Sunday, March 4, 2012

Investing PART 15

Options: 2012 won’t be 2011

About January 1st everyone seems to think they have to make a prediction for the coming year. My plan was to do the same. Guess I’m a little late. The subtitle contains the essence of the prediction: 2012 won’t be 2011. As obviously true as that is, people can’t help using recent experience to forecast. So, how does that relate to options?

The option strategies of selling covered calls and selling cash covered puts are well known. Selling covered calls involves selling someone the right to buy your stock at a designated price. There are two ways to use covered calls. One is to remove emotion for the sell decision. For example, you may decide that if you can get an increase in price of, say, 10% over the next few months, you don’t expect more or you can be content with that gain. If you sell the call, you aren’t subject to the temptation to raise your sights as the stock climbs.

Alternatively, income investors may target a yield. If the stock price goes up without a dividend increase, the dividend yield falls. Pre-committing to sell if that happens (and getting paid for the commitment), can make sense if other investments with higher yields are available.

Not all sellers of covered calls are using them to sell stocks. Some sell the calls for the income that selling the call generates. They pick a selling price they don’t think will be reached. They sell the right for someone to buy the stock while hoping/expecting that the stock won’t increase enough for the option buyer to exercise the right.

Selling a cash-covered put is the inverse. The option seller is selling someone the right to sell them a stock at a certain price. It’s a way to target an entry point. You agree that you’ll buy the stock at a certain price, and get paid (the proceeds from the option sale) to hold the cash while you wait for your price. Again, some people sell cash-covered puts to collect the premiums and don’t really want the stock.

Both strategies have been described as picking up nickels. BARRONS (2/11/12) described them as “How to Hit Profitable Singles.” The article is a good overview.

Rather than describe the strategies in detail with examples, this posting just references some good discussions: in “My Long-Term, Enhanced Investing-For-Income Strategy” describes the strategies as follows:

“The two purposes for using options are: 1) Increasing income and 2) taking emotions out of your buy/sell decisions. The proper use of puts allows an investor to make their planned buys on down days when stocks are on sale. The other result of selling puts is creating an income stream from cash that is otherwise not invested.”

“The proper use of calls is to increase the yield from a portfolio of owned stocks that consistently pay a rising dividend. The key to this strategy is first choosing the companies you want to buy and hold and having the patience to collect a good income while you wait for your price.”

The article provides a number of examples.

Another article that addresses return on options with different examples is “How To Double Your Yields On Dow Dividend Stocks

How NOT to bet on Apple's quarterly earnings report” discusses why using options in a specific situation often backfires. It provides examples then notes:

“The explanation for those numbers is simple,… Over time, the options tend to overprice the potential post-earnings move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move."

This Apple example highlights the issue in 2012. The price of an option is sensitive to volatility. Last year volatility was particularly kind to the option strategies described above. Most people think of 2011 as particularly volatile. That may be the case, but there is a counter argument as presented in BARRONS “The Volatility Illusion.”

It argues there was a "volatility illusion" based on three factors:
1. The admittedly high volatility of the European stock markets is being mistakenly extrapolated to a relatively quiescent U.S. market.
2. The volatility of so-called safe 10-year U.S. Treasury notes actually exceeds that of the S&P.
3. Investors are not spooked by increasing volatility if it is in the context of a bull market.

The article, in fact, doesn’t make the full case. Whether 2011 was anything more than just a normal market year depends upon how one measures volatility, especially what time horizon one uses. The issue for options, however, isn’t overall volatility. It is the volatility of volatility itself. The pattern of fluctuations in volatility in 2011 made covered call and cash covered put strategies particularly profitable, and I would argue easy to manage. It would be unusual for the pattern of volatility in 2012 to be as friendly to these option strategies as 2011. Basically, if the strategies can be characterized as picking up nickels, in 2011 there were a lot of dimes among the nickels. In 2012 the nickels will still be there.