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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Options Strategies: What Worked for Me 4 comments
    Aug 15, 2009 3:50 PM

    It is often difficult to determine whether a given options strategy generates better returns than simply buying or selling the shares involved. Long term studies on systematic applications of the covered call strategy have been interesting, suggesting that there may be a slight advantage over buy and hold. For an individual investor, trading a small volume based on judgment rather than applying some system, determining whether options strategies have improved portfolio performance is necessarily subjective. Nevertheless, I recently made a review of my trading since 1/1/2007 and thought I would share the results, not so much as a matter of research findings but more as a way of talking shop.

    Methodology – the first step was to develop a data base starting with my open positions at cost as of 12/31/06, then adding all transactions through 5/31/2009, with the ending open positions valued at market. I use TradeLog, a capable piece of software that is designed to handle options and wash sales for tax purposes. The program downloads transactions from my brokerage accounts and assigns a self-consistent naming convention to the options, which starts with the stock symbol. Loading the data into a spreadsheet, and assigning each transaction a strategy and a sector, I can sort, subtotal, and analyze the rate of return. Commissions are included in the computations.

    Assigning the strategies, I used what I started with when I opened the position, except when I had made a definite change of strategy, or closed the position and resumed it later with a different strategy. For example, I lumped everything I did with homebuilders under the covered combination strategy, because during the time in question I consistently planned to sell both puts and calls when premiums were attractive, although at times I had no open options and simply traded the shares. I did not open any positions specifically to do covered calls, so there are no results for the strategy, although I sold calls against my shares from time to time.

    Bad decisions – a few of the trades were really bad decisions – I left them in. I played with analyzing things on the basis of “if you don't count that one bad case, the strategy worked well,” but in the final analysis options can magnify your errors and that fact has got to be accounted for.

    Results by Strategy – here is a table showing the strategies I assigned, the rate of return, and the percentage of my portfolio.



    Annualized Rate of Return (1/1/07-5/31/09)

    % of Portfolio

    Long shares



    Short shares



    Covered Combinations



    Long in the money Calls



    Long Diagonal Call Spreads



    Long Vertical Call Spreads



    Portfolio hedging by Index Puts



    Long out of the money Calls



    Selling Naked Puts



    Reverse collar or fence, I have heard it called a bullish reversal



    Total Portfolio



    S&P 500 from 12/31/06 to 6/2/09




    • covered combinations (long shares, short straddles or strangles) outperformed, somewhat surprising in my case because it included a lot of homebuilders, not a class that did well during the period. Logically, the strategy is attractive, under the theory that a stock can't go both directions at once and you are being paid to buy low and sell high, which is exactly what you want to do anyway. Volatility was elevated during much a the time, making the premiums attractive. I would guess that anyone who used this strategy and avoided the most troublesome sectors did well. Paul Price here on Seeking Alpha has recommended a great many of these positions.

    • Long in the money calls did well, surprising because the leverage involved should make it under-perform in a down market. I used mostly LEAPs, so the time to expiration and increase in premium due to volatility helped me exit bad positions with some salvage. The better positions I rolled down, selling time premium when volatility was high and lowering my break-even. This strategy did very well from 2004-2006 and stood up better than I would have thought during the meltdown.

    • Hedging with puts helped me a lot. I accumulated distant expiration S&P 100 (OEX) puts, out of the money, while the market was high and volatility was low. The intention was to protect the long in the money calls, which I expected to under-perform in a down market. I sold the puts way early, January 08: so sad, otherwise I would have escaped the collapse in pretty good condition.

    • Long vertical call spreads and diagonal call spreads should probably be lumped with the long in the money calls: they all rely on using calls as a substitute for owning the shares. Considering the group of them together with the OEX puts used to hedge them, they out-performed the market.

    • Selling naked puts – I don't want to talk about it...this is something I did with impunity during times of turmoil from 2004-2006, but which wreaked havoc during the big meltdown. Curiously, selling puts as part of the covered combo or reverse collar did me no lasting harm.

    • Long out of the money calls is not something I do much. It's like buying lottery tickets, so I try to restrict it to situations where I think I know the winning number.

    • Reverse collar or fence – buying out of the money calls and funding it by selling out of the money puts. This worked well the few times I used it. Probably it should be grouped with out of the money calls: they both rely on the idea that options premiums don't properly reflect the upside on beaten down or volatile stocks.

    • Long shares, at a little less than half of the portfolio, underperformed the portfolio as a whole, suggesting that options helped performance.

    Conclusions – options are fascinating and offer the attraction of leverage and the potential to change the risk/reward profile of a situation. Frequent trading exposes the investor/speculator to high commissions and slippage on the bid/ask spread. Enjoying options as much as I do, I have often wondered if overall they did me any good, or if I was enriching my broker at my own expense.

    Not specifically analyzed but looking at it this was a period of time where risking a lot to gain a little was punished: similarly, risking a little to gain a lot was often rewarded.

    To answer my own question, options increased my profits when I had an accurate understanding of the underlying stock in the context of existing market conditions. Where a conscious effort was made to use options to reduce or manage risk, benefits followed. There were cases where the stock made a round trip, or worse, but I made a profit. At times large returns were extracted from low risk propositions. The benefits outweighed the costs.

    Where I didn't understand the stock, or neglected risk management, options amplified the results of mistakes, with painful consequences. So options are good tools, effective, but need to be used carefully, with strategies that are appropriate to the underlying situation.

    Disclosure – I own and use the software mentioned, and have no other relationship with the vendor.














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Comments (4)
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  • Ricard
    , contributor
    Comments (3814) | Send Message
    Nice analysis. I've also been wondering the same for my own portfolio.


    I'm surprised your losses on naked puts was less than 100%...I'm scared sh*tless to use any strategy that involves margin.


    For me, surprisingly the most successful strategy has been cash secured puts. I think this is because of my initial attempts at long out of money calls being outlandishly optimistic, and they were unfortunately the bulk of my orders the past several years. I've since learned, and while I've only been writing options for less than two years, I've found the added flexibility it gives my portfolio to be a huge advantage.
    15 Aug 2009, 04:48 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6209) | Send Message
    Author’s reply » Ricard, good point on the puts. I don't normally use margin in the sense that I do not invest with borrowed money. The puts if they need to be backed up I have marginable securities in the account sufficient to cover them. But what I found was that if it gets bad enough they will produce margin calls, not fun. So cash secured has an advantage that you avoid being pressured at market bottoms, also it may be more realitic to compute your return on the total amount of risk assumed.


    Figuring the rate of return (or loss, in this case) was subjective, I finally ran my spreadsheet backward to figure how much money I would have needed to back up the puts with 30% cash and computed the return (loss) on that.
    15 Aug 2009, 05:43 PM Reply Like
  • Alok Swain
    , contributor
    Comments (40) | Send Message
    Hi Tom,


    Great Article.


    Tom, I also started doing options trading nearly the same time period. Started on Nov 2007 to till date. Would like to review my performance maybe this year end. I was about -2% last year (Jan-Dec 2008, M2M), considerably up this year.


    I do options trading (as well as stock trading) in both my Margin (ordinary trading account) and IRA (non-margin account).


    One thing I am still unable to quite properly grasp (or have a good handle on) is how to calculate the returns, from an accounting point of view.


    Let me elaborate with a simple example.


    Say I sell a PUT (Cash Secured Equity Put) in my IRA (non-margined) on C (current price $4.77) (at strike of $5.00) and collect a premium of $0.415.


    So my return should be calculated on $4.585 (Strike Price - Premium) as thats what I posted in my a/c.


    If it expired worthless, then my returns would be computed as $0.415 / $4.585 (which is monthly that needs to be extended annually based on some proper discounting mechanism.) Fair enough.


    But in my trading account which is margined I only post $1.369 per share.


    In this case if it expires worthless whats my return and how do I calculate it properly. Should it be same as above or $0.415 / $1.369 (Premium /Margin Posted).


    If instead of expiring worthless lets assume that C closed at $4.99.


    What would be the returns in that case.


    For non-margin accounts (($0.415 - $0.01) / $4.585)
    For margin accounts (($0.415 - $0.01) / $1.369) if I decide to buy back the puts on the last trading day.
    But if I am assigned then its going to be different as now it becomes a stock and the margin changes to $2.5 .
    So the proper calculation would be (($0.415 - $0.01) / $2.5) perhaps.


    So the proper accounting of option trading profits is very difficult based on various factors, margined account or non-margined, expired worthless or assigned, bought back or assigned, share price of the stock (as the margin changes on the share price etc).


    You have not said how you computed it, whether on a margin account or non-margin account etc.


    And the things get really complicated when a trade has multiple legs and you re-adjust the trade midway, then the margin and risk changes and how do you calculate the returns in that case. As the money at risk is different in those cases. Hence the returns would be different. Or you try to take a position in the stocks as a hedge, the returns would change too, and so would the strategy.


    So the accounting of profits and losses is very complicated from what I have found, and I dont have a good framework on how to deal with it. Its not as cut and dry as one may think.


    Thanks for your article and insight. But I feel the returns that you attribute to each strategy maynot quite reflect these considerations.




    Alok Swain
    3 Sep 2009, 04:58 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6209) | Send Message
    Author’s reply » Alok, I computed the returns shown by using the XIRR function in my spreadsheet software. After importing the transactions from my brokerage account, I select the transactions I want the return on and use the spreadsheet function. For some cases it is necessary to use XNPV and goal seek in order to develop the rate of return. This procedure allows computations on large groups of transactions with very little effort and also takes care of the discounting to develop annualized rates of return.


    You are correct that this type of computation does not reflect margin requirements. To do so it would be necessary to introduce two dummy transactions, one when the put is sold and another reversing it when the put expires or you are assigned on it.


    When evaluating risk and return on individual transactions, in order to be realistic, it is necessary to consider the sum of money at risk when computing the rate of return. For that purpose I would advocate computing the return as you discuss for your non-margin account when selling puts,


    Leaving out the margin requirements when computing returns makes both gains and losses appear bigger in percentage terms. From the standpoint of computing returns on a portfolio, the normal way to compute that would be by comparing the beginning balance to the ending balance, which leaves out margin requirements. Becasue selling puts in a margin account can lead to borrowing money, it is a leveraged strategy and returns need to be higher to compensate for the risk.


    The question of computing returns on options strategies is difficult. At one point I had software that did that for me, and it gave me alternative returns, I could choose how much I wanted to use to compute my rate of return. Anyway, here is what I think is the best way to present it.


    07/01/09 STO 1 XYZ Sep09 20 put 2
    07/01/09 Cash Secure XYZ put -20
    09/19/09 Put expires worthless 0
    09/19/09 Release cash security 20
    XIRR 61.7%




    3 Sep 2009, 09:28 PM Reply Like
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