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Guest Post: Buy-Write Strategies, Widows, Orphans And 1987
Submitted by Credit Trader
The Buy-Write or covered-call strategy has become increasingly popular and I suspect is dramatically responsible for the "surprising" rally in stocks and compression in vol of the last month or so. The covered write (long underlying stock and selling in-the-money calls against it) supposedly allowing investors to benefit from the enhanced return offered by the option premium.
However, the synthetic equivalent of the position is a short put (think about the payoff profiles) and I wonder just how comfortable these home-gamers would be with the strategy of naked option writing. "Covered Call" just sounds so much better.
Anyway, the point is that while this strategy may be 'ok' for widows and orphans who will never be selling their stocks and are perpetual buy-and-holders. However, to most as the position is working out profitably, the cheap out-of-the-money put that is created will reach a point when it is not worth holding onto any longer (i.e. becomes very rich to the equivalent put or greek speed picks up). This is the point at which the position should be rolled to optimize the income enhancement process.
The issue is that just as during the 1980s and specifically the lead up to 1987, the covered-call creates more positions that need to be liquidated or require more hedging which helps to exaggerate or create selling pressure in any downturn.
The covered-call in fact offers limited protection in a severe sell-off as the hedge is in fact nothing like as linear as many would hope. The synthetic equivalent of the covered-call necessarily puts upward pressure on stock prices and downward pressure on vol - exactly what we have seen in the last few months and saw in 1987.
The charts attached show normalized vol and S&P for the 1987 period and same 2009 period. Look at the similarities! However, the moth of October has been very interesting, we have seen credit markets start to stall, the dollar tanking and TSY yields pick up and at the same time the S&P has burst higher as vol has dropped dramatically.
The regime since the March lows has been of credit leading equities (up and down) and the stalling of the credit rally recently while stocks push divergently higher (and vol lower) has been very conspicuous! A look at the vol term structure (VIX/VXV for a simple example) shows that short-dated vol (the most likely to be used for covered-writes) is exceptionally low (with the term structure steep).
We feel the possibility for a very much self-fulfilling drop in stocks and rise in vol is at hand and the last few days massively schizophrenic behavior is perhaps the first signal that cracks are appearing.
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Fascinating.
The only problem facing any type of sell off is the role that HFT will play in it. If the banking interests do not want a sell off, can the HFT-Hk machines prevent it?
Next year is different with tax law changes, but this year?
Get yer popcorn ready and have the Tivo set to record the expressions of all of the twits on CNBC.
Not quite accurate -- the Call doesn't need to be "in-the-money".
"The covered write (long underlying stock and selling in-the-money calls against it)"
The schizo behavior plays out beautifully on an emini 60 minute chart (24 hr) going back to 10/15-16.
Looks like a new ride at Disney.
unfortunately, this pattern has been played out for the last few consoldation periods. The highs and lows diverge (with some support established somewhere at the end of the pattern) before it breaks out to the upside.
I know exactly what you mean (I think).
However, this one feels a little more desperate to hang on.
It looks like early August but with more volume, which should make it more interesting.
But hey, look at me trying to use logic, not the most useful tool to use in this market.
"the covered-call creates more positions that need to be liquidated "
I don't understand? If I write a covered call, how are more positions needed in liquidation? The price is predetermined and is executed between the two parties. If the option is in the money, I sell my underlying stock to whoever calls the option at the strike. The transaction occurrs outside of the bid/ask that is being quoted on the exchange.
...What am I missing here? Are you saying those that end up buying at the strike automatically FLIP the position in the open market and lock in the spread, thus causing an increase in sell orders? But if that's the case, then these additional sell orders will come only if stock is going up.
IF there were a massive selloff and you wanted to get out of your covered-call arrangement, you would have to sell your underliers and buy-back your calls instead of simply selling your underliers (or buying back your short puts) if you don't use this strategy.
this was conditional, and wasn't quite clear in the description, i think...
The limited downside protection of covered calls is highly overrated. If a stock tanks badly, in some cases you will have to buy back the call at a higher price than what it was sold at, even though the underlying stock is down significantly. People are so desperate to get out and buy back the calls that the price decouples from "fundamentals" and becomes a strictly demand driven creature. Talk about adding insult to injury.
Played with this a while, and concluded that the potential for limited gains don't offset the risks. If we have a repeat of the 1970's, widows and orphans will get royally screwed following this strategy. If you have good screens, indicators and stops, you can do much better timing your longs.
High finance by way of children's song lyrics.
Frank Sinatra sings "High Hopes"
Next time you're found, with your chin on the ground
There's a lot to be learned, so look around
Just what makes that little old ant
Think he'll move that rubber tree plant
Anyone knows an ant, can't
Move a rubber tree plant
But he's got high hopes, he's got high hopes
He's got high apple pie, in the sky hopes
So any time you're gettin low
stead of lettin go
Just remember that ant
Oops there goes another rubber tree plant
When troubles call, and your back's to the wall
There's a lot to be learned, that wall could fall
Once there was a silly old ram
Thought he'd punch a hole in a dam
No one could make that ram, scram
He kept buttin that dam
cause he had high hopes, he had high hopes
He had high apple pie, in the sky hopes
So any time your feelin bad
stead of feelin sad
Just remember that ram
Oops there goes a billion kilowatt dam
All problems just a toy balloon
They'll be bursted soon
They're just bound to go pop
Oops there goes another problem kerplop
How is it that covered call writing is popular? Covered calls are more popular during sideways markets, not in a 60% rally like we've since this year.
Anyone who wrote covered calls since March most likely had their shares called out from under them. I doubt buy-and-holders did that in this type of rally, or they did it once or twice and then got their shares called away and waited for the shares to come back to rebuy them, and they never did.
Right, repeat this eight months straight and it's clear why CC's are popular.
Well, I have small hedge fund set up, that is really just funded and managed by myself and my friends who are in the biz. More of way to test various strategies without having to explain ourselves to any outside investors.
Anyways, we have been doing a lot of option strategies and covered call writing since the beginning of this year, though not exclusively. We have a modest short position, and we currently we have about 50% in cash equivelents, and our YTD return is 28%, which I believe is beating the S&P -- not the Nasdaq though.
However, if you talk about risk-adjusted returns, we're killing both indexes. If/when the market goes down, we should be able to increase our outperformance substantially.
Yes, we're not up 60% from March, but you can't just look at raw performance. Returns must always be looked at from a risk-adjusted basis.
"Returns must always be looked at from a risk-adjusted basis."
That's what fund managers who don't beat the index say to justify their lack of performance.
I'd love to see how you performed during the crash, not only in terms of fund performance, but having to handle the redemptions, people calling you on the phone yelling at why they lost money, etc.
If people put their money in an index fund, and employed dollar-cost averaging religiously throughout this entire year, I'll bet dollars to donuts they'd beat almost anyone.
You'd be surprised. No one cares about risk-adjusted performance, especially investors. 10% is better than 9%, that's all they care about. Beta is sold as Alpha on the street. Everyone is seduced by the best <absolute> performer in the peer group.
Underperforming managers during downturns can't use risk-adjusted return as an excuse, b/c more often than not they took on more risk (which is why they underperform during downside, and outpeform when there's upside). The excuse they use is "Well, look at our long term performance" -- which tends to be positive.
With only my word to back the following, our performance from January to March was Positive 1%, while S&P was down double digits during that time. Granted, from March to present, we we underperformed the S&P in terms of returns, but we had a good head start between Jan-March.
As I mentioned, we're only managing our own money, so there's no risk of redemptions, etc. But, yes, redemptions can be a huge problem...
There is risk, and there are returns, but "risk-adjusted" returns are a bunch of BS. Returns are backward-looking. Risk is forward-looking.
The great dollar rally is coming. Remember it has zero chance of happening, just like stocks had zero chance of hitting 1100 on the SPX in March.
What happened to gold and silver during the '87 crash? It can play out differently because of the dolar picture but just curious as to what one can expect when the SHTF.
<< The covered-call in fact offers limited protection in a severe sell-off as the hedge is in fact nothing like as linear as many would hope. >>
Can someone help me? I thought a covered call was a way to squeeze some money out of sideways moving holdings (MSFT). It's not a hedge, is it?
I'm not the smartest tool, maybe I misunderstand the article. A naked put is not the opposite of a covered call, is it? What is the 'synthetic equivalent' he mentions?
naked put = covered call
They are equivalent.
Remember your put-call parity? S - C = Ke^(-rT) - P (covered call = long stock + short call = cash and short put). You can just plot payoffs to see this, also.
It is a good way of earning steady extra income (the call premiums) from a stock that never makes a big move up (which would force sale of the stock to cover the call payoff), though.
If you hold a stock and sell a call, if the stock goes up you will have it called away at the strike price. If it goes down you keep the option premium but now your stock is worth less. A "naked" put works the same way but the timing is different - if the stock goes down you will be forced to buy it at the higher strike price.
BTW, "naked" short pu is misleading. It is actually a cash-covered put. I don't think a retail broker would let anyone sell a truly naked put.
Irene Aldridge on Dark Pool regulation: http://watch.bnn.ca/trading-day/october-2009/trading-day-october-23-2009...
mdtrader said:
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I believe this too, been selling my AUD and Swedish Krona all week. AUD been berry, berry, good to me.
If you are selling in the money calls for a traditional buy-write strategy, you are doing it incorrectly. If you are using the buy-write strategy as a long term, buy and hold strategy in this market, you are driving the accountants crazy. This is a very good strategy in sideways markets, not in markets with a 60% up move. If you are using this strategy as a trading strategy, you are a very busy person.
This article is very misleading.
I get this:
Long AMZN 100 shares $100 - Sell Dec $100 Call for $5 (basically selling shares for $105)
= from a profit point of view = Selling $105 put with no shares ---> hoping shares are over $105 in Dec if less you have to cover the difference
I don't get this:
The synthetic equivalent of the covered-call necessarily puts upward pressure on stock prices and downward pressure on vol - exactly what we have seen in the last few months and saw in 1987.
I am sure this is "options 202" but maybe you can explain it for those who've only taken o"options 101"
nhsadika,
When you write a naked put, the buyer of the put will (likely) hedge their position by purchasing the underlying stock (creating upward pressure on the stock). As more put options are written, the price of that contract will fall (volatility is based on the price of the near-money put contract; lower option price = less expensive "insurance" = lower volatility).
say what? how is Buying the stock a hedge for a short Put?
this whole thread is a little outside the typical understanding of covered call writing. it is an income strategy. period. In the old days of OTC options, it was called "double your dividend"
Regarding calls used as a hedge where you have a long position that you wish to hedge in anticipation of a decline, is is of course possible to sell a deep in-the-money Call. If the underlying stock declines, the option value wil also. Depending on how nimble you are, it is possible to sell a Call Credit Spread, selling a deep in-the-money Call, while at the same time buying an at-the-money or slightly out of the money Call. Using a little math, it is possible to create possition with little cost that will profit from a decline in the stock, at the same time, particpate in any up move in the underlying long stock position. of course, the cost would be about the same as a Put hedge, but it brings cash into the account instead of a debit hit.
the article above did not make sense on many levels.
The strategy makes sense if you're worried about an end to this market rally.
Uh, no it doesn't. If you really think the rally is ending, and you utilize this strategy, all you'll do is pocket the premium from the covered call. Meanwhile, the underlying stock will decline > premium pocketed when you sold the call.
You're better of selling the stock directly, if you think the rally is about to end.
However, if by worried you mean the rally will end and then go sideways vs a drop.... well I wouldn't be worried in that case, just disappointed.
Dick Bove is getting too much credit - where none is due. His "events" have been a coincidence and nobody wants to investigate that. For example, MS could not buck today's trend despite Dick's price target raise. The dollar is the tail wagging the dog. As far as I know, Dick knows squat about FX!
+1 To be it looked like the market decline correlated (to the minute, 13:11 if IIRC) with Bloomberg's "Banks who took Tarp to get 90% pay cut" or something to that extent. Bloomberg.com quickly took it down as the lead story and changed the headline to read "50%"
The comments on options above make little sense, so far.
Writing a covered call is a strategy to generate income from holding the underlying shares.
People that I know that sell in-the-money calls this way are usually jumping into very volatile stocks, playing russian roullette for high stakes. They're selling these calls, trying to pocket large premiums. The risk they have is that the stock price goes down significantly more than the amount of the premium they've collected. Therefore, the lower the strike price they select, the more of a buffer they have to the downside before the trade looks like a loser.
People selling out-of-the money strikes are taking much smaller premiums in, but have much less risk of having the stock called out from under them.
The synthetic equivalent of writing a covered call is selling a put. It's the same profit/loss profile. But Tyler seems to imply that this is more risky than holding the underlying equities. In reality, the owner of shares faces 100% loss, just as the writer of a naked put does.
The comments on options above make little sense, so far.
Writing a covered call is a strategy to generate income from holding the underlying shares.
People that I know that sell in-the-money calls this way are usually jumping into very volatile stocks, playing russian roullette for high stakes. They're selling these calls, trying to pocket large premiums. The risk they have is that the stock price goes down significantly more than the amount of the premium they've collected. Therefore, the lower the strike price they select, the more of a buffer they have to the downside before the trade looks like a loser.
People selling out-of-the money strikes are taking much smaller premiums in, but have much less risk of having the stock called out from under them.
The synthetic equivalent of writing a covered call is selling a put. It's the same profit/loss profile. But Tyler seems to imply that this is more risky than holding the underlying equities. In reality, the owner of shares faces 100% loss, just as the writer of a naked put does.
The chart in this article proves nothing. The vix is inversely correlated to the market. When the market goes up over time, volatility generally trends down. That's why the chart of a big rally in '09 looks like the chart of a big rally in '87.
As for your contention that people are buy-writing like crazy, who? Certainly not in the MSM, not on CNBC, and not any of the fund managers I know. Do you have any evidence to support that more people are buy-writing? Probably not.
Mr. Collar says hello and waves his hand.
You got that right, omi!