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TMFPostOfTheDay (< 20)

Selling the Upside

Recs

3

June 11, 2012 – Comments (2)

Board: Value Hounds

Author: captainccs

DTM:

I have to thank you for your objections to the covered call strategy. I have been thinking about explaining why it is a good idea to exchange a large potential upside for a smaller realizable upside, the proverbial bird in the hand vs. two in the bush.

In reply to the covered call strategy you wrote in part:

I am just saying that people should be conscious that they are selling off the upside associated with their stock picks, that they may or may not be getting adequately compensated for this, and that for most people, knowing whether or not the compensation is adequate is not within their sphere of competence, and quite apart from the other reasons to be wary about options (the commissions, the large spread, the unfavorable tax treatment, etc.), they should think twice before adopting this strategy.

Regards, DTM


That's a rather long sentence. Let's break it up:

people should be conscious that they are selling off the upside associated with their stock picks

YES! This is a point I have pondered long and hard. I have an answer that is satisfactory for me but not necessarily for others. Details below.

that they may or may not be getting adequately compensated for this

Well, one should sell the calls only when one is satisfied that the compensation for the potential lost upside is adequate. This is also part of the answer that I find satisfactory but which might not satisfy others.

...and that for most people, knowing whether or not the compensation is adequate is not within their sphere of competence...

I don't like calling people incompetent ;). People have been known to learn new tricks ;). But in any case this is not my concern. It would be if I were a professional investment adviser which I'm not. My concern is solely my portfolio.

and quite apart from the other reasons to be wary about options (the commissions, the large spread, the unfavorable tax treatment, etc.), they should think twice before adopting this strategy.

It's their money so yes, they should think about it twice, three times, ten times. Until they are satisfied that it is or is not worth doing. I certainly don't have a quarrel with that.

--------------------------

I have no idea who Al Duncan is but his words, quoted below, sum it up rather nicely.

“Don’t rock the boat.”
“Better safe than sorry.”
“A bird in the hand beats two in the bush.”

These timeless maxims are sage advice. When taken to the extreme, however, they create a certain poverty of ambition.


http://www.alduncan.net/poverty-of-ambition.html

What should one's ambitions for one's portfolio be? If you want to be ambitious, what's the most you can expect from investing in the market?

Seventy five percent of all investors under-perform the market. If you just want to match the market, buy index funds and be done with it. I wrote about the systemic distribution of wealth that applies to the stock market. It might be a good place to start understanding my POW:

Why Does the Average Mutual Fund Under-perform?
http://softwaretimes.com/files/why+does+the+average+mutua.ht...

The market averages in the long run around ten percent. If you want more you have to be in the top 25% of investors. How much can a "super-investor" expect? Walter Schloss with a 20% lifetime average was considered a genius. Expecting more than 20% would not be "poverty of ambition" but "reckless ambition."

Peter Lynch is famous for ten baggers but he never said in what time frame. A ten bagger in 100 years has a CAGR of 2.3%, nothing to write home about. A ten bagger in ten years has a CAGR of 25.9%. If you can put together a string of investments yielding 25.9% you have a "synthetic" ten bagger. I'm more than happy to give up potential yield above 26% in exchange of a more certain 26%.

One also has to worry about the downside. What if the trade goes against you? I want to buy my stocks at a discount, how deep depends on the stock. Suppose you want a 15% discount. The premium has to be 15% of the stock's current price.

Now you have the two numbers that allow you to find the ideal option, the one with a high enough yield and a high enough discount. You calibrate the option by adjusting the strike price and the expiration date. That's why you need a spreadsheet. If you find a stock you like with an option that meets your selection criteria for yield and discount, you go for it. Else you pass.

By a curious coincidence, selling covered calls also solves part of the problems talked about in the biology of a bubble. Your upside is capped so there is no sense in wasting adrenaline on it. But there is still downside you can use your extra adrenaline to worry about that.

Like with all tradeoffs, you have to make sure you are getting a good deal.

Denny Schlesinger

2 Comments – Post Your Own

#1) On June 11, 2012 at 2:27 PM, NajdorfSicilian (99.88) wrote:

Selling covered calls is an absolutely terrible strategy.

You have no idea if the price you are receiving is sufficient for the return given up unless you are a professional options trader. Unless you believe 'Price doesn't matter....' like TMF used to.

 Adding in the massive b-o spread, fees, comissions, and taxes, and it is literally the very WORST 'strategy' available to retail.

The absolute worst.

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#2) On June 11, 2012 at 3:06 PM, JaysRage (90.03) wrote:

There is nothing wrong with selling covered calls against a long position that is relatively non-volatile that you think might be topping.   It's similar to setting a sell position, only you also get the premium.   If the stock doesn't reach your sell point, fine, you pocket the premium, if it does, you sell at the strike price + the premium.  No big deal.  

These strategies are not intended for use with highly volatile stocks, high beta stocks, or high growth stocks.....these are just small income strategies to lever already existing stable positions for some additional income.      

It's similar to buying into a stock by selling cash-covered puts.  

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