me a call option on your holdings. At some price, you would be willing to consider it--not matter how aggressive an investor you are--because I will be offering more than the upside on your stocks is worth. When market volatility is really high and investors become indiscriminately risk averse, they may offer a lot for that upside.

Option valuation can be theretically complex, but it is ultimately just a matter or valuing the probability distribution in returns beyond the strike price. Even with a fat tailed distribution, you can model that upside somehow.

Global Giants and Diversifiers To Supercharge a Portfolio

Note also that the EXPECTED return for this portfolio was higher than the historical trailing return. Reversion to the mean was set to act in favor of this portfolio. This is an attribute that I like in a portfolio and was not true of a number of broad indexes at the time.

Unique Diversification Benefits of Utilities

The Climate Prediction Center (CPC) of NOAA has issues its forecasts for this summer:

www.cpc.ncep.noaa.gov/...

They show generally warmer than normal conditions on both coasts. This will benefit utilities' earnings. I noted that Accuweather's Joe Bastardi has a similar analysis--probably he got a lot of his ideas from the CPC guidance. Even if this does not occur, it is quite possible that the forecasts alone will drive up the near-term prices of the major electrical utilities. This does happen.

Unique Diversification Benefits of Utilities

Nice point--I will consider this for future analysis.

Warren Buffett invests heavily in utilities and insurance--probably at least partly for these reasons. Mr. Buffett tends to speak disparagingly of quantitative measures but his portfolio seems to exploit these effects--se my articles on analyzing BRK's holdings with Monte Carlo, for example.

Portfolio with Substantial Single-Stock Concentration

Yeah, there is something a bit paradoxical in all this. I pick individual stocks that I feel are good firms and that have good portfolio effects (Buffett). What I was trying to say is that you need to commit to one route or the other. If you are going to go with small positions in various firms, you will end up with less than ideal results. If you don't want to analyze stocks, go with asset class allocations (Bogle). If you do analyze stocks, take a smaller number of decisive equity positions (Buffett). If you read my articles you will see that I am a fan of buying individual equities in real concentrations--not trying to replicate an index. If you are nervous enough to go with 1-2% allocations to things, you may as well go with asset class investing. Thats what I was trying to say.

But Cramer? Haven't you seen the analyses showing the performance of what he pitches? He is the antithesis of rational portfolio construction :)

Low-Beta Portfolio Strategies: Devising A Low Risk Game Plan For the Current Market

Here's a great argument for the low Beta / low R^2 portfolio from Ben Bernanke:

biz.yahoo.com/ap/07011...