Thursday last week, early in the trading day, I did a series of adjustments to the Synthetic Dividend Growth Portfolio. It was busy work, rolling various LEAPS up where the stocks had made large upward moves, and reselling calls where I had bought them back on dips, in cases where the stock had since recovered.
Then Friday I became concerned that I wasn't keeping my spreadsheets on the trades up to date. In point of fact, I hadn't made any. Back in June when I created the portfolio, that wasn't a problem. But after five months of trading and adjusting, it's difficult to track results and plan the next trade without having the history and the position where they can be worked on.
Using InterActive Brokers, the commissions are very low. However, the mechanics of exporting trades into a spreadsheet aren't as good as Ameritrade or Schwab. I finally took the time to understand what InterActive was offering, it's the same interface you get with a database program, so you can develop queries on trades or positions and pick the fields that will be returned. I was able to replicate what I had been getting from the more expensive brokers.
So I created the spreadsheets, for example, Exxon Mobil trades would be called XOM TRX. From there, I started analyzing the trades, to see if they were developing according to expectations.
Managing Diagonal Spreads
Of course the usual problems were apparent. Briefly, the covered call that has been sold against the LEAPS position can go into the money by quite a bit if the stock makes a large upward move. At that point, seller's remorse sets in, since the buyer of the call has now grabbed a large part of my profits. Also, if the stock continues upward, I have very little exposure to the move.
First, I roll the underlying LEAPS call up. Often this can be done for something like $4.50 for a $5.00 increase in strike. While this reduces the expected return in dollars if the share prices remain the same, it frees up cash and increases the IRR, all else equal. Plus, if the shares return to the starting point, it can be rolled back down, perhaps for something like $3.50.
Second, I add a position in another stock that appears either undervalued or fairly valued. During the past week, that was WalMart (NYSE:WMT). Since the likes of Raytheon (NYSE:RTN) and Bristol Meyers (NYSE:BMY) have made large moves, I have very little exposure to price moves, based on low Delta for the positions. I've been going slow on adding positions, since I anticipate a correction.
Third, I buy back calls when the stock dips enough to make the price attractive. I don't sell calls that are too far out of the money, so why should I leave them out there when I've already earned most of the premium?
As mentioned earlier, I sold calls where I could do so on terms that made sense to me. Again, I don't think the market can go up indefinitely and would like to be earning premium if it starts to decline.
To illustrate the process, here's my file on Darden (NYSE:DRI) trades:
The position was opened on 7/12. The DUMMY entry is made in order to make the spreadsheet calculate the return on the options position plus the additional funds that would have been required to do a covered call over the actual stock.
By 9/3 the stock was down enough that I rolled the 40 LEAPS down to 35, and bought back the 55 calls. By 10/14 I was able to resell the calls for a profit. Then on 11/7 I rolled the 35 strike back up to 40, again for a profit. The average cost to roll down was $3.915, the average credit rolling back up was $4.65. The profit was $147, I could take my wife out for dinner at a restaurant, maybe some sea food would be good.
As the situation has developed, annualized returns are 15.9%. Meanwhile, just buy and hold on the stock itself would be 11.9% annualized.
Macro Call Not So Good
When I undertook the LEAPS covered call or diagonal spread strategy for the portfolio, I expected the market to work its way higher, for the usual reasons. I didn't anticipate the power of the move, and the strategy will underperform a strong market.
On the other hand, if the market should tank, for whatever reason, the options positions are an advantage over owning the stock, and the funds that were not deployed can be used as dry powder.
What to Do with the Cash
The strategy as implemented leaves me holding a lot of cash. In the interest of getting a return similar to short-term bonds, I did one options trade, long an in-the-money vertical call spread on Kulicke & Soffa (NASDAQ:KLIC).
Projecting that shares will be above $11 at expiration, the returns are shown in the second set of trades, with the hypothetical future in gray. As before, a dummy amount has been inserted to reflect my plan to by the shares if the stock is below $11 at expiration. If that occurs, I would plan to sell more covered calls at the 11 strike.
As explained in my instablog post on the KLIC trade, this company has a lot of extra cash and trades at low multiples. I really don't think if will go below $11 and stay there indefinitely. The implied volatility is high enough to make the premiums for selling calls attractive. The downside risk is greatly reduced by the excess cash.
So, thinking of the $990.15 expected profit, if that's the return on the $200,000 of cash I've held out of the market by using options instead of buying the shares, it's 1.13% annualized. If I come across some similar ideas, I may do a few more trades of this type.
A Walk Down Memory Lane
Speaking of sticking to your knitting, I once worked for an outfit that was run by some foreigners who were characterized by a remarkable insensitivity to political correctness. My bosses boss, on being introduced, remarked that I had the look of a man whose future is behind him. Some of us thought the remark reflected age bias...
Now my boss had this vision, that if he relocated the business to the right location, and received sufficient inducements from the local authorities, he would make more money. Our location had one big drawback, you couldn't get US citizens to do the work for minimum wage, so you had to resort to illegal immigrants.
Anyway, he and his colleagues in upper management jetted here and there, playing one state against the other, and paying no attention to the business. I submitted regular monthly reports, detailing rapidly escalating labor costs per unit of production. The reports were ignored.
Of course it ended badly, in a product recall and severe cash crunch. I had the pleasure, while sitting in my bosses chair, leaning back with my feet on his desk, of informing his boss that all of them should have been sticking to their knitting, and would be well advised to do so, going forward.
It was kind of sad, I was laid off soon thereafter. To his credit, my boss did remark in letting me go that he should have stuck to his knitting.