Excellent quote about the market and Depression from the Davis Dynasty

[Guest JackRiver]

SD

 

If we all wait till March might we not get it for 50% to 60% off?  I think you are walking down a very slippery slope with your line of reasoning.  Your logic will eventually take us to a price just shy of zero.

 

Yours

 

Jack River

[Guest ericopoly]

Eric

 

My post/reply was directed towards SharperDingaan. 

 

Yours

 

Jack River

 

 

Okay, thanks.  Didn't see the "SD".

 

 

"Look for the lowest point on the historic trend & set at 10% above that. "

 

What period of history is relevant to this "historic trend"?  Past 10 days, 10 weeks, 10 months, 10 years?  

 

And then what?  There won't be any more bear market rallies that will carry you up to your purchase price only to take you down 40% from there?  That's what I'm getting at.

 

 

 

 

 

[SharperDingaan]

 

Not that slippery, & its really only feasible if you're private money.

Its essentially a version of the 'paradox of thrift' & its not untill too many people (public money, mass market, etc) do it that it becomes a problem. For the most part the first time you get whipsawed (hopefully at an inflexion point) you will be back in the security, however there is nothing to say that it might not drop again right afterwards. Its just a one-time mutually exclusive purchase, based on the best information that you have today.

 

Its also self correcting as the lower the price goes, the more market $ on the sideline waiting for that 'trigger' event, the bigger the subsequent rebound, & the greater the market incentive to trigger it.   

 

 

 

 

[Phoenix01]

I have been looking at selling puts as a way to generate some $$ while waiting for the prices to drop.  If the price does not drop, the premium is cash in the pocket a t a time when cash is king.  If the price drops, the net price paid is lower than if the stock had been purchased initially.

 

Any thoughts on this strategy?

[Uccmal]

I have been looking at selling puts as a way to generate some $$ while waiting for the prices to drop.  If the price does not drop, the premium is cash in the pocket a t a time when cash is king.  If the price drops, the net price paid is lower than if the stock had been purchased initially.

 

Any thoughts on this strategy?

 

Yeah, Unless you have a huge amount of margin available dont bother.  Selling puts in a declining market sets you up for margin calls.  Take my word for it.  Unless you have the cash set aside to buy the underlying stock at the strike it will be a complete disaster.  I have decided that my market prediction skill is simply not good enough for this climate.  I sold GE puts for $6 when the price was at around $19.  Well, January came and went and I became the proud owner of GE stock which I have since sold to generate the tax loss and buy FFH calls.  If you have a huge amount of cash then go for it. 

 

But then If I had a huge amount of cash I would be buying about 6 zillion other things right now. 

 

 

[oec2000]

I have decided that my market prediction skill is simply not good enough for this climate.

 

What?! And, you didn't make this disclosure when you made the mkt capitulation call? Phew, am I glad I didn't act on your call. ;D (Sorry, just couldn't resist making that dig - but we need all the humour we can get in these dismal markets.)

 

I have been looking at selling puts as a way to generate some $$ while waiting for the prices to drop.  If the price does not drop, the premium is cash in the pocket a t a time when cash is king.  If the price drops, the net price paid is lower than if the stock had been purchased initially.

 

Any thoughts on this strategy?

 

My 2 cents:

 

1) Generally speaking, the drawback of selling options is the poor risk/reward economics - i.e. your downside is more than your upside. At a time when many stocks are 70-80% off their highs, are trading below intrinsic value and have very favourable risk/reward characteristics (on a 5-yr timeframe), you have to ask yourself whether you want to limit your upside while still exposing yourself fully to the downside.

 

2) It depends on how is the rest of your portfolio positioned?

 

If you are already significantly long stocks and would benefit from a mkt recovery, then selling the puts to get some income (best case) or average down on your existing stocks at lower prices, then the strategy is probably OK if you can find generously priced options.

 

If you have very little exposure to stocks currently, you would be better off scaling gradually into stocks. You can, for e.g., plan your purchases such that you would end up having an average cost no different from what you would have achieved by selling the puts. This way, you retain some upside if the mkt bottoms out right here.

 

3) The other disadvantage of trading options is that timing is crucial. Say you sell GE $5 puts because you think $5 is a good entry level for GE. You collect $1.30 for the 2010 LEAP. Then GE drops below $5 over the next 3 months but then recovers to $10 by Jan 2010. You will make $1.30 but you will have missed the opportunity to buy GE at $5 even though you were perfectly correct in your price predictions.

 

My personal preference is to use options as a risk management tool (which usually translates into buying options) although there are times when I do sell options when I fell they are grossly mispriced (e.g. when FFH options were selling for 8-9% with less than a month to expiry in Sep 08).

 

You might find it useful to try both alternatives on a small scale just to get a feel for which works better.

 

I know there are other members on this board who appear to be more prolific options traders then I am. They might see some flaws in my thinking.

 

 

 

 

 

[Guest ericopoly]

 

My personal preference is to use options as a risk management tool (which usually translates into buying options) although there are times when I do sell options when I fell they are grossly mispriced (e.g. when FFH options were selling for 8-9% with less than a month to expiry in Sep 08).

 

 

 

I don't know if you saw my post about hedging.  I suppose I created a bit of a Frankenfund.  I was heavily concentrated in FFH, so I sold some.  The cash from the sale I used to write cash-covered puts, the premium generated I used to buy FFH calls to replace the exposure I sold.

 

So it's a diversified downside, and a concentrated upside.  The 2011 FFH LEAPS are cheap compared to many of the deep-out-of-the-money puts.  I pointed out that the 2010 SHLD $12.50 puts are selling at roughly 20% of strike price (I got paid $2.50) -- the company would be trading for it's cash at that strike price.  That 20% can be used to buy at-the-money 2011 FFH LEAPS.  So you see, the downside exposure expires in 2010, but the upside expires a full 12 months later.  During those 12 months, I will have no downside exposure and could thus generate more money from cash-covered puts.  Far more than the FFH dividend I might add.

 

A little over a month ago I was paid 75 cents for the $2.50 strike RWT puts.  Now that's a 30% of strike premium, despite the fact that RWT was trading around $15 on that day.  So there is about 83% decline needed before I would have to buy the shares at $2.50.  For every dollar at risk, I can buy 1.5x dollars of upside of FFH (because the FFH premium at-the-money is only 20% vs 30% premium for deep-out-of-the-money RWT).

 

So, I think if you are clever you can find extremely expensive yet deep-out-of-the-money puts to write, and then use the premium to buy cheaper longer lasting LEAPS at-the-money.

 

I think you'd be surprised how much some of the puts go for, and what that premium can do for you in terms of picking up cheap calls -- you can actually lever up this way while reducing your downside risk at the same time.  Leveraged upside vs deep-out-of-the-money unlevered downside.

 

Maybe I'm just too bored.  I did go skiing today (Big Sky) -- that was a good break from the laptop.

[Guest ericopoly]

It looks like you can write the 2011 $10 LUK put and lever up nearly 2:1 by using the proceeds to buy the at-the-money 2011 FFH call.

 

 

Does that make sense?  Is LUK riskier than FFH?  Will 2:1 FFH leverage not likely exceed the unlevered upside potential of LUK?

 

 

[oec2000]

I don't know if you saw my post about hedging.

 

I did and thought it was a smart way to pay for your FFH calls because it addresses two points I raised - risk mgmt (the FFH calls reduce your FFH risk) and selling expensive (or mispriced) options.

 

The problem with Phoenix's strategy is that there is limited upside for him if the mkt bottoms here.

 

I have also been buying the cheap FFH calls (which have been getting even cheaper!) to limit my downside and using the balance of the cash, which I would otherwise have had to use if I had bought FFH common, to buy pfds yielding 20-30%. So, say I bought the 250 FFH calls for $50; then used $200 to buy WFC.PR.L yielding 20%. By Jan 2011, assuming WFC is still around and did not stop the dividends, the $200 should have accumulated to more than $280. Anything I can recover/earn from the FFH call is icing on the cake. If your risk tolerance is lower than mine, you can buy the 12% ORH.PR.A pfds instead. There's more - whipped cream on the icing - if the pfds trade back closer to par, there is a capital gain on the pfds to boot!

 

 

[Guest ericopoly]

I like the idea of the preferreds.

 

The big thing working in our favor is that the 2011 option costs only 38% higher than the 2010.  This implies that there should still be about 72% residual value in those 2011 calls a year from now even if FFH price is exactly the same.

 

I know there was some concern on this thread about margin calls with writing puts -- to clear it up, you don't need a margin account to write puts.  I have written them in my IRA accounts, where margin is not allowed by law.

 

 

[Phoenix01]

Thanks to Al, Eric & oec2000, your insight is very useful.

 

I have had several of my puts assigned.  Usually when the market is tanking.  Lesson #1: keep the cash on hand!  The margin will probably disappear at the same time that you need to buy the shares.

 

The market usually bounces back fairly quickly, so once the initial cash drain occurs, there is usually an opportunity to offload a portion of the position at a profit.  This however does not seem to last very long.  Lesson #2: don't get too greedy.  Take the easy return and leave the balance to others.

 

Eric, I find your strategy with options intriguing.  It appears that the puts are a way of getting a yield on your cash.  The re-investment of the yield on cheap calls is simply an investment (in this case of the yield).  This works if the puts are not assigned.  I am guessing that your puts are significantly out of the money.

 

I was looking at a much simpler view of buying using puts.  If assigned/exercised, then the desired discount was achieved and the shares are purchased at a discount.  If not, the cash is yours to keep.  In this environment, there are so many opportunities that collecting the premium creates new opportunities in the future.

 

[Uccmal]

Eric, I should have phrased that more appropriately.  When you write puts you are required to post a large amount of collateral.  The more the stock drops the greater the collateral requirement.  In my case writing puts caused me to have a margin call due to the huge amount of collateral they require.  This was in the November phase of the crash. 

 

Moving along, I dont know if you have perused Derek Foster's book "Money for Nothing".  Derek bills himself as Canada's youngest retiree.  Recently he was talking about a situation where he wrote some puts for Vulcan.  Vulcan, an aggregates company in the US, was trading around $80 when he wrote the puts.  He wrote the puts for 60 strike for $4.00.  The stock dropped way down.  He didn't have to exercise since they are 2010 puts.  He states that he renegotiated the puts at a cost of $8.90 to a 45 strike price for proceeds of $9.40.  In effect he reset his buy-in price to 45-9.40 = 35.60.  His profit on the puts would then be $4.00 from the original wiriting plus 0.50 fromt he renegotiated price.

 

Is this possible?  How would one go about it?

 

It wouldn't have helped me at the time because I was in a position of margin calls but in the future it is worth knowing.   

 

Phoenix, Lesson #1 is proving to be perhaps the most important lesson of all.  The margin does disappear when you need to buy the shares! 

 

Lesson #2:  I agree fully.  I am narrowing my focus to companies where I can definitely quantify the risks and fully comprehend the business model.  If I had 15 cents for everytime a CEO has uttered the words "we have no intention of cutting our dividend"  I wouldn't need to be writing puts for income.  It has become very clear to me that the vast majority of the business leaders in the area of finance, insurance, and banking have NO IDEA how to manage risk or even identify it. 

 

 

[Guest ericopoly]

Moving along, I dont know if you have perused Derek Foster's book "Money for Nothing".  Derek bills himself as Canada's youngest retiree.  Recently he was talking about a situation where he wrote some puts for Vulcan.  Vulcan, an aggregates company in the US, was trading around $80 when he wrote the puts.  He wrote the puts for 60 strike for $4.00.  The stock dropped way down.  He didn't have to exercise since they are 2010 puts.  He states that he renegotiated the puts at a cost of $8.90 to a 45 strike price for proceeds of $9.40.   In effect he reset his buy-in price to 45-9.40 = 35.60.  His profit on the puts would then be $4.00 from the original wiriting plus 0.50 fromt he renegotiated price.

 

Is this possible?  How would one go about it?

 

 

 

The pattern I've noticed is that initially the out-of-the-money put is fairly expensive (relatively high volatility when written), and it doesn't get relatively all that more expensive when the stock drops down to strike.  For example, I think GE was a $9 stock recently (Feb 25th) when I wrote the 2010 $5 strike put for about 98 cents.  Now the stock has dropped almost $2 but the put has only increased by about 35 cents.  I would expect the put to go to maybe $2 per share if the stock drops all the way down to $5 bucks.  So, I could have initially been long GE stock and been down about $4 when the stock drops to $5, or be down just a buck on the puts if the stock drops to $5 (that's my answer to the guy who says that by writing the put I miss out on being able to buy GE at $5 if it gets there).  So, let's say the shares are at $5 and I decide that I really want to own the stock.  Well, one thing I could do is just take the $1 loss by buying the put back at $2 and essentially I'd be at roughly a cost basis of $6 for the stock.  Still much better than if I'd initially paid $9. 

 

Back on November 14th, LUK was trading at a low of $18.73 and a high of $20.93.  Now get this, I wrote the 2010 $15 strike put on that day for a little more than $5 (actually, the exact prices were $5.09 and $5.29).  Today, the stock has tanked about $8 and yet I can buy those puts back for $6.30, no more than about $1.20 extra.  However, at current stock price I'm still in profitable territory by expiration date whereas the guy who bought at $20 is taking quite a hit!  Now, I might decide that this is the bottom tomorrow and buy the puts back at $6.30 and use my cash to just buy the shares instead.  I'm in a lot better position than if I'd initially bought the shares for about $20.  My adjusted cost basis would be about $12, vs nearly $20.  This isn't quite as good as the guy who just did absolutely nothing and paid $10.85 for the shares, but it isn't realistic for a guy like me to just sit on cash and not swing at $15, or $14, or $13... I'd never be the guy who calls the bottom accurately in other words.  But I hate being the guy who buys at $20 trying to hit a home run when I could instead swing for 50% without any risk of loss until the stock get cut by more than half.

 

So to me, this is what puts offer in an environment of high volatility.  They give you a decent return (in this LUK example it was 50% return over the cost basis put at risk), and they also give you the optionality to wiggle out of the put for just a $1.20 or so fee per share and buy the shares after they've dropped by $8-10 per share.  Now, go back to November 14th and the guy buying the shares would need a price of $30 to get a 50% return, at risk of nearly a 50% loss if shares dropped to where they are today.  My position gives me a 50% gain as long as the shares trade no lower than $15 at expiration, but provide me with a loss only if the shares are under $10 at expiration.  The only situation where I come out behind is if the shares had just gone up and had never dropped down to today's prices -- but again, how greedy must you be?  50% isn't enough?  Now that I have much more downside protection, I might just get greedy and buy back the LUK put and buy the shares.  After all, it's roughly at book value excluding the tax asset -- this might be the time.

 

 

 

 

 

 

[Guest ericopoly]

In Derek Foster's example it sounds like he bought back his original put position once it was in-the-money (the volatility premium was therefore largely gone), and then replaced it with another round of at-the-money puts at a time when volatility was very high.  If volatility was 33% of strike when he wrote the replacement puts, then that would produce the kind of numbers to give him about a $4 per share gain (the initial premium).  He doesn't quite explain it that way, but it makes sense. 

 

[oec2000]

Is this possible?  How would one go about it?

 

In Derek Foster's example it sounds like he bought back his original put position once it was in-the-money (the volatility premium was therefore largely gone), and then replaced it with another round of at-the-money puts at a time when volatility was very high.  If volatility was 33% of strike when he wrote the replacement puts, then that would produce the kind of numbers to give him about a $4 per share gain (the initial premium).  He doesn't quite explain it that way, but it makes sense. 

 

It's possible but in order to get a net credit on the switch, he would have had to extend the expiry - the 45 put will have to be for a further out month. But, you cannot always save your position this way - it depends on how much the price has dropped and how much further out you can go.

[oec2000]

(that's my answer to the guy who says that by writing the put I miss out on being able to buy GE at $5 if it gets there).  So, let's say the shares are at $5 and I decide that I really want to own the stock.  Well, one thing I could do is just take the $1 loss by buying the put back at $2 and essentially I'd be at roughly a cost basis of $6 for the stock.  Still much better than if I'd initially paid $9. 

 

What I said was to scale into the position - "plan your purchases such that you would end up having an average cost no different from what you would have achieved by selling the puts." So, you would not be stuck with stock at a cost of $9 on your full position if the stock does fall to $5 or lower. The key is that if the stock does not fall below $9 and the mkt bottoms and GE recovers to $20, your upside is not limited. The reason I'm advocating this approach is because of where mkts are today (stocks already down 70-80%) and the "risk" that mkts could be very close to the bottom - to me, managing the upside risk is as important as managing the downside risk.

 

Also, by trading the common, you are not exposed to volatility spikes that might be expected if GE were to fall to $5. The option strategy can work, I agree, but has too many moving parts and requires higher maintenance. It's probably fine if you can initiate your put at very good prices but these opportunities are transient and easy to miss unless you are glued to the screens all day.

[oec2000]

I agree fully.  I am narrowing my focus to companies where I can definitely quantify the risks and fully comprehend the business model.

 

In the situations where you can do this, wouldn't it make more sense to just go long the stock or calls, as in FFH or ORH?

 

Btw, is Derek Foster the guy who retired on something like $1,500 a month? Wonder how his strategy is coping with the dividend cuts we are seeing everywhere?

[nodnub]

Btw, is Derek Foster the guy who retired on something like $1,500 a month? Wonder how his strategy is coping with the dividend cuts we are seeing everywhere?

 

That's the guy, but I don't know what his retirement income was.  He wrote a book on using put options for income so it's likely that his strategy has changed a bit over the last couple years.

[Guest ericopoly]

 

What I said was to scale into the position - "plan your purchases such that you would end up having an average cost no different from what you would have achieved by selling the puts." So, you would not be stuck with stock at a cost of $9 on your full position if the stock does fall to $5 or lower. The key is that if the stock does not fall below $9 and the mkt bottoms and GE recovers to $20, your upside is not limited. The reason I'm advocating this approach is because of where mkts are today (stocks already down 70-80%) and the "risk" that mkts could be very close to the bottom - to me, managing the upside risk is as important as managing the downside risk.

 

 

 

Yes -- long shares/calls will be the winning strategy when the underlying turns.  Whenever that is, we won't know it until it's passed.

 

 

[Uccmal]

In the situations where you can do this, wouldn't it make more sense to just go long the stock or calls, as in FFH or ORH

 

Well OEC, that is exactly what I have done.  I have not been out of FFH for 12 years and my position is now as high as it has ever been.  Unfortunately the recent 35% drop in the FFH share  price didn't help my portfolio value in these tough times.  However, I have reasoned that FFH is exposing me to a proportionate share in GE, WFC, JNJ, etc.  Interestingly if I add up all of my shares of FFH and the amount of shares/FFH share of each of these companies it would likley equal what I would want to hold in anything else on the rebound. 

[Guest ericopoly]

In the situations where you can do this, wouldn't it make more sense to just go long the stock or calls, as in FFH or ORH

 

However, I have reasoned that FFH is exposing me to a proportionate share in GE, WFC, JNJ, etc.  Interestingly if I add up all of my shares of FFH and the amount of shares/FFH share of each of these companies it would likley equal what I would want to hold in anything else on the rebound. 

 

I reasoned it's better than that even, because you have this roughly 15% or so (relative to share price) after-tax from the rest of the portfolio (bonds).  At least that's what I think it will come in at -- will be nice when we actually get a portfolio yield update from Watsa.

 

So that's why I bought so many FFH calls and paid for quite a bit of it by writing puts way-out-of-the-money to diversify my downside with a huge margin of safety at the same time.

 

Anyways, that's why I write puts in such names instead of just buying the shares -- I want a large margin of safety and I am essentially buying the shares anyhow with the FFH calls, plus income from the float, without even taking on the risk of the float!

 

I guess I talked about that too much now -- I am just very excited about the prospects.

 

 

 

 

[Guest ericopoly]

In this respect FFH acts like a transform, buying individual names where options are expensive, repackaging them into FFH, and the end product is cheap options.

 

Maybe Mr Market's theory is still that structure reduces risk?

 

[Guest ericopoly]

Nice, I'm a "Full Member".

[oec2000]

Well OEC, that is exactly what I have done.  I have not been out of FFH for 12 years and my position is now as high as it has ever been.  Unfortunately the recent 35% drop in the FFH share  price didn't help my portfolio value in these tough times.

 

Al, maybe you might find this useful. It's a strategy I use to try and dampen the impact of FFH price volatility on my portfolio since it is also my largest position (although my % exposure is nowhere near as high as yours, as you've indicated in other posts).

 

1) I try to take advantage of sharp swings in FFH trading to sell options to reduce the cost of calls that I've bought. So, I might sell shorter dated calls against the longer dated calls that I am holding. For e.g., I did this after the short squeeze in Sep/Oct and more recently before the Q4 results. Yes, I do run the risk of limiting my upside if FFH has a major run-up - but I manage this risk by i) selling no more than half the number of calls that I'm long, ii) selling these calls in stages as the price keeps on going up, iii) doing the Derek Foster thing if the calls go into the money.

 

If/when the price goes the other way, as in recently, I look for opportunities to sell puts with matching maturities to the calls I've sold. If I'm able to do this, my breakeven levels get better since I can only get exercised on one side - but I've collected premiums on both sides.

 

2) I also look for opportunities to swap between holding common and LEAPs. As long as the LEAPs are not deep in the money, they do not move on a 1:1 correspondence with the common (basically, the delta). So, if the common rises sharply, I switch out of the common into moderately in-the-money LEAPs - if the market corrects, the LEAPs should fall in value less than the common thus offering some downside protection. If the common falls sharply, I look for opportunity to switch back into the common - to get the full benefit of a rebound. (I have not done it this round because the calls are so cheap and I want to take advantage to build up a much bigger position with limited risk.)

 

I know it's complicated and it's high maintenance but I don't like volatility and I am driven by a desire to squeeze out risk wherever possible. For a significant holding in extremely volatile markets, I feel this extra effort is worthwhile.

 

Ericopoly, as the resident options guru, any thoughts on what I'm doing?

 

 

[SharperDingaan]

 

Pay more attention to liquidity as you will need to maintain around 130% of the contract value.

If you're also doing this entirely with margin recognize that you're leveraging up your risk, so assume that the portfolio you're margining against will be down 30% on maturity date. As Eric has alluded, margin driven premature sales can really wreck your day. 

 

Assume: 1 short put @ 50

- It generates a put margin requirement of 6,500 [100x50x1.30]

- At 70% margin, the 6500 requires 9,285 of unencembured marginable portfolio assets [6500/(1-.3)]

- Anticipate a 30% portfolio decline & you need 13,265 of assets [9250/(1-.3)]

 

But ... holding a significant portion of the 130% margin requirement as cash, will significantly reduce your portfolio risk.

Liquidity.

 

SD