God is a Capitalist

Thursday, October 9, 2014

Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.

But if the market rises enough to persuade the buyer of the option to exercise it and call away the seller’s stocks, then the seller will keep the premium and sell his stocks at a higher price than when he sold the option. The higher the strike price was above the price of the stock at the time of the option sale, the more profit the investor will make. And by exercising the option, the buyer will have done the investor the favor of helping him sell his stock near the top of the market.

A similar strategy can be used at the bottom of a bear market in the depths of a recession, but the strategy will shift from selling calls to selling puts. Investors can find a good introduction to such strategies in Michael Thomsett’s Options Trading for the Conservative Investor.

Writing or selling options is a conservative strategy in spite of what the experts say. While it's true that buying options limits an investor's risk to the cost of the premium. But it's not true that by selling an option the investor's risk is unlimited. The risk is unlimited only if the market can rise or fall by an unlimited amount during the life of the option. Markets moves of even 10% are rare. And the seller always has to opportunity to close out a losing option at any time and stop the hemorrhaging. 

The real risk in options is the time value, which for OTM options makes up most of the premium. For options lasting short periods of time, say three months, the time value erodes rapidly. It's rare for the market to move enough to overcome the entropy of the time value. 

If you must buy options, then buy the longest ones, known as LEAPS (Long Term Equity AnticiPation Security). They're a better value for the buyer and give you time for the market to make a big move. But if you need to buy a derivative, the better choice is a futures contract because futures give the investor as much leverage but without the disadvantage of time entropy. 

No comments: