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Richard Berger
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Mr. Berger is the creator and developer of the YDP screening tool, a chart system and its analysis for screening and monitoring dividend income equity investments. The recipient of Seeking Alpha's Outstanding Performance Award (... More
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Income From Covered Option Writing
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Income From Covered Option Writing
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  • Mr Briggens
    , contributor
    Comments (355) | Send Message
     
    Hi Richard,

     

    I have read the entire series and commend you for putting it out there knowing that people will nit pick on any aspect that is not suitable for their specific situation. I am very pro selling puts and covered calls....in certain situations. As noted, one should not trade any strategy one is not comfortable with.

     

    I do like the fact that you are very explicit about factors which may adversely affect your picks. Big props for that. It's appreciated.

     

    All that said, I have some observations about puts of which I am a big fan of using as an entry strategy.

     

    1. You show an initial $1000 starting to compound at 12% with a $1000 contribution each year. Sure, it's very possible to 12% back on 1k, but not with any certainty unless you have a red hot market like we've had the past few years. We've essentially gone from 1100 to 1850 on the S&P the past 30 months if memory serves me correctly. Those returns only exist because of the 40% drop in 2008 of the S&P. So far this year, the market is essentially flat and we're heading into summer with many investors/pundits expecting a pull back.

     

    In a normal market, there's going to be a mix of up and down years. And with 1k, you have very limited options.

     

    If you want decent dividends, you'll need to go with a dividend ETF or similar product but those charge yearly fees. If you want to establish individual positions and build a diversified portfolio, your options are limited further. Do you want to put all your money into one stock to limit fees or purchase several different stocks over several sectors for some diversity.

     

    Say you choose 4 stocks as your initial investment. My broker charges $9.95 so with 4 stocks that's almost $40 or 4% of your initial investment. If your portfolio yields about 4%, your initial investment will be eaten up in fees. And that's not selling any position.

     

    Personally, I would encourage people to establish individual positions from the beginning while keeping a log book of their rational for purchasing particular stocks. That way they see how their picks behave in different markets. And they make small mistakes involving small amounts.

     

    You get my point. Any actions involving small amounts limits options and mobility and fees will eat up quite a bit of any return. Small amounts paying dividends and enrolled in DRIPs will likely get the average new investor the best returns out of the gate.

     

    That brings me to account size.

     

    2. Even with $100k, if you assume a 4% dividend return as a conservative figure, you will have $4000 in cash at the end of the year, assuming no trades. That's enough for 100 shares of RIG (at this time) or 1 option contract. ATM, the bid on RIG Aug 40 puts is 2.37. With Rig trading at 40.58, that's a 5.66% discount if you get exercised. Not bad especially since 40 has been very firm support and you'd be in at 37.74 after fees. I like that trade because RIG tends to find support in the low 40s and move back up over 50 - 60 regularly on a mid term basis.

     

    But my point is that even with 100k in the account, you can basically sell 1 put for 4 months assuming you don't have a large cash position if the stock sells at 40....again your options are limited.

     

    3. You've stated that recently you've been 70% in cash. If most people had been 70% in cash, they would have missed a majority of the recent bull market, depressing returns unless they did a whole lot trading which tends to depress returns over time unless they are a hell of a day trader or swing trader. Often times, the major move is at the open.

     

    4. Assuming people have somewhere between 0% and 70% cash, there's still the issue of the capital needed to use your strategy. Most of the stocks trade from between 30 and 100 per share. 100 shares or 1 contract requires between 3k and 10k per trade. 1 contract at 50 requires someone with 50k in their account to tie up 10% of their capital in one option.

     

    My account isn't 100k yet (it's getting there), but I will rarely buy 100 shares of any company at one time unless it's trading at 30 or less. If you have 50k in your account, $3000 on a single trade is 6% of your total account. At 80 per share, it's 16% of your capital....a huge risk in my view.

     

    5. If you are trading stocks which trade at less than 30 per share, it's tough as nails to find any options with built in premiums that make them worth the trade after fees. You can certainly make that up by trading more contracts, but then you run into the same problem of risking an imprudent amount in accounts under 100k.

     

    6. You've stated that you often trade 20 contracts. 20 contracts even at 15 strike price as your trade in F is 30k or 30% of a 100k account. That does not make sense. That trade, assuming you get your 1% per month after fees, does make sense in an account with a million. 3% of capital is not a huge risk.

     

    With multiple contracts, say 10, you can always sell 5 calls on your shares to get some income, lock in some profit, and still benefit from the upside. I have not seen your critics point that out. They tend to look it as an either/or situation. The same goes for puts. You can sell a portion of your position if you get exercised and the stock rebounds temporarily. That's great because you free up cash and keep a low basis in the stock.

     

    7. If you do find a great stock with an acceptable put premium and you pull the trigger, there's a fairly good chance that you will be underwater for a time which locks in your capital...and that's assuming the stock rebounds. The reason there's a premium in the stock, it's been going down. If you have several trades go against you initially and you are not willing to wait out the stock, it's easy to dig yourself a double digit hole. Puts take patience.

     

    Personally, I love puts as an entry strategy. I will generally put a fair number of stocks on my watch list across sectors I feel are undervalued and hope they come to me. If I want to own the stock, getting it at a discount is even better in my view and I am willing to wait while collecting dividends. But as a sector investor, just as often I will opt to buy a basket of several stocks in the sector to spread out my risk.

     

    Anyway, my basic point is that your strategy requires a lot of research, patience and, most importantly, a fair amount of capital. I find it almost impossible that anyone could pull off this strategy as a new investor unless they learn the quirks of each stock and the market right off the bat.

     

    I have enjoyed your series and will continue to follow it. I am just pointing out that being well funded greatly increases the chance of success.

     

    Mr. B
    18 Apr 2014, 10:53 PM Reply Like
  • Richard Berger
    , contributor
    Comments (2564) | Send Message
     
    Author’s reply » Thanks for your interest and taking the time to share some well thought out comments.

     

    First, let me say that the 12% is not for good markets only or for bubbles, it is the 100% probability statistical average annual return when you stay broadly invested in the S&P500 over a period of 25 years or more through all markets including bubbles and major crashes (see the 1st table in the opening article of this series at

     

    http://seekingalpha.co...)

     

    You are quite right to point out that transaction costs can severely eat into return performance, especially when beginning with a small nest egg. That is why I suggest using a broad market ETF for long term growth investors just starting out. I didn't explicitly say so, but I am not a fan of dollar cost averaging largely for that reason, it drives up transaction costs, often in excess of any averaging improvements. Even at that, transaction costs may indeed eat as much of 10% out of your available investment funds annually in early years if you start with just $1000/year.

     

    Again, as to options writing, it is of limited value to small investors that do not have significant blocks of 100 share round lots (or cash to cover them) on targeted tickers generally of $15 or above. Again why I suggest letting a simple portfolio of broad market ETFs grow until it is significant before considering boost strategies.

     

    Premiums do not exist because a stock is going down. They exist because there is a time value to money (an imputed interest paid for the tied up covering cash or equity value), a volatilty value (based on the swings in all directions even if they average out flat), and an intrinsic value (for any amount the option is in the money). In fact, the perfect option price can be (and is) calculated using the Black-Scholes equation, which incorporates each of those elements based on strict mathematical stochimetric formulation.

     

    As to my personal portfolio positions, I am not typical. I've been fortunate enough to reach retirement early and have a comfortably large portfolio that enables me to generate income with larger round lots, keeping my transactions costs lower than many others.

     

    I do think overall that you provide some very good cautions in your list of observations. I'm glad you have contributed them. Your concluding statement that being well funded increases chances of success is generally true. You need to be diverse and have the depth to ride out dips. Again, ETFs help the small investors meet both these hurdles while minimizing transaction costs and fees.

     

    In my next few articles I will be discussing another way to use call options on value priced dividend income equities to maximize income. I have not seen this exact strategy ever laid out before and I give it the name "Growth Stripping". Basically, it involves buying dividend shares at market when they are at or below fair value and concurrently selling the covered call at the money expiring several months out. This strips out the future growth potential of the shares and converts it to immediate and locked-in cash. It is a strategy suitable for pure income investors and for those that find "Strip" opportunities with yield rates sufficient to make it preferable to broader market risk.
    Look for my first Growth Strip article here on Seeking Alpha Monday Morning.

     

    I look forward to your further comments as the focus on value dividend equities and covered options continues.

     

    Richard
    18 Apr 2014, 11:26 PM Reply Like
  • Mr Briggens
    , contributor
    Comments (355) | Send Message
     
    Hi Richard,

     

    Thank you for your gracious reply and for taking my comments as intended.

     

    Of course you are correct that the option premium is not due to a stock going down, but a function of time and volatility. I did not express that eloquently.

     

    As for the 12% return over time in a well diversified portfolio, I have not audited the studies in detail but do know that every 25 year period since the 1930s has provided significant returns so we agree on that point. I was pointing out that starting out with a small amount, you can't assume you will get 12% back each year from the get go. Over a time period such as 25 years with a well diversified portfolio, one should do well provided they invest regularly and in a disciplined fashion. Results will vary wildly if someone continually churns a high risk strategy although the brokers will likely be very happy to spend your commissions.

     

    One thing that does intrigue me is the difference in returns on my real account which is somewhat less than $100k and my fantasy account which stands at almost $2M. I am earning double the returns in my large account on a percentage basis even though I am using the exact same methods in both accounts.

     

    It's a hell of a lot easier to take advantage of identified opportunities and spread the risk across several stocks or strategies in the large account. It's primarily allocation choices I face. With the smaller account, it's a continual game of making either/or choices although it's gradually getting better.

     

    I will look forward to your articles as I am continually looking for ideas.

     

    Regards,

     

    Mr. B
    19 Apr 2014, 03:28 AM Reply Like
  • Julp
    , contributor
    Comment (1) | Send Message
     
    Hi Richard,
    First off, thank you for this series. It has been very interesting to follow your thought process.

     

    I do have a question after reading the post on Blackstone. At this point (mid-May) their options contracts don't have as much premium as when you wrote the post a month ago (looking at one month out ATM puts). It seems the implied volatility must have dropped significantly since then. How do you find underlying stocks whose options have an above average implied volatility? Looking that up manually is both time consuming and subjective, as it's hard to find historic data.

     

    Thanks!
    Julian
    10 May 2014, 01:26 PM Reply Like
  • Richard Berger
    , contributor
    Comments (2564) | Send Message
     
    Author’s reply » I'm sorry for the late reply on this. Some how it escaped showing up on my pending comment flags and I therefore just noticed it.

     

    Thanks for reading and bringing up an interesting topic. Implied volatility is a major factor in the yield rate of option premiums. There are many sites that focus on option trading which are searchable based on one form or another of this metric. A Google search for Option trading tools or a variation of that should bring up several potential sources.
    I do not chase premium yield for its own sake however. For income investors, first and primary is to identify equities that you want to own based on their dividend quality and reliability.

     

    Next is to determine a fair value price (I lean strongly towards my YDP charting and analysis for insights to this and couple that with conventional value metrics.

     

    Finally, having identified attractive tickers on these criteria, it is then appropriate to review covered option trading to help establish an entry or exit point so as use the premium to give you a basis price better than the retail market.

     

    For established holdings that you wish to maintain based on the current share price and yield, it becomes a question of finding an attractive option premium yield far enough out of the money to so that it is attractive to sell the shares if that price is reached during the contract period (since the shares would be substantially "over value price" at that Strike). A quick scan of the option chains bid/ask/last trade will then reveal where the "sweet spot" is in premium yields. I personally will sacrifice a bit of yield to lock in a longer duration if the yield is very attractive (over 8% annualized) or take a shorter term if yield is low currently.

     

    For established holdings, virtually any yield that is at a fat premium Strike price over fair value can be acceptable if its "all you can get" since the alternative is to continue holding the shares without any option premium boost at all.

     

    If you are aggressively focused on generating cash income by using At The Money Strikes to convert all the upside capital appreciation into immediate cash income then you again are at "what the current market is offering in the active trade option chains" as opposed to any theoretical volatility figure. If you are looking to maximize cash income ATM on cash covered puts then you may have a broader stable of tickers you consider trading. However, you still need to bear in mind that you very well may (eventually surely will) end up owning the shares and therefore the above dividend income investing criteria still apply.

     

    One source of implied volatility data is

     

    http://bit.ly/13WlgME

     

    That is a paid subscription tool and I have not personally used it nor make any recommendation concerning it one way or the other. As I suggested earlier, Google is your friend.

     

    Richard
    6 Jan 2015, 09:42 AM Reply Like
  • curtisnh
    , contributor
    Comments (2) | Send Message
     
    Hi Richard: This is a great series of articles. I'm new to investing and very interested in using selling covered calls as a way to boost my returns as you've laid out. Is there a article series or guide that you would recommend for newbies? An options 101 course/guide type of the thing. Many thanks for your thoughts/recommendations
    4 Jan 2015, 12:44 AM Reply Like
  • Richard Berger
    , contributor
    Comments (2564) | Send Message
     
    Author’s reply » Thanks for reading and taking the time to write, the positive feedback is much appreciated.

     

    There are so many sources for exploring the basics of option trading that it is difficult to pick one. The CBOE is the primary platform for US based options and has a collection of materials describing all aspects of options and trading them.

     

    http://tinyurl.com/qck...

     

    Investopedia.com is a good source of investing tutorials and has a good selection of option material also.

     

    http://bit.ly/qvi7VO

     

    Many more sites also offer basic to highly advanced tutorials and advice on various option trading techniques. Google "option trading tutorial" or "covered option writing" for more references.

     

    Keep in mind that there are 3 principle uses for options and they differ greatly in their risk.

     

    1. Leveraged speculation: This is where you trade options simply to control 100 share/contract blocks at initially just the cost of the option premium. This provides extreme leverage for your money and the extreme risk that goes along with it as every move is magnified by that leverage. It is gambling at its most extreme and I prefer 23 red on the roulette wheel where the leverage is 36:1 balanced by the 37:1 odds against, a very small edge to the house for reasonably high leverage gambling. This is far more conservative than speculative option trading in my opinion.

     

    2. Options to hedge risk: Buying protective puts on holdings you have a significant gain in or for other reasons want to protect from a downside move while at the same time remaining invested is a way to buy insurance on your position. In this strategy, the option premium can be thought of just like your fire insurance premium, something you pay periodically and hope you never have to use but it does protect you and provides peace of mind.

     

    3. Options to lock in prices linked to commodity exposure. In this strategy, options are used to protect yourself from future price moves of a commodity. For example, say you manufacture aircraft parts and are about to sign a contract to supply $1 million in aluminum widgets over the next year. You have priced you bid based on certain assumptions of the cost of aluminum over the next year and you can buy options to protect yourself from significant moves above those prices. Again it is somewhat like insurance and it removes the risk from your bid price.

     

    4. Covered options to boost income and reduce market risk. This is the only use of options allowed within tax preference retirement accounts. You trade away some or all of the upside capital appreciation potential over the term of the contract in exchange for immediate cash income. So long as you pick Strike prices above your effective cost basis, you can not lose, you can only miss out on future additional gains. Because the premium income effectively lowers your effective cost basis on your shares, it also is lowering market risk. Similarly, cash covered put writing allows you to generate cash income on shares you do not own because you believe they are currently overpriced. Instead of just waiting on the sidelines, you earn income while waiting. You pick a Strike price that IS at or below what you consider fair value so that if/when the shares do pull back and you end up owning them, it is at the price you feel is reasonable to pay for them. Once again, you lower market risk by avoiding the "overprice". You do not eliminate all risk since you do not participate in any gain if the shares continue to rise in value and move out of the money away from your Strike price and you do continue to have the downside market risk if prices fall below your Strike (but this is lower than the market risk of owning the shares at the current retail price and also mitigated by the option premium cash you receive which lowers your cost basis below your strike price (fair value).

     

    As your continue to read through my articles on income equities and covered options, you should also start to develop a feeling for the dynamics of putting all of it together, from determining a "fair value", identifying quality reliable dividends, technical trends of where prices are likely to move during the option contract periods, and calculating annualized yields of premiums.

     

    I think you will find my recent Dividend Zombie series useful both for investment analysis and as further tutorial in using covered option writing. Most of my on-going writing will continue to focus on these themes.

     

    Richard
    6 Jan 2015, 10:16 AM Reply Like
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