Sunday, June 25, 2006

Maintaining speed in a falling market with covered calls

I received a funny email today from Bernie Schaeffer of Schaeffer's Investment Research. The subject was "Maintain speed in a falling market - for only $195". Personally, I would not pay $195 to maintain speed in a falling market. To slow down or even reverse in a falling market would be worth paying for, but you can maintain speed for free.

Bernie Schaeffer is yet another investment newsletter huckster. Bernie's particular shtick is options, momentum chasing, and swing trading. The email opens "RIGHT NOW THE MARKET IS UNDER SOME SERIOUS SELLING PRESSURE", and then quickly moves on to Bernie's main message. That you should subscribe to Schaeffer's Covered Call Plus for only $195, an amazing 60% OFF the regular price of $495. But you have to hurry, this incredible savings ends FRIDAY at Midnight.

The service claims to give you a constant supply of buy-write ideas. Buy-write is a strategy of purposefully buying stocks for the purpose of writing call options on them. The net position after writing a covered call is being short volatility. Is this really a good idea in a volatile market?

There are several problems with a buy-write strategy. The problems stem from being short volatility and the transaction costs of an active options strategy.

The main problem is that by writing covered calls on a stock you sacrifice all the upside movement past the strike price, while retaining all of the downside. If the volatility is positive and greater than expected, you get the fixed and limited return of the call premium. If volatility is negative and greater than expected, you get to keep all the downside, offset by the option premium. Only if the volatility is less than expected and the stock price does not move at all; does writing call options give you excess return. This is not a sound or risk averse investment policy.

The other problem is the transaction costs incurred by frequent trading. A single complete buy write trade (buy, write, (buy to close, get exercised) sell)involves at least twice as much commission as a normal stock trade(*). These transaction costs impose a very high hurdle rate.

A simple example: Assume a stock costs $24, and you buy two round lots (2x100) for $10 ($4800). Then you write two three month calls at $25 and receive $288 (10+2*0.75) (Option price for 90 day American call with Implied volatility of %36.44 and risk rate of 5.4%). So far you have spent $22.5 in commissions to set up the position. Assume that six days prior to expiration you decide to close out the position, *and that the stock is still 24. The option price is now 0.12. Your cost to close is (10+2*0.75+2*12+10) = $45.5. Combined with your opening costs of 22.5, your total cost on the trade is $68. Your annualized hurdle rate on your $4800 investment is 5.6% ((4*68)/4800).

While the example buy-write you ended up with net profit of $220 (for an annualized return of %12.7 net of expenses). However if things go badly, it gets ugly. That $220 is equivalent to getting an option premium of $1.10. Your downside protection is at most against a 5.3% drop in the stock price (assuming the options expire worthless). On anything more than 5.3% drop you get not only the losses from the stock's decline but also the addition expense from opening and closing the position. On a single buy-write The gains are limited to 4.6% of your investment ($265.5/4800), the losses are limited to $4,534 (94.4% of your investment). Actually the gains can be even further limited, because of the cost of getting assigned an exercise.

If the best you can do is gain 4.6% and the worst is lose 94.4%; then in the long run you must lose. And if you can consistently beat a 5.6% hurdle rate, the world of hedge funds awaits you. Every time the stock market gets stagnant, volatile, or trends downward some huckster comes along promoting covered calls as the universal cure.

(*) A complete buy-write involves 1.5 times normal commission if the option expires worthless meaning that the final close of the stock is less than strike + $0.25.

3 Comments:

At July 05, 2006 11:05 PM, Blogger Dan McCarthy said...

This comment has been removed by a blog administrator.

 
At July 05, 2006 11:07 PM, Blogger Dan McCarthy said...

I understand the logic but posted some counterpoints on my blog - http://thelearningblog123.blogspot.com/2006/07/quick-thought-on-covered-call-strategy.html

All the best,
Dan

 
At July 05, 2006 11:08 PM, Blogger Dan McCarthy said...

sorry about this-- too long and I am bad at html :(

blog is at http://streetplay.net

 

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