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Tom Armistead
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I'm a well-informed retail investor and formerly posted on SA in order to expose my thought process to critical examination and comment from readers. It made me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that... More
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  • Taking A Postion In Louisiana Pacific

    Louisiana-Pacific (LPX) makes OSB and other materials used in construction. At a price just above $18 it has a PE of 10.8, with the hope that springs eternal, that housing will continue its recovery.

    The stock has a definite seasonality to it, it goes up about 10% from January to early May, then starts to give back.

    With shares at $18.31, I was able to buy the May 2014 15/18 vertical call spread for 2.08. The thinking was, with 10% seasonality, the odds are good that LPX won't be below $18 at expiration. If it is, the PE at that point suggests that owning the shares won't do any lasting harm. I could sell another set of calls at the 18 strike and continue that way if I wind up owning the shares.

    It returns 132% annualized if shares are above $18 at the May expiration, which I think is the most likely outcome.

    Disclosure: I am long LPX.

    Tags: LPX
    Jan 14 4:00 PM | Link | 11 Comments
  • Selling Puts As A Substitute For Fixed Income

    Recently I looked at the U.S. High Volatility Put Write (HVPW) ETF, attracted by an article that touted it as an investment for "prudent income investors." The prospectus is somewhat less inviting, describing it as a "speculative trading instrument." But it still raises the question, can selling cash-secured puts substitute for fixed income?

    HVPW writes puts on the twenty large cap names with the highest volatility, 15% out of the money, with a two month duration. The puts are secured with treasury notes. The distribution rate is aspirational, at 9%. No estimate of maximum losses is provided, although the prospectus warns about possible complete loss of investment capital.

    I looked at this idea several years ago from the point of view of a dividend-oriented investor, and studied the likely outcome of a portfolio that sold puts on dividend stalwarts 10% out of the money, with a three to six month duration. I estimated that such a portfolio would produce 4.5% annually, with very infrequent drawdowns maxing out around 18%. Of course a dividend-oriented investor would not be too upset, being forced to buy at a market bottom.

    I also simulated the use of less than full cash security, resulting in proportionately higher returns and drawdowns.

    Implications for Synthetic Dividend Growth Portfolio

    The Synthetic DGI Portfolio has been working as expected, with one exception: the calls sold gave away the upside on a larger number of positions than I was looking for. Briefly, the results of the twenty names selected were more dispersed than I thought they would be.

    Another issue, what to do with the cash reserve, was resolved by buying vertical calls spreads, both legs in the money, on stocks that were selected for a combination of volatility and margin of security. That's been working well, returning 12.8% while maintaining cash sufficient to support the exercise of all long calls. This is a cowardly way of selling puts, in that such positions are easier to deal with in declining markets.

    Since the LEAPS which are the starting point for the Synthetic DGI Portfolio are at strikes averaging 80% of the share price, leverage starts at 5:1. Selling covered calls at strikes and expirations that provide income equal to the dividends, effective leverage to the upside is reduced because of the upside that is not realized.

    After reviewing this, I plan to greatly reduce the sale of covered calls, and replace the income by either the sale of cash-secured puts or the vertical call spread strategy described above. Theoretically, the 5:1 leverage will replicate capital gains and losses on the underlying. Meanwhile, using a portion of the 80% remaining cash to secure the sale of out of the money puts (or the equivalent), the income received will replace the dividends forgone by using the LEAPS as substitutes for share ownership.

    Incidentally, the 12.8% on the vertical call spread strategy includes stepping in the way of a sharp sell-off in Cisco (CSCO), precipitated by horrendous guidance for the current quarter.

    Under normal market conditions, this portfolio would replicate the results of owning the shares, other than the taxable nature of the income received. There are defensive advantages in a declining market, in that the LEAPS can be rolled down for less than the difference between the two strikes, resulting in a profit on the roll, or a reduced loss when compared to owning the shares.

    The difference lies in the returns to be received from the cash held aside. In more normal markets the money could be placed in Treasuries or corporates at some reasonable rate of return. With rates where they are, using the money to support the sale of puts seems like a viable alternative.

    Substituting Vertical Calls Spreads for the Sale of Puts

    Please consider the following trade on Corning (GLW).

    (click to enlarge)

    This is effectively the sale of a put, in that I bear the risk that the stock will be below $17 at expiration. GLW has a very strong balance sheet and a history of increasing the dividend. I would most likely exercise the $13 call at expiration, for a net cost of $15.67 per share.

    In the event something funky happens, if GLW gets down to the $13 area before expiration, time value will increase and cushion the loss. At that point, the position can be rolled down to pocket the time premium, or closed for proceeds of about 70 cents. Note the $9,100 I had available to exercise the call is intact, plus whatever salvage I get from closing the position. The downside is defined here, unlike with the sale of a put, where it theoretically extends to zero.

    Leverage Rears Its Lovely Head

    Note that the plan here is to have all puts (or equivalents) fully cash secured. The way I operate, it's not unlikely that at some point studied carelessness will result in positions that are less than fully cash secured, in the interest of improving returns.

    I had hoped to make $100,000 behave like $250,000. As a practical matter, the way I'm doing it I need to use about $160,000.

    What About All Those Covered Calls?

    After concluding that the sale of covered calls hurt my situation last year, I don't intend to buy back those I have already sold that expire this year. The thinking is, now would not be a good time to correct the situation. First one thing works, then another.

    As the situation stands, I'm controlling $270,000 worth of dividend paying shares, well-known names. Total account value is about $175,000, with $110,000 in cash. I expect to earn 9% on the cash, which is 3.9% of the value of shares controlled and exceeds the dividend income that the shares would generate if I owned them.

    As such, the covered calls aren't necessary to achieving the income objective, and are interfering with the capital appreciation objective. With the market near record highs, and shuffling back and forth nervously so far in January, I plan to leave the calls out there, but will discontinue rolling them. In the even of a market sell-off, they can be bought back at a profit.

    Disclosure: I am long GLW, CSCO, .

    Additional disclosure: I'm a retail investor, and blog in order to expose my thinking to critical examination and comment from readers, and as a way of talking shop. I'm writing about what I do with my discretionary investments, and not giving advice of any kind.

    Jan 09 9:13 AM | Link | 15 Comments
  • Opening A Speculative Account

    Please don't stone me for mentioning Jim Cramer. I don't watch him on TV (anymore): but I did read his book when I started investing, and I like his advice about speculation. The point is, it's a natural human activity, you're going to do it anyway, so just limit it to a certain size (20% per Jim) and then go out and have your fun.

    After returning from my hiking sabbatical and reopening my discretionary account, I re-entered the market cautiously and restricted myself to dividend growth stocks, somewhat overvalued, but unlikely to do lasting harm. Long term they'll do fine. The problem is, it's like watching paint dry: investment's too slow.

    Of course funds invested in the Vanguard S&P 500 Index performed wondrously, up 30%, who's counting? That's embarrassing, why not just leave your money with Bogle's boys and go fishing (or hiking)? permanently.

    Recently I set up a Chinese firewall and dedicated somewhat less than 10% of my investable assets to a speculative account. If the money was left in the bank, the rates on CD's are insulting. If you buy treasuries, the return is trivial, and you're bearing interest rate risk. Meanwhile, I can have some fun and make some money. Wall Street is the only casino on earth where you can leave your money on the table for ten years and still have something left.

    After what we went through in 2008 and 2009, it's hard to remember or believe that the stock market has a profound upward bias. The most likely 90 day return, based on history from 1950 to 2010, is 2.43%. Short-sellers and doomsayers will be correct from time to time, and amply rewarded, but the fact remains: the bias is up.

    What I've Done So Far

    Tech companies frequently have strong balance sheets, and many of them trade at conservative valuations. Implied volatility at times is high. There are stocks that have good downside support from excess cash, strong cash flow, etc., but sport low PE multiples and attractive premiums for selling options. I've been doing option trades that bet these situations will not go much lower, and receiving net time premium for doing so.

    Seeking Alpha is not looking for articles on options. With that in mind I plan to do brief write-ups of my trades in my instablog.

    Recent positions include Jabil (JBL), Intel (INTC) and Harmonic (HLIT), written up in the instablog, as well as Vishay (VSH) and Xyratex (XRTX), which popped shortly after I went long.

    The Jabil trade was a catch the falling dagger ploy, by means of a vertical call spread, with both legs in the money. A similar trade was done on Cirrus (CRUS), and noted in a comment to another contributor's article. For Intel, the speculative trade is a bullish reversal, based on the idea that the market doesn't appreciate the upside potential there.

    Portfolio Objective

    The immediate motivation for most of the trades is to sell calls and collect time premium. When a vertical call spread is used in an effort to catch a falling dagger, some of the temporarily high volatility premium can be captured. If the stock then goes up, while volatility goes down, the investor can sit and wait for a fine profit at expiration.

    If the stock continues down, the lower leg can be rolled down, in effect collecting additional time premium. If there is some sort of floor due to excess cash, strong cash flow, etc., from there it's a game of patience, keep betting it goes up and collecting time premium.

    Holding a good amount of cash, I'm prepared to actually buy the stocks involved if they stay down. The vertical call spread is being used similar to selling just out of the money puts, but in a format that I find easier to deal with if the situation develops unfavorably.

    I'm looking to generate about 15% per year by these tactics, more if the market will provide better opportunities. That would mean a nice correction with an increase in overall volatility.

    Disclosure: I am long INTC, JBL, VSH, XRTX, CRUS, HLIT.

    Dec 28 8:26 AM | Link | 3 Comments
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