4% Return in 25 Days! Options Trade

[competentone]

Nearly 4% "return" writing near-the-money calls on Freeport-McMoran (FCX).

One of this morning's trades:

Buy the stock at $84.84.

Write the December $85-strike call for $3.35.

Lock in a nearly 4% return -- for 25 days!

"Risks":

If FCX is higher than $85 in December, they take my shares (but what do I care, I've already got my 4%).

If FCX is lower than $85 in December at options expiration, I keep the $3.35 premium and my shares -- which I don't mind doing. Holding Freeport long-term is a good hedge against the inflation I expect our economy will be experiencing over the next few years. (Or I may buy my calls back if low enough before expiration.)

I just finished a similar covered-call trade with GSS calls that expired last week. I got to keep my shares and the option premium.

I'm finding writing covered calls is a good way to "sooth myself" during this crazy volatility. Being a long-term minded investor, I don't like the short-term mindset this market is forcing. The covered calls let me generate returns in the shorter term (and premiums are high due to the volatility) while still focusing on the long-term investing I prefer.

[legion]

I was about to type a rant about how most people don't understand options and make big mistakes with them, but you seem to understand what you're doing.

However, I'd never touch options myself. Being a long-term minded investor myself, I'm not in the least concerned what happens from year-to-year as long as the long-term trend is up. Options are, by nature, short term. They are useful for transferring risk, but they require someone willing to speculate to do so. My goal is to never be in a position where short-term results matter enough to me to make using options necessary, and I'd certainly never "bet" on a price movement with options with anything other than play money (money that I can afford to lose).

[Rich76_911s]

You took on the exact same risk as shorting the 85 put naked. Might think about doing that next time to lower transaction costs as well as interest costs if you are buying on margin or interest that would be earned on your capital. I do realize that the interest paid or lost is close to 0 in this situation.

Legion using options at times is a very smart move even for a long term investor. In 2007 I hedged my potfolio using longer term diamond put options when volatility was in single digits.

[jyl]

Curious, do you have to have an opinion on the short-term direction of FCX stock to do this?

Here's how it looks to me:
- FCX stock was $84.84 when you bought.
- If FCX stock is up 4.14% ($88.35) when the option expires, then the return from strategy (a) holding the stock and writing the call, and strategy (b) simply holding the stock, are the same.
- In strategy (a), the stock is called for $85, you have a gain of $85 - $84.95 + $3.35 = $3.51
- In strategy (b), you have a gain of $88.35 - $84.84 = $3.51
- There are different taxes and transaction costs too, the $3.35 is short-term capital gains, etc. But ignore those for now.
- If FCX stock move is >4.14%, strategy (b) is better. E.g. if FCX is up 5%, strategy (b) results in a gain of $4.24 versus $3.51 for strategy (a).
- If FCX stock move is <4.14%, you are better off with strategy (a). E.g. if FCX is up 3%, strategy (b) results in a gain of $2.55 versus $3.51 for strategy (a).
- And, of course, if FCX stock move is down, at some point you lose money in either strategy. If move is < -4%, the loss on the stock offsets the premium for the call and you start losing in strategy (a). Even if you "don't mind" the loss, rationally it is still a loss.

I guess it seems to me that, if one did had a view on whether FCX will be +4% or -4% over a very short time period (1 month), perhaps better to simply be long or short the stock? If one's view is very strong, perhaps be naked the call or naked the put, and even use more out-of-money options, for the greater leverage?

As you can tell, it is not really clear to me when and why an individual investor should choose a covered call strategy over the alternatives.

I've worked in shops where we wrote covered calls on portfolio holdings. But as large institutional investors, we had to be fully invested anyway and the trading costs of switching in and out of specific stocks was high. In effect, we already owned FCX and were going to own it anyway, so it made sense to harvest a little premium income even absent a strong short-term trading call on the stock. But that's not the case for an individual who buys FCX specifically to play the covered call strategy.

[trader220]

You might say I have a little experience in the options world. My screen name here may have tipped you off. Twenty years in the business and 16 of them basically as a market maker on three different exchanges.
Covered calls are a nice basic strategy what gets over looked is that in a bear market you really get your azz handed to you.

Looking at FCX… The implied volatility (IV )in FCX has been slammed pretty hard recently and as a professional I would not want to be shorting IV here in FCX, the premium received is just not worth the risk. Below is a one year indexed implied volatility chart on FCX, and now at the very bottom you want to start shorting premium in it? The real profits in selling premium in FCX have already been made. Keep in mind that calls and puts are somewhat irrelevant, you’re either long or short premium, long or short delta ( the direction of the underlying) and long or short a strike. Statistically when you sell the at the money call as you advocate you have roughly a 50/50 chance of that call being in the money at expiration, the premium in that strike is not justifying that particular bet right now and then you’re tossing in a directional guess on top of that.
I don’t trade with an axe, which means I don’t trade direction, and were I to start trading FCX I would not be shorting premium.

Jyl already made the strong case for not using the covered call and using an alternative position to achieve the same position. Its really a good point IMO. In addition to what he added I might recommend you consider a bull put spread if you think the stocks going up. That way you wont have naked options margin issues and you would eliminate any margin issue you might have in borrowing to pay for the stock. The 85 call and put should have the same amount of time premium built into them and if you shorted the 85 put and spread it vs something like the 80 or another strike you have a 100% handle on what you risk is and it’s a cheap position to hold.


Do yourself a favor and dont count that return till you close out the position and dont hang arund and try to collect that last quarter, if those calls get really cheap just buy to close and close out your risk.

[trader220]

[competentone]

Originally Posted by Rich76_911s

You took on the exact same risk as shorting the 85 put naked. Might think about doing that next time to lower transaction costs as well as interest costs if you are buying on margin or interest that would be earned on your capital. I do realize that the interest paid or lost is close to 0 in this situation.

It's not a trade using margin (it's in a Roth) so interest/margin are not in the mix.

I also wouldn't describe selling the put (with cash on the sidelines ready to pay for the stock if it's "put" to me) as the same -- even if the "risks" are the same as buying the stock, then selling the call. It's the "same direction" trade -- at least mildly bullish and locking in the (good) premiums the options offer -- but is "different," at least in the psychology of the trade.

[competentone]

Originally Posted by jyl

Curious, do you have to have an opinion on the short-term direction of FCX stock to do this?

Here's how it looks to me:
- FCX stock was $84.84 when you bought.
- If FCX stock is up 4.14% ($88.35) when the option expires, then the return from strategy (a) holding the stock and writing the call, and strategy (b) simply holding the stock, are the same.
- In strategy (a), the stock is called for $85, you have a gain of $85 - $84.95 + $3.35 = $3.51
- In strategy (b), you have a gain of $88.35 - $84.84 = $3.51
- There are different taxes and transaction costs too, the $3.35 is short-term capital gains, etc. But ignore those for now.
- If FCX stock move is >4.14%, strategy (b) is better. E.g. if FCX is up 5%, strategy (b) results in a gain of $4.24 versus $3.51 for strategy (a).
- If FCX stock move is <4.14%, you are better off with strategy (a). E.g. if FCX is up 3%, strategy (b) results in a gain of $2.55 versus $3.51 for strategy (a).
- And, of course, if FCX stock move is down, at some point you lose money in either strategy. If move is < -4%, the loss on the stock offsets the premium for the call and you start losing in strategy (a). Even if you "don't mind" the loss, rationally it is still a loss.

I guess it seems to me that, if one did had a view on whether FCX will be +4% or -4% over a very short time period (1 month), perhaps better to simply be long or short the stock? If one's view is very strong, perhaps be naked the call or naked the put, and even use more out-of-money options, for the greater leverage?

As you can tell, it is not really clear to me when and why an individual investor should choose a covered call strategy over the alternatives.

I've worked in shops where we wrote covered calls on portfolio holdings. But as large institutional investors, we had to be fully invested anyway and the trading costs of switching in and out of specific stocks was high. In effect, we already owned FCX and were going to own it anyway, so it made sense to harvest a little premium income even absent a strong short-term trading call on the stock. But that's not the case for an individual who buys FCX specifically to play the covered call strategy.

I'm doing essentially the same sort of calculations, and asking (myself) similar questions as those you raise.

A lot of it boils down to the comment I made about "soothing myself" in this volatile market (which seems to have been going on for over a decade -- I'm not just talking about the volatility over the past 18 months). I've seen "long-term" positions I take move to give me gains, then drift back to break-even, then to a loss, then back to gains....over and over it goes. I watch significant percentage gains-losses swings happening with my long-term holdings. Since I'm convinced that the long-term will give me a good upside return, I try to hold through the ups and downs rather than trying to "trade" in and out of positions.

Doing something like writing covered calls is effectively making me more of a "trader," but I see it as a more "disciplined" form of trading than trying to jump in and out catching the swings. And is more compatible with my (at least desire) for a reasoned long-term focus in investing.

With the trade, I'm not trying to necessarily predict the direction or magnitude of the move in FCX over the next month -- something like that is extremely difficult to do. This morning, with the dollar weak and gold and copper strong (and pre-market FCX trading), it looks like my FCX shares may be taken from me at expiration (or before), but next week, if the dollar stabilizes or strengthens (which could happen if the heavy short positions in it are covered) we could see copper and gold sell off and it will be looking like I'd be keeping my shares.

Buying a stock with ideas about writing covered calls to earn the good premium the options may be offering (assuming one has also researched the company and wants to own the stock at/near the price it is selling at), is sort of like buying a stock for the dividend return -- one isn't looking at the shorter-term price swings that my occur, one is focused on the "yield" the position offers.

4% in 25 days (only about 17 of them trading days) is a pretty good yield. If no situation happens where the "target stock" (for writing the covered calls against) sells off really sharply, and I repeat a 4% "return" five or six times in a year, the overall return is nothing to sneeze at.

[competentone]

Originally Posted by trader220

Looking at FCX… The implied volatility (IV )in FCX has been slammed pretty hard recently and as a professional I would not want to be shorting IV here in FCX, the premium received is just not worth the risk. Below is a one year indexed implied volatility chart on FCX, and now at the very bottom you want to start shorting premium in it? The real profits in selling premium in FCX have already been made. Keep in mind that calls and puts are somewhat irrelevant, you’re either long or short premium, long or short delta ( the direction of the underlying) and long or short a strike. Statistically when you sell the at the money call as you advocate you have roughly a 50/50 chance of that call being in the money at expiration, the premium in that strike is not justifying that particular bet right now and then you’re tossing in a directional guess on top of that.
I don’t trade with an axe, which means I don’t trade direction, and were I to start trading FCX I would not be shorting premium.

******
Do yourself a favor and dont count that return till you close out the position and dont hang arund and try to collect that last quarter, if those calls get really cheap just buy to close and close out your risk.

Looking at FCX… I didn't see anything you saw!

I don't invest on "technicals" about the stock. I look at the company and world economy and evaluate the future prospects. There are known variables and unknowns. I consider the known variables and speculate about the unknowns.

I'm not being critical about your (technical) approach -- it serves an important function in the market -- but quite frankly, I really don't care much about what a stock's "implied volatility" is at. As I see it, a technical approach is too much of a "backward looking" approach to investing. Yes, past behavior can be an indicator for future directions, but it's just not the way I like to research things.

As for closing out my call position not trying "to collect that last quarter": Yes, it is a consideration, but at the same time, having written the call, I see "time" as being on my side.

The time premium is what I'm collecting.

[trader220]

Comp,

No offense but I was not doing any technical analysis. I am just looking at the facts of how the market came up with the amount of premium in that option.

In 20 years as a professional trader I have gained a bit of an education on how to price options without caring what anyone’s guess of where the underlying is going. My point was that the IV level in the at the money FCX is just not very attractive a sale at this point. That has nothing at all to do with the direction of the stock.

Historically covered calls has been a reasonable strategy for the retail player but just be aware that statistically you’ll pile up a lot of wins on individual positions and every so often you’ll give back most of what you made in one position gone bad. You may justify that by saying I wanted to own the stock anyway but what the professionals do is take that out of the equation since a loss is a loss. Ask the covered call crowd how they did in 2008 and 2009, and you’ll get two answers. Some will say they did fine selling the calls they took in lots of premium but they will justify the massive losses in the underlying by saying they were holding the stocks anyway. The others will tell it like it is, they took significant losses on their portfolios and the premiums they collected helped them a bit.

Be very careful not covering those short calls for nice profits when the options have decayed down to the last quarter or dime. Any professional knows not closing them out is exactly how they can blow up in your face and the last dime or so is silly. I had 17 traders on 4 exchanges working for me and every day I had a clerk run me a report of how many open short options each trader had which was marked at 10 cents or less and I went in and closed em out all the time.

Don’t make the big mistake of booking profits before the positions are closed. Returns are not returns until the positions are closed out.

[trader220]

Originally Posted by competentone

It's not a trade using margin (it's in a Roth) so interest/margin are not in the mix.

I also wouldn't describe selling the put (with cash on the sidelines ready to pay for the stock if it's "put" to me) as the same -- even if the "risks" are the same as buying the stock, then selling the call. It's the "same direction" trade -- at least mildly bullish and locking in the (good) premiums the options offer -- but is "different," at least in the psychology of the trade.

Interest is always in the mix since you receive interest on the cash you have in the account, if you chose to use that cash for another investment the interest you would have earned has to be priced in. Options have an interest rate component priced in.

Selling the naked cash covered put is the exact same position as doing the covered call. You have fallen into the trap that many retail investors have, you are justifying your opinion based on your own psychology which excludes the actual facts.

You used the phrase “good premiums” … unfortunately that phrase needs a qualifier to mean anything. What some would consider “good” others would not. In the case of FCX the market has spoken and based on where the IV of FCX has been those premium are not that “good”

[MBAtarga]

Originally Posted by trader220

Looking at FCX… The implied volatility (IV )in FCX has been slammed pretty hard recently and as a professional I would not want to be shorting IV here in FCX, the premium received is just not worth the risk. Below is a one year indexed implied volatility chart on FCX, and now at the very bottom you want to start shorting premium in it? The real profits in selling premium in FCX have already been made. Keep in mind that calls and puts are somewhat irrelevant, you’re either long or short premium, long or short delta ( the direction of the underlying) and long or short a strike. Statistically when you sell the at the money call as you advocate you have roughly a 50/50 chance of that call being in the money at expiration, the premium in that strike is not justifying that particular bet right now and then you’re tossing in a directional guess on top of that.
I don’t trade with an axe, which means I don’t trade direction, and were I to start trading FCX I would not be shorting premium.

I THOUGHT i could read english!

[competentone]

Originally Posted by trader220

Interest is always in the mix since you receive interest on the cash you have in the account, if you chose to use that cash for another investment the interest you would have earned has to be priced in. Options have an interest rate component priced in.

Selling the naked cash covered put is the exact same position as doing the covered call. You have fallen into the trap that many retail investors have, you are justifying your opinion based on your own psychology which excludes the actual facts.

You used the phrase “good premiums” … unfortunately that phrase needs a qualifier to mean anything. What some would consider “good” others would not. In the case of FCX the market has spoken and based on where the IV of FCX has been those premium are not that “good”

But why are you looking at IV during the turmoil late last year and earlier this year? It's not a comparison I make; it was a different situation in Dec. 08 when FCX was trading at $17 and copper was $1.40.

Additionally, the purchase of my FCX shares was funded by the sale of another natural resource-focused company (part of my inflation defense strategy), at a gain (22% worth), where I could not get the same percentage premium writing calls.

"Opportunity costs" -- interest, gains, or dividends that could have been earned in some other position -- are always there.

I do trade/invest based on my own psychology -- my own psychology is part of the "actual facts" when making investment decisions.

I can tolerate unrealized losses on my positions (as I did last year) so long as I am confident about the longer-term prospects for what I own. (This is understanding and investing based on my own psychology.)

As for the comment about looking at IV "not being technical analysis" -- it is when compared to looking at FCX as a company and looking at the copper, gold, cobalt, and molybdenum markets.

I used the term "return" in quotation marks (when discussing collecting the 4% premium selling the call) because I recognize it does not represent any realized return until the entire position is closed.

My eyes are wide open.

And I do appreciate your comments.

[jyl]

I find options very interesting.

I do not have professional experience in options, all my work has been in vanilla equities, and the only way I know to make money is to do a heck of a lot of research, make a directional and preferably non-consensus bet, be right 60% of the time, and not get killed by the other 40%.

Currently we have a bunch of stocks with charts like FCX. I bought them in late 2008 and early 2009 and am getting out, or have gotten mostly out, of most of them. If a stock is up +300% or +400% in the past year and near its old highs, I consider that a negative not a positive. I'm looking for stocks that have not recovered, not those that have recovered. However, I know zip about FCX so maybe its good for another +100%, I have no idea.

Note also we're at the time of year where a lot of portfolio dressing and/or revamping will be done. Managers desperate to outperform in the last month of 2009 will chase the names with momentum, for perceived safety or simply to show those holdings in their year-end report. Managers who have already outperformed will be taking profits on the big winners of 2009 and looking for the big winners of 2010, which are unlikely to be the same stocks. So beware the trends in the final weeks of the year, those are often misleading.

I also find volatility very interesting. It "feels" like the market is terribly volatile. But the data shows that volatility has declined all year and is at its lowest point since pre-Lehman. (See VIX and VXN, those are implied volatlity but I think that usually tracks actual current volatility?)

[trader220]

The point I was making is that your fundamental anaylsis of the company should and does have no effect on whether shorting those options is giving you enough premium.

I looked a that time frame simply becasue it exposed how far the IV has fallen and now you want to start selling premium.

[competentone]

Originally Posted by MBAtarga

I THOUGHT i could read english!

All that is really being discussed is that when a stock's price is "whipping" up and down, its expected (implied) volatility makes the costs of buying options on it higher.

The volatility in stock prices makes "predicting" their future prices more difficult, so the premiums paid (and received for those selling options) is higher.

Why that happens largely relates to human behavior. People generally expect that the future is going to be the same as the present/recent past. So if prices are "uncertain" today, people translate that into an expectation that prices will be "uncertain" in the future.

[trader220]

JYL if you can pick 60% winner then you da man, history shows that it a blisteringly good track record.

The IV in the market has gotten smoked and the risk premium in equities IMO is far to slim at this point, I would not be long here from a portfolio basis, but thats strictly my opinion.

Your persepctive on what the market "feels" like is one shared by many retail investors and your analysis of the markets volatility is spot on. I would much rather be long Vol here than opening short premium positions

[trader220]

Originally Posted by competentone

All that is really being discussed is that when a stock's price is "whipping" up and down, its expected (implied) volatility makes the costs of buying options on it higher.

The volatility in stock prices makes "predicting" their future prices more difficult, so the premiums paid (and received for those selling options) is higher.

Why that happens largely relates to human behavior. People generally expect that the future is going to be the same as the present/recent past. So if prices are "uncertain" today, people translate that into an expectation that prices will be "uncertain" in the future.

Be careful using the word "people" the markets pricing is not really based on retail or people.

[jyl]

Originally Posted by trader220

JYL if you can pick 60% winner then you da man, history shows that it a blisteringly good track record.

The "killing" is the problem . . .

We could benefit from using options to hedge the downside on some of our names.

[competentone]

Originally Posted by trader220

The point I was making is that your fundamental anaylsis of the company should and does have no effect on whether shorting those options is giving you enough premium.

I looked a that time frame simply becasue it exposed how far the IV has fallen and now you want to start selling premium.

"True" on the first point. "Enough" premium is a pretty subjective thing. 4% for 17 trading days is "enough" for me in this instance, at this time.

Yes, Implied Volatility has fallen over the past, but I didn't just want to start selling it "now." It is just that "now" is where I'm at!