This week and last, I find myself staring at many shares that are showing paper losses. Paper losses present a quandary for the covered call writer when the available option premiums just aren't enticing enough.
Barely a year ago a young woman, who probably knew nothing about stocks or options, made the same walk that countless college seniors before her had done, as she proudly received her diploma. Like others, she may have been thinking about the uncertain job market that awaited in the real and cruel world, but she had already helped to beat that cruel world.
Like most, she had friends and family in the audience that shared in the glow and probably reminisced all the way back to her birth, her infancy and all the years between those days and this one.
After that day, for all anyone knows, she may have joined other jobless and under-employed graduates around the country and is now occupying something here or there to protest educational debts and perceived societal inequities.
Although lots of people making that walk have their own truly unique stories, this graduate made her news even before her birth and gave rise to an investing strategy for me, years later.
And so it was more than 21 years ago that everyone was debating the very ethics of her actual birth and plans for her life.
No she wasn't going to be sacrificed at some Aztec altar, nor was her death intended as a sign of some covenant. It was also not part of an elaborate plan to pay back some childless drug baron in South America, in order to spare the lives of a village that didn't meet its cocaine harvest quotas. (As an aside, my advice to those farmers? The State Department and I both urge you to diversify.)
Her birth was engineered, following her father's reverse vasectomy procedure, in the hopes that her bone marrow would be a match for a then 16 year old child with a rare form of leukemia. All other hopes had been exhausted and the clock was ticking.
The probabilities were small. Being 40+ year old parent wannabes already puts you at a disadvantage. There's nothing like carefree teenaged sex to ensure a pregnancy. Once you get to 40 and have the stress of desperately wanting to procreate, you're already behind the eight ball.
Sure, most of the time the reverse plumbing procedure works, but add that into the mix along with the fact that you're hoping for a perfect match.
And then there's the march of time, as well. Nine months to create a child, then another year to be medically cleared for being a marrow donor is a long time, especially when cancer is involved.
It was a long shot and raised lots of heated opinions when the story broke before her birth. The story itself, despite all of the controversy, recruited more than 100,000 people to add their names to the bone marrow donor registry. That created lots of liquidity.
Just 10 years earlier, I had been a resident at Boston Children's Hospital, back in the early days of bone marrow transplantation. There was no certainty of a good outcome at that time. In fact, the certainty was in the other direction. On top of the horrific chemotherapy came months of isolation in the "laminar air flow" room, before and after the procedure. Long story short, the match was perfect and the older sister was there to watch her baby sister receive that diploma.
Alright, that's enough of a preamble. What does that have to do with stocks and investing?
There are essentially three outcomes you must be prepared for if you are an inveterate seller of options.
The most pleasing is the continued inflow of option premiums that are paid to you by those seeking to leverage their money and take the risk of losing it all. Bless those people.
The second, which is cited by the naysayers of the strategy is that you don't get to share in the profits beyond the strike price. Clearly, those people insist on participating in only those activities that follow the concept of having your cake and eating it, too. They also are the kind that must consistently ask the question "what have you done for me lately?" as they ignore the past stream of premiums all the times that the option contracts expired.
Finally, there is always the question of what to do if your stock takes a significant price hit, as if that only happens to the sellers of options. But the follow-up to that scenario is the question of how you handle paper losses and the selection of strike prices for upcoming cycles.
A few years ago, when portfolio values were plummeting, I decided to adopt the "Having a Child to Save a Life" investment strategy. Other than David Einhorn and John Paulson, who didn't get vanquished? Back in those days we didn't really talk about the 99% to 1% schism. But on paper, at least, the 1% probably got hit disproportionately, although they still would have stayed in that 1%.
I've used that strategy over and over again on individual stocks, although it certainly would have been easier to have been smart enough not to have bought them in the first place. As opposed to critics, I haven't been blessed with perfect vision and timing.
Face it, your choices are limited when faced with vast declines in your stock prices. It's not like reversing a vasectomy.
You could hope for an incredible climb back; you could dump your losers and try to pick "winners"; you could cash out or, if you have available cash you could add new positions or average down.
With an investing strategy based on collecting options premiums, it's difficult to stomach taking those premiums for strike prices that are well below your cost basis. There's a limit to how many strategic tax losses you really need. Worst of all, you would hate seeing those beaten down shares get exercised at beaten down strikes just as the market seems to be reversing course and heading back upward.
My choice, in general, is to average down, as long as I don't believe that the stock is irreparably broken. When averaging down, it is almost with a bomb shelter mentality of survival, except that no squirrels are skinned in the rebalancing of any portfolios.
Those sister shares, the new ones added to existing positions form the basis for the climb back. I've previously chronicled such climbs back with the shares of Green Mountain Coffee Roasters (GMCR) and Riverbed Technology (RVBD). I've just newly added the activity in GMCR, specifically following its first plummet in November 2011, after disappointing earnings. It took lots of children in that case, but I have a big heart and had dug a big hole.
I still have fond memories of a long ago held stock, LSI Logic (LSI). Just another one of those companies that I owned at one time, yet had no idea of what it is they made or provided.
I initially bought those shares for my kids' account and it became one of the first stocks on which I sold calls. With an initial purchase price of about $10, it just went down from there. I kept buying more shares and selling calls on those new shares. I would then use the premiums to buy even more, but cheaper shares.
Occasionally, in fact, more often than not, the new shares would be lost to assignment, with ensuing capital gains on both the shares and the options premium.
Then it would be time to buy even more shares to replace the ones lost.
Over and over again. And over. Until that day came that premiums offset the loss in shares, and the shares were eventually assigned. In that case, the net result was to break even. At the time, I was pleased to have gotten even that far, particularly since LSI never got anywhere near my original price point.
I never went back to that specific well, but the concept stuck and after a couple of years of dormancy, the time returned for its application, once the post March 2009 climb ran its course.
Instead of considering my lots on the basis of their average share cost, I considered them on the cost per lot. There was the old sickly child and the new healthy one. It was the healthy one that held out promise.
Instead of selling call options on the entire holding, I chose to sell call options, typically for in the money or near the money options on the new shares only. Those premiums were the basis for restoring life to the older shares. By selecting in the money options the prevailing thought is that shares may still decline in value, but by so doing you achieve a greater option premium and perhaps a greater chance of having your new shares assigned.
Of course, while doing that, you can still squeeze out some pennies from the original lot of shares by selling call options that are near their purchase price. If you're really the risk taking kind of investor, you can also try to collect whatever crumbs may be left on the table as the clock is ticking away.
Ultimately, the idea of just breaking even was inadequate. Now, although sometimes irrational, even after a large price drop, my anticipation is that through having lots of children I'll be able to return to a positive ROI on the original shares.
Where I differed from the parents from that ground breaking story 21 years ago is that I don't really care about the well being of my baby shares. They're around for that single purpose of contributing to the effort of reducing the paper loss of the older shares and restoring them to healthy profits.
When you do so, you have the advantage of knowing that your old and new shares are a perfect match. One share of Riverbed Technology is precisely the same as the next share.
I have no doubt that if that baby born 21 years ago had not been a perfect match, or if the bone marrow transplantation had failed, the parents would still have given unconditional love to their newborn child.
I wish I was that kind of person.
For me, it is all about the Aztec sacrifice or paying off the debt borne out of a bad harvest or stock selection.
Unfortunately, this is one of those weeks that I've needed to add lots of new children. I'll have high hopes for all of them, but am consigned to the fact that some of them, will be held hostage by the external factors that rock the markets, making them the investing equivalent of an imperfect match, but only because of timing. Goldman Sachs (GS), Mosaic (MOS), Direxion Bull 3x (FAS) fell into the category and now have siblings, as did MolyCorp (MCP) yesterday.
Instead of giving up on those "losers," there will be plenty of opportunity to dip into the equivalent of a modern medical miracle of bone marrow transplantation. At some point, the timing will be right, as long as patience can replace fear.
Stock options give new life and hope to live yet another day and battle against the dreaded paper loss.
Just as a child is the derivative of a parent and the organs, stem cells and marrow are a derivative of that child, there shouldn't be any qualm, fear or concern about using "instruments" that are so far removed from their origin to help sustain life or financial health.
This article was written by