The perfect trade

[TwoCitiesCapital]

Let's say 20% on a $1,000,000 investment. You're out 200k if you owned the stock, but you can close the position and move on.

 

If you sold the same notional in cash secured puts, you're going to have to pay more than 200k above your sale price to close the contract because now vol has exploded across the term structure and the puts you sold are now going to be at a premium (unless if they're WAY out of the money - and even then, massive bid/ask spreads).

 

 

For institutional trader yes. For PAs you can wait until expiration and take delivery or close out with limited vega and theta exposure.

 

Well yes, that is what I characterized as being stuck in the position. The capital is tied up until expiry OR you lock in a loss greater than the common stock.

 

If you're only selling 1 month puts, being locked up isn't a big deal, but your premiums are tiny, transaction costs eat most of it, and you can expect these things to move against you more frequently. 

 

If you sell them further out, much more opportunity to make greater premiums, less frequency of a negative outcome if held until maturity, but ALSO tying up capital when you're wrong OR taking greater losses than in the common.

 

It's not the same thing as stock ownership and comes with its own set of psychological barriers/problems/biases to work through.

 

I personally like options, but they're not easy and certainly not a substitute for outright stock exposure IMO.

[Castanza]

Let's say 20% on a $1,000,000 investment. You're out 200k if you owned the stock, but you can close the position and move on.

 

If you sold the same notional in cash secured puts, you're going to have to pay more than 200k above your sale price to close the contract because now vol has exploded across the term structure and the puts you sold are now going to be at a premium (unless if they're WAY out of the money - and even then, massive bid/ask spreads).

 

 

For institutional trader yes. For PAs you can wait until expiration and take delivery or close out with limited vega and theta exposure.

 

Well yes, that is what I characterized as being stuck in the position. The capital is tied up until expiry OR you lock in a loss greater than the common stock.

 

If you're only selling 1 month puts, being locked up isn't a big deal, but your premiums are tiny, transaction costs eat most of it, and you can expect these things to move against you more frequently. 

 

If you sell them further out, much more opportunity to make greater premiums, less frequency of a negative outcome if held until maturity, but ALSO tying up capital when you're wrong OR taking greater losses than in the common.

 

It's not the same thing as stock ownership and comes with its own set of psychological barriers/problems/biases to work through.

 

I personally like options, but they're not easy and certainly not a substitute for outright stock exposure IMO.

 

Again, I'm not denying the risk. But I think you're overstating it. MSFT has better premiums doing it weekly than it does monthly. Also avoiding earnings weeks can help reduce risk. Plus if you're really worried about a 20% drop you can offset premiums buy buying a few OTM puts.

 

edit: And you could get whipsawed on that hedge put. So it doesn't completely negate risk.

[TwoCitiesCapital]

Let's say 20% on a $1,000,000 investment. You're out 200k if you owned the stock, but you can close the position and move on.

 

If you sold the same notional in cash secured puts, you're going to have to pay more than 200k above your sale price to close the contract because now vol has exploded across the term structure and the puts you sold are now going to be at a premium (unless if they're WAY out of the money - and even then, massive bid/ask spreads).

 

 

For institutional trader yes. For PAs you can wait until expiration and take delivery or close out with limited vega and theta exposure.

 

Well yes, that is what I characterized as being stuck in the position. The capital is tied up until expiry OR you lock in a loss greater than the common stock.

 

If you're only selling 1 month puts, being locked up isn't a big deal, but your premiums are tiny, transaction costs eat most of it, and you can expect these things to move against you more frequently. 

 

If you sell them further out, much more opportunity to make greater premiums, less frequency of a negative outcome if held until maturity, but ALSO tying up capital when you're wrong OR taking greater losses than in the common.

 

It's not the same thing as stock ownership and comes with its own set of psychological barriers/problems/biases to work through.

 

I personally like options, but they're not easy and certainly not a substitute for outright stock exposure IMO.

 

Again, I'm not denying the risk. But I think you're overstating it. MSFT has better premiums doing it weekly than it does monthly. Also avoiding earnings weeks can help reduce risk. Plus if you're really worried about a 20% drop you can offset premiums buy buying a few OTM puts.

 

edit: And you could get whipsawed on that hedge put. So it doesn't completely negate risk.

 

The aggregate of shorter term premiums typically exceeds long term premiums. (I.e. selling 4 1-week puts would generate more premiums than a 1- month put), but that excludes transaction costs (which aren't insignificant for options and you have 4x as many) and means you'll be assigned shares more frequently because your options have to be near-the-money to make anything.

 

I just think it's a false equivalence to say they're the same just because they are IF you hold to maturity. IF the thesis changes in the underlying, you don't have that luxury and paid a massive penalty for it.

 

The only times options are a decent proxy for the underlying is when you have a long time frame (I e. LEAPS) and are massively in the money so the vol premium is near zero and your delta is 1.

 

I do this all the time in my IRA to get leverage, but it's going long deep-in-the-money calls with 15-18 month expiries.

 

You could do the same selling deep-in-the-money puts and watch the premium erode while the stock rises in value, but this basically ties up the same capital as  owning the underlying.

 

 

 

 

 

 

[Spekulatius]

Or buy puts when VIX is<14 and SPY >300. I am 3:0 on this trade. I think I made about 70% on average each time, just closed my last round yesterday. It’s definitely a no brainer, especially when in addition to above Trump says that trade talks are going well.

 

I am almost serious about this.

 

Have been doing something similar myself, bit it's based entirely on "when markets do well, Trump has enough flexibility to hang himself with it".

 

As long as that dynamic holds, this trade will be profitable. But hard to know when he finally decides to let things ride OR isn't going to save the market by backing down.

 

It’s basically a bet that Trump blows some kind of gasket, or that an generally overvalued market falls or that the continued weakness in many sectors leads to some economic trouble impacting the stock market. The amazing thing to me is not that any of the above frequently occurs, but that Mr Market returns to a state of piece and quite in between where puts become cheap again (with allow VIX).

 

That said, the 3:0 is probably just luck. There is no free lunch and sooner or later  Mr Market will score against that trade.

[DooDiligence]

So the consensus is "trade around core positions that you'd be OK owning in an extended downturn".

[Gregmal]

So the consensus is "trade around core positions that you'd be OK owning in an extended downturn".

 

Ding, ding, ding. We have a winner.

 

 

[jgyetzer]

Also, what percentage of your portfolio are you comfortable committing to these types of strategies?  Although annualized gains on a single trade might look good, if you can only apply this to a small portion of overall portfolio the returns on your time and stress seem limited.

[DooDiligence]

Also, what percentage of your portfolio are you comfortable committing to these types of strategies?  Although annualized gains on a single trade might look good, if you can only apply this to a small portion of overall portfolio the returns on your time and stress seem limited.

 

Yeah & although day trading doesn't fit my temperament, BRK seems to be a safe bet to do this with.

 

Only problem is that when I buy under $200, with the intention of doing this, it goes up & I don't want to cut loose of any shares.

 

Maybe if I got rid of the $200 anchor (and blind trust in management) & just started pulling the handle every day?

 

Not really much stress in that.

[Cardboard]

"Also, what percentage of your portfolio are you comfortable committing to these types of strategies?  Although annualized gains on a single trade might look good, if you can only apply this to a small portion of overall portfolio the returns on your time and stress seem limited."

 

Unfortunately, I think that you have to do that with a fairly large portion of your portfolio these days to generate any kind of attractive return. If not, might as well buy SPY and be done with it.

 

We are in a sideways market where valuation is high and bargains are not say at 3 times earnings or selling for 1/2 of cash. It is quite interesting that LC and I are in agreement for once and he explained it in a much better way than I could:

 

"First, you have a fair value which you believe BAC is worth.

 

Lets say you think fair value or intrinsic value etc. is $35/share, well then you are buying at 77% of FV and selling at 85% of IV."

 

If you look at anything cyclical, turnarounds, asset plays, moderate growers or where value investors typically gravitate they are all quite correlated to market movement right now. So even if your company is making solid progress, it always seems to be brought back down by macro and allowed only to go up when the market goes up.

 

The very small or illiquid stocks may avoid some of that but, even there I am not completely convinced. It is also a different story for the hyper growth and things that cannot be rationally valued but, even these guys are hitting a lot of air pockets these days.

 

There is no exact science to this and it is a case by case but, I think that the fear of missing out especially on mega caps is a big watch-out for investors right now. We always like to hold out to realize full value but, it seems rare these days that we are given this opportunity. So might as well try to take advantage of Mr. Market and risk to see one over-shoot a little.

 

Even Buffett and his bunch trade around core positions if you look at their quarterly holdings. Not with Coke but, they are doing it with banks and other holdings. Then compare with charts or valuation to see when and why they do it?

[muscleman]

What bothers me the most is that Cardboard's definition of the "perfect trade" is a trade that psychologically makes him feel good regardless of the outcome, while the actual "perfect trade" should always have been one with highest expected return, meaning I could lose 5 out of 10 such perfect trades but still make a ton of money.

And some people here seem to really think he came across a genius idea.

Let's take his idea to the extreme: With zero commission these days, Cardboard should have gone to the extreme and always place a buy order at BAC's bid, and right after fill, place a sell order at the ask. In this way, he can make 100 trades per day, making probably 1 cent per trade, which $1 per day. That's 3% a day, and 60% a month! How about that? Is this even more genius than his original idea?  :)

[Gregmal]

What bothers me the most is that Cardboard's definition of the "perfect trade" is a trade that psychologically makes him feel good regardless of the outcome, while the actual "perfect trade" should always have been one with highest expected return, meaning I could lose 5 out of 10 such perfect trades but still make a ton of money.

And some people here seem to really think he came across a genius idea.

Let's take his idea to the extreme: With zero commission these days, Cardboard should have gone to the extreme and always place a buy order at BAC's bid, and right after fill, place a sell order at the ask. In this way, he can make 100 trades per day, making probably 1 cent per trade, which $1 per day. That's 3% a day, and 60% a month! How about that? Is this even more genius than his original idea?  :)

 

I think your interpretation is wildly off base. His idea isn't really groundbreaking, many have been using the framework of this idea forever. Its not really controversial or risky. Its really just called managing a position. For those of us capable of doing fundamental research and investing based off of that, doing this makes perfect sense. Ive never understood why value investors consider it perfectly acceptable to buy the dip over and over but find it blasphemous to sell on the bounce back up. To me it seems both perfectly reasonable, and just logically the proper way to keep you portfolio balanced and flexible. This is irrespective of the parameters one places around risk management and position sizing, which is a totally different subject.

[Castanza]

It's a pretty good idea - I am not denying that.

 

The other component is the "brain damage" associated with this.

 

I do not invest for a living, so I have to ask myself, what do I want to spend my energy on:

 

1- trying to be correct in the long term, or;

2- trying to be correct in the long term AND trying to trade around relative valuation AND trying to value put premiums on a risk adjusted basis AND trying to manage exposure per trade and per portfolio?

 

For those with the time and energy, it is a great idea. Just take a look at boilermaker's posts about doing this with BRK over the years, he is an inspiration in this sense!

 

The writing of puts takes very little effort on blue chip stocks especially if you're not greedy about premiums and go decently out to 95%+ profitability range. I just don't see how this is anymore risky than owning the underlying stock. As Greg pointed out. Value investors are just as likely to hold BAC on the way to zero as someone who would write puts for premiums with the risk of potentially getting assigned. Now if you do this on say Beyond Meat yeah you're a moron. But doing this on SPY or other securities you would hold long-term, I don't see the risk. Maybe I'm missing something....the majority of you on here are much better investors than myself.

 

How many of you would liquidate a portfolio of $SPY if it dropped 15% in a day? If this were to happen the person who got assigned shares now has the advantage vs the person who is holding. I could write covered calls and collect premiums while you have to hold until SPY climbs back to your dca before you could sell or write covered calls.

 

Think about worst case scenario. Stocks gaps down due to bad earnings or after-market news.

 

Let's say 20% on a $1,000,000 investment. You're out 200k if you owned the stock, but you can close the position and move on.

 

If you sold the same notional in cash secured puts, you're going to have to pay more than 200k above your sale price to close the contract because now vol has exploded across the term structure and the puts you sold are now going to be at a premium (unless if they're WAY out of the money - and even then, massive bid/ask spreads).

 

So your two choices are to accept a loss greater than 20% to close the position and stop the bleeding OR to be stuck with the position.

 

It's NOT the same dynamic as owning the underlying stock.

 

Say MSFT is at 140 and I sell strikes at 115 collecting premiums. If MSFT happens to gap down and I get assigned shares bi deal. I have more leverage with my shares than the guy who bought shares at 140 and is now holding the bag. If MSFT bottoms out there I can now sell covered calls and still profit off my cost basis or simply hold long term. But if you bought at 140 you’re going to be taking a loss until it’s back to your cost basis.

 

I don’t see the risk. If MSFT drops 20% I’m buying anyways. I’m collecting premiums up front so really the only thing to keep this stars they going is to not get assigned (which isn’t bad) plus if I buy an OTM put at say 110 and structure the ratio of buy to sell 2:1 I’m only going to lose money on in the range 110-115. Anything below that is a profit and anything above 115 is a profit of premiums. These are just rough numbers.

[jgyetzer]

Muscleman, that is pretty much how I think about it as well.  Maybe it’s because I have a hard time nailing down intrinsic value with precision.  I’m lucky to find businesses in which I am confident that over time, earnings and returns will be satisfactory.  Because those are rare, it’s hard to sell unless I am very certain of full or overvaluation.  I’m usually uncertain that another opportunity to own it will present.  However, if someone is excellent with valuation precision and feels the likelihood for future volatility is high it makes perfect sense to increase or lighten exposure based upon variations in price/value.  I’m just not that good.

[Spekulatius]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

[boilermaker75]

Wrote WFC 48.5, Oct 18 puts for $0.65 per share this morning. I've been doing this for more than 10 years with WFC, BAC, and BRKB. When I get put to I sometimes keep the shares, so a form of a limit order to accumulate stocks at better than current prices, or if I already have a full position I turn around and write covered calls, which is identical to writing CSPs.

 

Edit: I also already have WFC 46.5-strike Oct 11, and 47.5-strike Oct 18 open positions.

[LC]

The master strikes again :D

 

I've been reading your posts doing this for years now - can you comment on average returns (or at least a sense of them, if you don't track explicitly?)

[TwoCitiesCapital]

It's a pretty good idea - I am not denying that.

 

The other component is the "brain damage" associated with this.

 

I do not invest for a living, so I have to ask myself, what do I want to spend my energy on:

 

1- trying to be correct in the long term, or;

2- trying to be correct in the long term AND trying to trade around relative valuation AND trying to value put premiums on a risk adjusted basis AND trying to manage exposure per trade and per portfolio?

 

For those with the time and energy, it is a great idea. Just take a look at boilermaker's posts about doing this with BRK over the years, he is an inspiration in this sense!

 

The writing of puts takes very little effort on blue chip stocks especially if you're not greedy about premiums and go decently out to 95%+ profitability range. I just don't see how this is anymore risky than owning the underlying stock. As Greg pointed out. Value investors are just as likely to hold BAC on the way to zero as someone who would write puts for premiums with the risk of potentially getting assigned. Now if you do this on say Beyond Meat yeah you're a moron. But doing this on SPY or other securities you would hold long-term, I don't see the risk. Maybe I'm missing something....the majority of you on here are much better investors than myself.

 

How many of you would liquidate a portfolio of $SPY if it dropped 15% in a day? If this were to happen the person who got assigned shares now has the advantage vs the person who is holding. I could write covered calls and collect premiums while you have to hold until SPY climbs back to your dca before you could sell or write covered calls.

 

Think about worst case scenario. Stocks gaps down due to bad earnings or after-market news.

 

Let's say 20% on a $1,000,000 investment. You're out 200k if you owned the stock, but you can close the position and move on.

 

If you sold the same notional in cash secured puts, you're going to have to pay more than 200k above your sale price to close the contract because now vol has exploded across the term structure and the puts you sold are now going to be at a premium (unless if they're WAY out of the money - and even then, massive bid/ask spreads).

 

So your two choices are to accept a loss greater than 20% to close the position and stop the bleeding OR to be stuck with the position.

 

It's NOT the same dynamic as owning the underlying stock.

 

Say MSFT is at 140 and I sell strikes at 115 collecting premiums. If MSFT happens to gap down and I get assigned shares bi deal. I have more leverage with my shares than the guy who bought shares at 140 and is now holding the bag. If MSFT bottoms out there I can now sell covered calls and still profit off my cost basis or simply hold long term. But if you bought at 140 you’re going to be taking a loss until it’s back to your cost basis.

 

I don’t see the risk. If MSFT drops 20% I’m buying anyways. I’m collecting premiums up front so really the only thing to keep this stars they going is to not get assigned (which isn’t bad) plus if I buy an OTM put at say 110 and structure the ratio of buy to sell 2:1 I’m only going to lose money on in the range 110-115. Anything below that is a profit and anything above 115 is a profit of premiums. These are just rough numbers.

 

I must not be very good at communicating the nuance of the position.

 

Selling puts is a grand strategy. I do it myself.

Selling puts on positions you don't mind owning is a grand strategy. I do it myself.

 

My argument has been:

1) Selling puts is NOT equivalent to owning the stock in most circumstances

 

2) Selling puts has its own unique challenges - particularly with position management when the underlying has steep losses AFTER selling the put and/or if your underlying investment thesis changes and you need to get out of the position

 

 

I'm simply cautioning people from believing that selling puts or going long calls is the same as equivalent to owning the underlying because the economics are very different all the way up to the contract's maturity.

 

This will be my last post on this because if that doesn't successfully communicate my points, or people still disagree, then we're just at an impasse.

[boilermaker75]

The master strikes again :D

 

I've been reading your posts doing this for years now - can you comment on average returns (or at least a sense of them, if you don't track explicitly?)

 

I don't track explicitly. My main use is as limit orders to enter positions at good prices. Every stock I own I entered this way and I am close to 100% invested. The only stock I didn't get doing this was MCD back when MCD was around $90. That is the downside, missing out because the stock moves up and I never get put too. Since I am typically 95-100% invested, if I get put to everything I would be on margin. So I am usually conservative writing out of the money puts so I am not looking to make 15-20% with this strategy. I'm happy with 8-10%, which is about my guess for my put writing return.

[Castanza]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

[boilermaker75]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

 

And you are not going to get steamrolled if you are purchasing companies like BRKB, WFC, and BAC. There has never been a time where getting put to on BRKB was not a good thing.

[Liberty]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

 

And you are not going to get steamrolled if you are purchasing companies like BRKB, WFC, and BAC. There has never been a time where getting put to on BRKB was not a good thing.

 

Getting put the big banks at the beginning of the financial crisis probably wasn't that great, though...

[TwoCitiesCapital]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

 

And you are not going to get steamrolled if you are purchasing companies like BRKB, WFC, and BAC. There has never been a time where getting put to on BRKB was not a good thing.

 

Hind sight bias.

 

Seems like plenty of people would have been steamrolled doing this with WFC or BAC in 2007/2008.

 

Plenty of people would have been steamrolled doing this with KHC/GE in 2018/2019.

 

Every year, there is a "safe" and "solid" blue Chip that has dismal performance. Hindsight bias makes us feel comfortable taking risks with these names, but it can be a pretty bad deal if you're selling puts on margin on one of these when that occurs.

 

If options were so easy to make money in, everyone would do it. The problem is that there are occasional blow-ups where the loss on the position wipes out multiple prior trades' gains.

[writser]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

 

Ask the traders from LTCM.

[Castanza]

I think these “perfect trades” are a well known staple in trading. It’s called picking up pennies in front of a steamroller.

 

Is it really picking up pennies when your making 30-40% ROC a year?

 

Ask the traders from LTCM.

 

They were heavily leveraged. 25:1 debt ratio....I’m selling otm cash covered puts on blue chip equities which I already own. Hardly an equal comparison.

[writser]

Of course I know that. My point was that the return you generate doesn't tell you whether the underlying strategy has blow-up potential or not. You can pick up pennies with high turnover, or with high leverage, or with high profit margins, but, to answer your question, even if your strategy returns 30% p.a., yes, in the end you are still picking up pennies in front of a steamroller.

 

Also, you sell insurance on blue chips. I don't know how you calculate your ROC but consider me extremely skeptical about that strategy generating a 30%-40% risk-adjusted return for a retail investor. It's not exactly rocket science.