Some readers have expressed interest in options investing blog topics. So I’ll pontificate a bit about options investing.
I view options as generally “zero-sum” hedging tools. When I buy and sell (mostly sell) options my first thought is not making money on the options trades. My main goal is transforming and reshaping my portfolio.
In my IRA portfolio option trades cost me about $8.00 each. Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.
The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY. In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out. That call option either expires worthless or I buy it back just before it gets exercised. I then repeat every couple months; selling 4-5 option contracts a year.
The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips. The trade off is missing out much of the upside return during bull markets. Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums. Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.
The other factor to keep an eye on is implied volatility. The most common way to track implied volatility is via the VIX. When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option). I prefer to sell call options when the VIX is 18 or higher.
So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY. Real time bid/offer quotes are almost essential and allow you to make limit order trades. I recommend starting near the option midprice when selling a covered call. For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]
To make things a little more confusing, most options are quoted with a 100x multiplier. So that means that an option quote of $2.18 actually sells for $218.00. Each option contract transacts 100 shares of the underlying security (the “underlying”). So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.
The CIA Account (yes, its redundant) closed today at $24,127. The covered-call SPY play and the TOT stock buy continue to pay off.
Today, the Ivan account closed at $24,060. TOT shares lead the rise with a 1.7% gain to close at $53.95 per share. SPY and JNJ also gained. The only hold to lose ground was the CALL (SPY) SPDR S&P 500 ETF MAR 19 11 $115. Collectively the SPY and its covered call were a net gain (as expected when the market rallies).
While the Σ1 Fund is currently a real 100% privately-held investment vehicle, all language and speculative plans about its future are currently (9/28/2010) STRICTLY THEORETICAL. There is currently no SOLICITATION or even OPPORTUNITY for anyone other than Balhiser LLC shareholder(s) to invest in the fund. Further, there is currently no SOLICITATION nor OPPORTUNITY to invest in Balhiser LLC at present. Thus the HYPOTHETICAL and SPECULATIVE language is merely just words at this point and time. It is entirely possible that outside investors NEVER be given the opportunity to invest.
I’m wondering… should I revise my $10K minimum investment. Perhaps $5K-$9K with a ~2% up-front load ($5000 yields $4900 of principal, $5000 yields $5100). Increments above $5K are $1K with an up/down choice. Increments are also $1K for investments over $10K. Additional subsequent investments for current investors are $2K minimum with $1K increments. Withdrawals minimums are $5K or %100 plus optional $1K increments. Additional fund investments are subject to the same early withdrawal penalties as initial investments. ALL requested redemptions are FIFO by default.
Distributions (realized capital gains, dividends, etc) are annual. How they are distributed is TDB. My initial inclination is that there is an ex-dividend date on the last trading day of each month, and dividend income is distributed in proportion to #months held * #shares. Distributions are re-invested by default. Non-reinvested distributions are held in a non-interest-bearing manner until $500 is reached, upon which the total distribution will be paid in full by ACH or check. Non-reinvested dividends may be paid, upon request, before the $500 minimum is reached, but a distribution-collection fee of $50 will be assessed. For shareholders with >= $100K NAV none of these distribution restrictions or fees apply.
75% of redemption fees will be paid to Balhiser LLC, the remaining 25% will be paid to the Fund.
Requirements for potential investors:
- Minimum of 5 years experience investing in stocks, bonds, ETFs, and/or mutual funds.
- Acknowledgment that this is an investment of at-risk capital that may be subject to forced liquidation without notice during volatile and illiquid market conditions. This could result in severe or even total loss of investment.
- Acknowledgment that options WILL be part of the Fund’s holdings/obligations. While the primary target use of options is “covered-call” writing the notion of “covered” is not strict. The fund may consider an RNM (Russel 2000 mini call option contract) to be “covered” by ownership of “an appropriate amount” of SPY (S&P500 ETF) shares.
- Acknowledgment that ETF futures contracts may part of the Fund’s holdings/obligations.
- Signed (and notarized) legal waiver that specifies that in exchange for participating in this fund, fund participant, fund participant beneficiaries and/or heirs, agree to hold legally blameless the fund manager and Balhiser LLC for losses sustained by the Fund.
- Solid familiarity with E-mail and the Internet and Internet-based “paperless” documents and communication.
In exchange for these concessions, the fund manager agrees to the following “skin-in-the-game” and transparency conditions:
- So long as fund assets (or total net unredeemed funds invested) exceed $50K, the fund manager and/or Balhiser LLC will maintain a minimum of $25K invested in the Fund.
- So long as fund assets exceed $50K, the fund manager and/or Balhiser LLC will reinvest all fund net distributions and net fund management proceeds into the Fund.
- So long as FE>$50K. Fund manager and/or Balhiser LLC will be subject to same fees, terms, and conditions as all other investors PLUS will have to provide an ADDITIONAL 60-day advance notice to all fund shareholders (via email or other means) prior to any sale of holdings in the Fund.
- 100% of Balhiser LLC/fund manager redemption fees (fees incurred for “personal” withdrawals) will be paid to the Fund.
- End-of-month NAV reports will be delivered by email to shareholders. (delivered within 5 business days)
- Subject to NDA: Unaudited Annual Report detailing complete fund holdings (delivered within 20 business days). Disclosure to CPA is permitted.
- Subject to NDA: Upon request unaudited inter-year report (delivered within 30 business days). A $250 fee applies. Disclosure to CPA is permitted. Fee is waived once per year for investors with >= $100,000 invested in the Fund.
Base Management Fee Rates (similar, but not identical, to an expense ratio)
- 7.8 basis points per month (0.078%) of previous close-of-month fund NAV.
[~0.95% in simple interest, or ~0.9772% compounded annually]
- Base management fee reduced by:
- 10% for investors with >= $50,000 NAV (or $50K net unredeemed investments).
- 25% for investors with >= $100,000 NAV (or $100K net unredeemed investments).
- 33% for investors with >= $250,000 NAV (or $250K net unredeemed investments).
- 50% for investors with >= $1,000,000 NAV (or $1M net unredeemed investments).
This week was kind to the the two accounts I manage. In its first week the Σ1 proprietary trading fund eked out modest gains; $25.00 invested last Friday has a NAV of $25.04 today. The Crazy Ivan Account (CIA) is showing a nice $23,473 balance.
I already had one person express interest in investing in Σ1. I had to inform him that that was unlikely to happen in 2010. I have a lot of reading and researching to do first. Probably a visit or two with my LLC’s accountant and perhaps a visit with my lawyer who may have to recommend another lawyer more specialized in the industry.
Until then I must, sadly, say “no”.
But I can map out a tentative outline of possibilities. Here a few potential thoughts.
- Initial share reference price, $25.00, dated Sept.17, 2010.
- Minimum initial investment: $10,000.
- Fine print: Σ1 is not a mutual fund. It is more aptly deemed a proprietary trading group (or entity) for experienced investors and is for risk capital only. The types of risks associated with this investment group fund go well beyond those of established mutual funds.
- Long-term investment is encouraged. In order to discourage short-term trading the following penalties will be assessed:
- 5% fee for redemption of funds held less than 181 days.
- 2% fee for redemption of funds held less than 365 days.
- 1% fee for redemption of funds held less than 2 years.
- No redemption fee for funds held >2 years.
- Redemption requests (received by email) will be honored by mailing a check within 45 days of receipt. Notional NAV of redeemed funds will not be lower than the minimum of the 5 closing NAVs in the 5 business days after receipt of the redemption request.
- Redemption requests must either a) Exceed or equal $5000, b) 100% NAV of portfolio. Redemption requests of $5000 or more that have lower NAVs will receive 100% liquidation as per terms above.
- Redemption requests will be non-revocable, unless written special dispensation is granted by fund manager.
If you have read this far, apologies. This is very dry stuff, and very speculative at this juncture. Thanks for reading.
While discussing synthetic CDOs one of my colleges suggested that they reminded him of fantasy baseball. He said that creating synthetic CDOs is like creating a virtual baseball team, and that betting on this virtual team is like writing credit default swaps on synthetic CDOs.
I liked the analogy and thought it might be helpful in explaining some of the details of the sub-prime mortgage crisis.
Applying this analogy to credit rating agencies who gave AAA ratings to crappy securities is like creating a fantasy baseball team that is rated to be as talented as the Yankees but is actually made of mostly minor league players.
I have been so busy that I haven’t been blogging much recently. Busy doing my taxes, and doing a second round of tax planning such as determining how much I can put into a Roth IRA for 2009. Once I figured that out I had to determine how to invest my Roth IRA contribution. I opted for the Vanguard Inflation-Protected Securities Fund.
Since Balhiser LLC has not yet made me fabulously rich, I still have a full-time day job. I upped my 401(k) contribution percentage to take advantage of the new $16,500 maximum for 2010. I also made some decisions about whether and when to sell some restricted stock and stock purchase plan stock. I did not exercise any options.
Total personal and business debt is about $30K and $10K respectively. I’m looking at ways to pay down both. My best guess is that I can cut them down to $10K and $5K by the end of the year.
Rental property income is currently showing positive cash flow which can be channeled towards reducing business debt. Advertising expenses were incurred to help find prospective renters, but were relatively modest. It’s time to to order new business cards. I’m thinking of changing my featured title from “Finance Guru” to “Financial Blogger.”
I’ve been making some subtle portfolio adjustments. The recent large 1-yr run up in stocks has persuaded me to do some mid-year re-balancing. The S&P is up 42% in the last 12 months, the Russell 2000 is up 55%, and Ex-US stocks are up 50%. I’m reducing my new-found over-exposure to stocks by some selling and some call option writing. (I haven’t purchased any puts yet, but I’m considering it.) I’m putting the proceeds into 1) paying down my home-equity line of credit 2) TIPS funds at Vanguard, 3) Tax-Exempt bond funds. All these adjustments are relatively minor, amounting to less than 5% of my securities holdings.
Finally, a CIA update. The Crazy Ivan Account (CIA) is up nicely, closing today at $22,661. Current holdings are $11,876 in SPY, $12,496 in cash, and a ($711) short position on a covered Sept SPY call.
I’ve now got a spreadsheet where I can enter 3-year daily stock price data and get a beta versus the S&P500 as modeled by the ETF SPY. There are still a few finer points I don’t like about the modeling. The biggest remaining gap in the computation is that the model doesn’t account for dividends on either the stock or the S&P. Ideally it would add the dividend into the price on the ex dividend date. If I could find a source where that data is built in or I took the time to merge the data it I would be set… but I haven’t bothered to do so. Another nice feature would be an R-squared computation.
So now what? Probably nothing for a while. I’m already thinking about different things. Most are things I wish other people would do .
- Create a low expense-ratio ETF that tracks a passive covered-call index like BXM. (No, and not an ETN… I want collateral!)
- Create an open-source format for storing and sharing stock, index, portfolio, bond, ETF data. Perhaps XML-based. Nice features would be handling of splits, ticker symbol changes, dividend and ex-dividend dates, and market holidays. Support for different time periods would be a must. Support for earnings, book values, revenue and other supporting data would be nice. Perhaps such a format already exists?
- Glue together this format with cool graphing software like Open Flash Charts and/or something HTML5 based.
- Open source statistical tools to work with this format to compute volatility, beta, R-squared, P/E ratios, etc.
Until next time, happy financial modeling.
Updated value $21,967. The CIA is looking pretty boring with just a 100 shares of SPY and the rest in cash earning a very paltry 3 basis points of interest.
I’m getting anxious to make this fun money more interesting. The VIX is pretty low – around 20 — so I’m not inclined to sell calls. Buying a SPY put position is a possibility. As is good old-fashioned stock picking.
Today I uncovered my SPY call. I did so by buying an identical March SPY call to close my outstanding position. Specifically I bought a SPY MAR 2010 $100 call option for $1465. I placed a limit order bid of $14.65 while the ask was $14.75 and the other bids were $14.60. (Note that quoted value $14.65 is the price per share of stock. One standardized option is the right to purchase 100 shares. Thus the total price of the option contract is 100x the quoted price, or $1465.)
So far this trade looks decent with the bid/ask closing at $14.80/$14.95.
At the end of the trading day the Crazy Ivan Account is worth $22,212.
I paired my SPY 87 Nov Put write with writing a SPY 87 Nov Call. Both are covered, the call with 100 shares of SPY, the put with cash. The account value is down to $20,417 with -$1360 the present market value of the straddle. Ideally SPY with stay within a small range of 87 and the straddle will expire worth very little. The worst case scenario is that SPY falls like a rock and eats into my put. I’ll keep things update periodically, regardless of how the market winds blow.
So I must confess this market has me a bit nervous. My main outlet for financial nerves is my “play money” (aka mad money) IRA account. Here are my recent plays:
- Buying an SPY call to close my covered call. (realizing ~$300 gain on the call)
- Selling 100 shares of SPY (about $1100 loss realized over about 1 year, offset by about $700 in call gains and dividends)
- Buying 2 OCT 123 SPY puts yesterday (~$490 profit on paper in a day and a half).
So far I am happy with these moves. It frees up cash for future buys and gives me the feeling of security of cash (in a money market). More importantly it makes feel active rather than feeling passive. This is helpful as part of me wants to sell sell sell! shares in my broader portfolio.
For me getting out of shares (selling) is emotionally easier than getting back in. Thus, staying in is important. I must admit it is feeling harder to resist a bit of selling. I am certainly discouraged by the lack of gains in the last 10 years in the stock market.
Which gets me to real estate. My home has been a pretty solid investment. It has appreciated about 4-5% annually inclusive of the recent slight housing downturn. This is not bad considering :1) it is a leveraged investment, 2) tax-deductible interest payments, and 3) I enjoy my house and my neighborhood. So I take some solace in the fact that while stocks have been mediocre, my other investments (house, bonds, money market, options) have provided decent (if not exactly spectacular) returns.