Value investing in options?

[bargainman]

I think a great target for covered call strategies are relatively stable stocks that aren't moving too much, things like MSFT, Loews etc. If you have a strong idea of the firm's intrinsic value, this is another great way IMO of expressing that view and gaining an extra return because you are going into the trade more informed than your counterparty because you know the stock so well. This strategy IMO, is perfect for value investors. I believe WEB himself began his position in BNSF by selling puts.

 

I agree with relatively stable stocks, but disagree with the 'aren't moving too much'.  Options premium is determined by volatility which does not always equal business risk.  As such you will get relatively small premiums for companies with low volatility.  Personally I prefer stocks that are pretty volatile where I believe there is reasonable downside protection, either in the way of assets or recurring revenue and moat.  Your premiums in those scenarios will be much higher.

 

The other thing I usually do is sell puts right after a stock gets dumped.  Usually near the 52 week lows.  In that case you get 2 benefits if you fundamentally believe in the stock.

1. the stock just dumped and is near lows meaning chances are there's a margin of safety, plus at a supply/demand level, the people who were going to sell are already shaken out to some degree.

2. due to the stock drop, usually you get a spike in volatility driving put premiums up, sometimes through the roof (check out EBIX's latest options.  you can get something like an 8% return in less than 2 months)

[ItsAValueTrap]

Options premium is determined by volatility which does not always equal business risk.

 

I would second that.

 

It's kind of confusing and unintuitive, but the direction of a stock more or less doesn't matter when it comes to pricing the option.  If you delta hedge the direction of the stock price mostly doesn't matter (and if dynamic hedging worked in real life, the direction of a stock really wouldn't matter at all).

 

Another common factor that affects options pricing is the borrow cost to short a stock.  Bargainman mentioned EBIX.  The costs to short sell EBIX is probably very high since put/call parity for the options have broken down (I am too lazy to check the borrow costs).  If you are a retail investor, the options on heavily shorted stocks can make A LOT of sense.  Because your broker usually does not pass the borrow costs onto you (they lend your shares out, collect interest, but don't pay you that interest)... the options market allows for an easy arbitrage trade (the risk is that your broker blows up, causing you to lose money in your margin account; this risk is low in my opinion).

If a stock is heavily shorted, it's probably a bad sign for the stock though.

[hyten1]

some info on constructive sales

 

http://www.fool.com/school/taxes/1999/taxes990723.htm

[hyten1]

so lets say you use this constructive sale exception

 

lets say BAC pops sometime this year, let just say it goes to $20 (but you still want to hold the stock for long term), you decide to lock in some gain, yet at the same time you don't want to pay capital gains tax

 

you can than sale short BAC sometime this year, lets say you sold short at $20 (and you have 1000 shares).

 

- You bought 1000 BAC for a cost base of $5 in 2011 - $5000

- You sold short BAC in Dec 31 2013 at $20 - $20,000

- You close your short on Jan 10th (before Jan 30th) of 2014, let say stock drops to $15, you have a $5 per share gain

- You keep on holding you BAC after 60 days pass Jan 30th of 2014 when you close your short

 

in this senarios you have took out gain of approx $5,000, but you now have to reset your holding period for the stock you hold for BAC to Jan 10th (which can be good or bad depending on what you want) and you don't pay any capital gains tax (your cost base for BAC is still at $5, however your holding is reset to Jan 10th 2014).

 

i hope i got this right?

 

 

 

[ERICOPOLY]

so lets say you use this constructive sale exception

 

lets say BAC pops sometime this year, let just say it goes to $20 (but you still want to hold the stock for long term), you decide to lock in some gain, yet at the same time you don't want to pay capital gains tax

 

you can than sale short BAC sometime this year, lets say you sold short at $20 (and you have 1000 shares).

 

- You bought 1000 BAC for a cost base of $5 in 2011 - $5000

- You sold short BAC in Dec 31 2013 at $20 - $20,000

- You close your short on Jan 10th (before Jan 30th) of 2014, let say stock drops to $15, you have a $5 per share gain

- You keep on holding you BAC after 60 days pass Jan 30th of 2014 when you close your short

 

in this senarios you have took out gain of approx $5,000, but you now have to reset your holding period for the stock you hold for BAC to Jan 10th (which can be good or bad depending on what you want) and you don't pay any capital gains tax (your cost base for BAC is still at $5, however your holding is reset to Jan 10th 2014).

 

i hope i got this right?

 

I believe you got it right.

 

You anticipated a pullback so you hedged.  But you only have to pay tax on the $5 gain (the size of the pullback in the stock price) instead of paying tax on $15 of gain. 

 

So it's a nifty trick.

 

Prior to this rule coming into effect (under Clinton's second term), there was no requirement to ever close out your hedge.  So you could suspend your capital gain into perpetuity (or until you die to get the tax-free step up in basis deal).

 

[hyten1]

eric,

 

haa, one part i got it wrong

 

i thought you don't pay tax on the $5 gain, i guess you do.

 

hmmm, that make this less attractive :), i long for the good old days when you can hold the hedge indefinitely

 

so i guess this is useful in cases when you want to hedge (lock in your gain), your hedge can either lose or gain that is the cost of the hedge, but then after the hedge you are back to square one. hmmm, less useful, still thinking under what scenarios would this be of use.

 

hy

 

[hyten1]

eric, trying run thourgh under which scenarios would this "constructive sale exception" be useful?

[ERICOPOLY]

eric, trying run thourgh under which scenarios would this "constructive sale exception" be useful?

 

 

I'm guessing Moore (and many others) sold some of his BAC in January/February this year without attempting the constructive sale.  I'm pretty sure he paid about $7 for it last summer.

 

What if he wants to buy it back at $8 or $9 after a pullback this summer?

 

He could have deferred some gains for his investors if he had done a constructive sale instead of just selling his shares.

 

I guess that's the typical time that you'd want to employ this -- whenever you sell due to "frothy" market but might later want to get back in to that very stock after the market has blown off some steam.

 

[LC]

It seems like a good strategy to use when there are temporary overvaluations, but you expect there to be a continued undervaluation in the future.

[Palantir]

I agree with relatively stable stocks, but disagree with the 'aren't moving too much'.  Options premium is determined by volatility which does not always equal business risk.  As such you will get relatively small premiums for companies with low volatility.  Personally I prefer stocks that are pretty volatile where I believe there is reasonable downside protection, either in the way of assets or recurring revenue and moat.  Your premiums in those scenarios will be much higher.

 

I disagree with this somewhat. IMO when you're selling calls you're not really taking the position that the option itself is overvalued. You're really taking a long position on the underlying. The option position is merely expressing that bullish view, while you don't retain any directional opinion on the option price.  When you sell calls on a volatile stock you're shorting volatility, which I think is a different concept than what I'm proposing - which is taking a long position on a moderately undervalued stock.

 

But all IMO of course.

[ItsAValueTrap]

You can look at it this way.  With options, you are making a bet on two main things:

A- Volatility

B- The direction of the stock

(*Ignore other things that affect options pricing like borrow costs, dividends, interest rates, interest on short sale proceeds, taxes, etc.)

 

If dynamic hedging and delta hedging worked perfectly, then B is not really relevant.  It comes down to a bet on volatility.

 

If you want to bet on the direction of a stock, then just buy the stock.  Doing the trade through options will increase your transaction costs and you might be on the wrong side of the volatility bet.  You might also forget to exercise your options before dividends.

[bargainman]

I disagree with this somewhat. IMO when you're selling calls you're not really taking the position that the option itself is overvalued. You're really taking a long position on the underlying. The option position is merely expressing that bullish view, while you don't retain any directional opinion on the option price. 

 

What are you talking about?  selling calls is bearish.  buying calls is bullish.  (although selling covered calls is mildly bullish)

 

How much options trading/investing have you done?

[Palantir]

I meant selling puts actually.

[KinAlberta]

I don't know if this was ever posted here, somewhere, but it was quite a good read...

 

 

Naked Short Put Options - Warren Buffett's Little Secret  April 23, 2014

Grahamites

 

http://www.gurufocus.com/news/256254/naked-short-put-options--warren-buffetts-little-secret

[SmallCap]

I don't know if this was ever posted here, somewhere, but it was quite a good read...

 

 

Naked Short Put Options - Warren Buffett's Little Secret  April 23, 2014

Grahamites

 

http://www.gurufocus.com/news/256254/naked-short-put-options--warren-buffetts-little-secret

 

This article nicly describes the thinking behind the limited option selling I have ever done. Providing insurance for someone else and being fine if put to because I wanted to own the company in the first place and this gets me in at a discount to the share price at the point I decided I wanted to own the company.

 

I will tell you that so far I have been put to since I have sold the most put options on PWE as it declined. Psychologically that's a hard pill to swallow as I have been put to at $5 when the share price is 90 cents. But I have an idea that the emotional difficulty is what makes most people shy away from it.

 

Then again maybe I am just delusional.

 

I have a question from those who have more experience. I have seen good arguments that when buying call options you commonly get better returns by going with the long term leaps. But when you sell puts is it generally better to stick with the short term or the long term duration?

[rishig]

An interesting case study is how Cornwall capital (profiled in The Big Short and Hedge Funds Market Wizard) used long term options to compound their capital from 100K to $30M in a short time (and to hundreds of millions thereafter thanks to the housing short).

 

Their first investment was in Capital One, when it dropped in mid 2002 from $60 to $30 when it was under investigation by banking regulators and the CFO was forced to resign due to insider trading on nonpublic information. Once it dropped to $30, it traded in the $27 to $30 range for the next 6 months. The low volatility meant that out of money LEAPS became cheap because of the normal distribution assumption of Black Scholes. As per Black Scholes, the liklihood that the stock would jump to $40 is lower than it would jump to $35. This is a crazy assumption in this case. Either it is a fraud or it is not. If it isn't, the stock would probably go back to $60 in a matter of months once the investigators announce their findings.

 

They did a lot of scuttlebutt research to feel comfortable that Capital One was indeed not a fraud. Not too different from Buffett during the American Express scandal. Cornwall purchased LEAPS (2.5 years out) for strike price of $40 at a premium of $3 for a total of $26K. The far out of money options were very cheap. Even if they were wrong, the odds were too crazy to not bet. In a few months, the stock jumped to $60 once the findings were out, and they made a killing of >$500K.

 

What I learnt is that if you have an event driven situation where the outcome is binary with a fixed deadline and the stock has been trading in a range, one could get LEAPS at a cheap price.

 

If were there LEAPS for ZINC for 2018 and they were cheap, it probably would fit the criteria. Either ZINC's plant is going to be up by 2018 (and the stock will sky rocket to $6-$8) or they will go bankrupt. May be with the leverage, the stock is now a stub and acts like an option (which will expire in 2018 when their debt is due and the plant is not up - causing them to restructure the company).

 

Buffett has also spoken about the mispricing of long term options in his 2008 letter:

http://www.berkshirehathaway.com/letters/2008ltr.pdf

 

[TwoCitiesCapital]

I don't know if this was ever posted here, somewhere, but it was quite a good read...

 

 

Naked Short Put Options - Warren Buffett's Little Secret  April 23, 2014

Grahamites

 

http://www.gurufocus.com/news/256254/naked-short-put-options--warren-buffetts-little-secret

 

This article nicly describes the thinking behind the limited option selling I have ever done. Providing insurance for someone else and being fine if put to because I wanted to own the company in the first place and this gets me in at a discount to the share price at the point I decided I wanted to own the company.

 

I will tell you that so far I have been put to since I have sold the most put options on PWE as it declined. Psychologically that's a hard pill to swallow as I have been put to at $5 when the share price is 90 cents. But I have an idea that the emotional difficulty is what makes most people shy away from it.

 

Then again maybe I am just delusional.

 

I have a question from those who have more experience. I have seen good arguments that when buying call options you commonly get better returns by going with the long term leaps. But when you sell puts is it generally better to stick with the short term or the long term duration?

 

Depends on what you're purpose for selling the puts is, right?

If you're selling to capture the decay of the value of the option, you want short dated options where theta is high so the option is worthless quickly.

If you're selling to enter the position at a discount, selling longer-dated options can get you a larger discount by increasing your premium.