Friday, September 7, 2012

The Contract Business

Regular readers of Private Trader will know that it focuses on the fun stuff: Directional trades that can in weeks win a glorious fortune or toss a trader into the pit of despair.

Whether it's traditional trend analysis, as outlined in my essay "10,000 Charts", or the stricter Turtle Trading, as described in my essay titled, appropriately, "Turtle Trading", these positions require constant care, record keeping, updating stop losses, blood, tears, toil and sweat, along with much joy and laughter.

I love them!

In truth, though, I keep the bulk of my funds in positions that are far more staid, boring even. They have their risks, as any profit-seeking position does. But they require very little care once entered -- I deal with them once a month.

These laid back positions are covered calls and their cousins, diagonal spreads. Trend trades are bets on the direction stocks will take. But diagonals and covered calls are a different game entirely. They are the business of writing contracts.

It works like this.

Stock options are contracts. A call option is a contract to buy shares of stock at a specified price. If I buy a call, I'm paying a premium, as in an insurance premium, for the right to purchase stock at the call's strike price. If I sell a call, then I'm promising to sell you the stock on demand at the strike price.

It is directly analogous to the insurance business, buying and selling policies. An excellent book, The Option Trader's Hedge Fund, discusses this way of looking at options.

I will say, in fact, that I found it impossible to truly understand the options game until I began to think of these derivatives in terms of insurance.

When I set up diagonal spreads and covered calls by selling call options, then, I am acting as an insurance agent. I am writing insurance contracts.

Now any insurance company knows that it will have to pay off on some of its contracts. If I sell a call option, then I'll have to pay off if the stock's price rises above the strike price. If it stays below the strike price, then the contract will expire worthless and I get to keep the premium.

An insurance company must have the assets needed to pay off its contracts. Otherwise, it risks bankruptcy.

So when I sell a call contract, I cover my risk by owning the stock on which the contract was written. If the price rises -- if I have to pay off -- then I simply hand my shares over to the person who bought the call.

Shares can be quite expensive. A cheaper alternative is for me to buy a call option allowing me to buy shares at a reasonable price. If I need to pay off, then I'll exercise my call option and then turn the shares over to whoever owns the call I sold.

Basically, I'm buying insurance that allows me to pay off the insurance I sold. My private comes from the difference between the two premiums.

Two other concepts:

Delta describes how much an option's value changes for each dollar change in the stock's price. A delta of 70 means the option value changes by 70 cents whenever the stock changes by a dollar.

Also, delta is a measure of how far away an option is from the current price. An option whose strike price is the same as a current strike price will have a delta of about 50.

The higher the delta, the more the stock is in-the-money, with a strike price higher than the current price, and the more expensive the premium.

Lower deltas cost less.

Expiration tells when an option expires. Option contracts all have limited lifespans. They eventually cease to exist. The term "front month" refers to options expiring next. Options are designed to expire on the Saturday that follows the third Friday of the month, unless that Friday is a market holiday, in which case the expiration is on the Friday. So the front month is either that date this month, or if it has already occurred, that date next month.

When I sell options, I always sell contracts expiring in the front month, typically when that expiration is about 30 days away.

Calls covered by stocks produce smaller yields -- I aim for 3% or so a month. Diagonal spreads, because of the lower cost of covering, have higher yields. I generally aim for 25% to 30% a month.

To summarize,
  • Covered call
    • Buy 100 shares.
    • Sell a front-month call option with a delta between 30 and 40.
    • Continue selling each month until the option is exercised, in which case you turn the stock over.
  • Diagonal spread
    • Buy a call option that doesn't expire for three or four months and that has a delta close to 70.
    • Sell a front-month call option with a delta between 30 and 40.
    • Continue selling each month until the option is exercised, in which case you in turn exercise your delta 70 option and turn over the resulting stock.
The main risk is that the price of the stock falls so low that it doesn't pay to sell contracts against shares or calls that I own. Most recently, that has happened to be with Facebook (FB). If I'm covering the calls I sell by owning shares, then I can wait out the slump. If I've covered using call contracts (diagonal spread), then I face a deadline when the calls I own expire.

The process of closing out a contract I've sold and selling a new one is calling "rolling". I roll the calls I sell near the close on the Friday prior to expiration week. Currently, for example, my sold calls all expire on Sept. 22, their last trading day is Sept. 21, and I'm rolling them over for October calls next Friday, Sept. 14.

I treat covered calls and diagonal spreads as time-based positions. I don't set a stop/loss. I don't close out midway through a contract period. I play it by the calendar and take my profits and losses as they come.

Finally, because of the conservative nature of covered calls and diagonal spreads, I am willing to hold larger positions. 

For trend and Turtle Trading positions, I make each position 1% of my trading funds, and then adjust for volatility.

For covered calls and diagonal spreads, I make each position 4% or 5% of trading funds.

There is much more to now about covered calls and diagonals spreads. I recommend any trader looking to use the strategies perform the due diligence of Google searches and some book reading. Amazon has a fine selection of books about covered calls. See the results here. There are far fewer books on specifically on diagonal spreads, which belongs to a class called "time spreads".

 This book....

... is a wonderful encyclopedia of option strategies, including diagonal spreads.

ThinkOrSwim, now a division of TDAmeritrade, has a fine explanation of diagonals, which can be read here.

In any case, I find the business of selling contracts to provide a steady income while allowing me to invest more money without being overwhelmed by the workload. I can handle about 20 active positions at a time. Above that, I start making mistakes.

I turned to covered calls and diagonal spreads because I was dissatisfied with results from high-dividend shares and bonds. I like the risk profile of the contract business better because the higher returns will offset more capital loss.

I touched on the subject in an essay, "Risk Free: A Letter to a Friend".

By higher returns I mean much higher. A really high dividend stock or bond will pay, say, 13% a year, and the stock price will go down each time the stock goes ex-dividend.

A covered call position potentially can yield 30% a year, and a diagonal spread series, 300%, without ex-dividend risk.

There are many other risks, to be sure, but the high reward does much to mitigate them.

No comments:

Post a Comment