On synthetic covered callsHi everyone,
I am a brand new irregular, very much impressed by the rich content of this site, Travis’ contributions and the lively discussions in the community. This is my first post.
I consider myself a long-term investor, not a trader, who is using options to build-up stock positions and manage risk. Fifteen years ago, I was a CANSLIM swing trader, ten years ago I was trading non-directional iron condors on RUT and five years ago I thought I could consistently make profits trading risk reversals on short term VIX options. After much reflection, counterfactual analysis and programmatic backtesting, I came to the conclusion that options are priced to perfection in the short-run. In hindsight, the evidence has always been right in front of me as the only consistently profitable part of my portfolio has been my long-term buy and holds. I do not regret my long and steep learning curve, today I enjoy investing more than ever (this exceptional bull market of course helps…).
I noticed that some people have expressed interest for more discussions on option strategies, so I happily try to contribute (sporadically). Please understand that, by no means, I claim that my method of investing is better than anyone else’s. Investing with options is all about making trade-offs and bringing your choices in line with your risk tolerance. There is not, and never will be, a holy grail method of option investing (despite of what several guru’s will try to make you believe). What I explain below is nothing fancy or high-tech and people well versed in options can skip this post, there is so much else to read on this forum!
Inspired by another thread, where an interesting newsletter promising 100x returns is being tracked, I yesterday decided to open two new positions, one in $NNDM and one in $OPTT. Yesterday’s closing prices of these stocks were 14,53 and 5,02 respectively. Rather than outright buying 100 shares of each, which I will use as a benchmark below, I bought what is called the ‘synthetic’ equivalent, namely I bought one call and sold one put with the same strike and the same expiration date. To lower my debit paid, I also sold an out-of-the money (OTM) call, essentially making these positions synthetic covered calls. Here are the specifics:
For $NNDM:
Bought May21’21 strike 10 call for 6,8 debit
Sold May21’21 strike 20 call for 3,7 credit
Sold May21’21 strike 10 put for 1,85 credit
Total combo: 1,25 debit or 125$ paid
For $OPTT:
Bought May21’21 strike 5 call for 2,2 debit
Sold May21’21 strike 10 call for 1,4 credit
Sold May21’21 strike 5 put for 2,1 credit
Total combo: 1,3 credit or 130$ received
Note that, combined, these positions have hardly influenced my total available funds. Yet, for sure, I am now invested in these stocks as I will explain below. So here is a first reason why I think this method can be beneficial, at times, and for some of you: when your newsletter on a regular basis comes out with new recommendations, and you try to buy each and every new recommendation in fear of missing out, many people face difficulties financing the new recommendations and therefore, reluctantly, see themselves forced to sell parts of another winning position. By switching to options, you buy time, in this case until May 21 of this year.
Because what is going to happen on that day? If $NNDM is still under 20 and $OPTT still under 10, I will exercise (or be exercised) on my position and essentially buy 100 shares of $NNDM for 11.25$ (10$ long call strike + 1,25 debit) and 100 shares of $OPTT for 3.7$ (5$ long call strike – 1,3 credit). Note that I have fixed my purchase price yesterday, although I will own the stocks only in May. I buy these stocks at a 22,5% and 26% discount, compared to yesterday’s closing prices, respectively. This is obviously a second reason why you could consider buying a synthetic position.
Are these two reasons combined too good to be true, in other words, what is the extra risk, compared to simply buying the stock immediately? Well, the same as any covered call position really, I have put a cap on my upward profit potential (on top of the downward risk of the stock going to 0, which a buy and hold stock buyer also faces). If $NNDM closes above 20 and $OPTT closes above 10, I will (only) make 875$ (=(20-10-1,25)*100) and 630$ (=(10-5+1,3)*100) profits and not own the stock and maybe miss out on some extra profit by that time. Does that bother me? Not really, but maybe it does bother you. This is exactly the trade-off at play here, and the outcome, i.e. your choice how precisely to invest, will depend on your risk-profile and your trading psychology. I am not really concerned because I know that I will set-up a new synthetic position and eventually the stock will let me in, as no stock shoots straight to the moon. If these stocks really have 100x potential, which will take them very likely at least a decade if not more, I can afford to wait a quarter (note that I am buying and selling options 3 months out) or more now.
When owning the stock in May, it is likely that I will try to lower the purchase price further, by selling another OTM call, this time turning the position in a standard covered call. Of course also then, there will be similar risks as described above to be considered.
But, in sum, I think it is worthwhile considering this method when constructing a well-diversified portfolio of micro/small cap stocks, certainly if you often find yourself in difficulties financing them. For reasons of margin requirements, the method can only be used for lower priced stocks, but for many microcaps that is the case anyways.
I hope this post was interesting for some option enthusiasts here.
Good luck and to paraphrase Travis: thanks for reading!
This is a discussion topic or guest posting submitted by a Stock Gumshoe reader. The content has not been edited or reviewed by Stock Gumshoe, and any opinions expressed are those of the author alone.
Hi T_T_P. Very interesting approach. Thanks for that share. I am starting looking at options trading and so keen to learn such solutions. Eager to hear from you more if you happen to apply another approach and be willing to share. Regards
Hi chmarpio, thanks for your message, I am glad my post was helpful. I will provide an update on the two positions in May.
On the upside risk of missing out, I should have added that in case I am being exercised, a 78% (875/1125) and 170% (630/370) return in three months is nothing to complain about. And as I wrote, I can always jump in again the next day. That is why I like to track and compare the benchmark case of buying stock outright and the alternative of buying synthetic on all my positions. It is like a horse race, you will see it is fun (and over time the synthetic is hard to beat!)!
I am personally always much more worried about the downside risk of microcaps going bankrupt. Take $OPTT as an example. Deriving energy from sea waves sounds like a great idea on paper, but looking at the monthly chart of the stock, things do not look very exciting. And if you look at the very volatile daily chart, it is not hard to conclude that so many retail traders have lost money on this stock. Either they sell in panic when there is a big price drop or, worse, they put in stop-loss orders, which the moneymakers love to trigger to make some money themselves. It is just the way most retail traders manage downward risk. What they overlook, is that instead of selling stock, you can also manage the downward risk by selling time premium on your OTM call. I never put in stop-loss orders and I try, as much as possible, to never sell stock. That is why I am forced, from a risk managing perspective, to sell time premium in my covered call positions. If you keep following this post, you will see that I will not stop my covered call position on stocks like $OPTT until my purchase price is down to zero and bankruptcy risk is completely hedged. The nice thing is that, looking at the rich premia of the options, it is likely that I will get there maybe already within a year. So fingers crossed that $OPTT survives 2021 (which it probably will do). And I can assure you, once you have a stock for free in your portfolio, it is psychologically much easier to be a long term investor. Best wishes.
Hi T_T_P,
I will second that! Thank you for an excellent lesson – clear, concise, and thorough – smooth writing quality – and at the exact level of complexity for this second semester student. Particularly the part about the risk assessment. I’ll look forward to anything you might have to say in the future.
Hello T_T_P,
Love your writing style and the easily understood information. New to options, but this appears to be a fantastic alternative to rushing to buy each and every stock mentioned with a limited account. I will definitely be following this thread and look forward to more posts if you have the time and inclination. Thanks again!
Hi timcoahran and lacasaless,
Thank you for your kind words, very much appreciated!
I am currently discovering the content of the site further, mainly reading (and learning from) Travis’ Friday Files. Very exciting!
I noticed that Travis often writes something like: “I like stock XYZ, but would not buy it today at price A, because it is too richly valued by any reasonable metric. I’d only consider nibbling at price B (where price B is then, say, 20-25% lower than price A).”
For the stock investor who wants to follow Travis’ advice, there is really only one thing he or she can do, i.e. submitting a limit buy order at price B and start waiting (and hoping) that the price drops from A to B. If there is one lesson I have learned in the stock market, then it is that when you start hoping for a price change, you are doing something wrong.
How different is the situation for the option investor! Admittedly, it will not work every time, but it is certainly worth investigating the option tables whether or not you can fix your purchase price of stock XYZ at price B already today, simply by using the technique that we are discussing in this thread (recall that I bought $NNDM and $OPTT at a 22,5% and 26% discount). This might be surprising for readers unfamiliar with options, but it is, I think, a very important insight and useful advice, given the many recommendations posted on this forum.
What is the worst thing that can happen? Well, that at the end of the story, both the stock investor and the option investor find themselves in a situation where they do not own the stock. But their situations are far from identical and the asymmetry between them is crucial to understand. The stock investor does not own the stock because the price never dropped to B. The option investor does not own the stock because the price, at expiration of the combo, exceeds the strike price C of the OTM call option that was sold. The stock investor is left empty-handed, the option investor pockets (C-B)*100. Anyone looking for a motivation to start learning options, ask yourself: Who of these two investors would you rather be?
The discussion we are building here is, in my mind, also very relevant during the inevitable, sudden and scary market selloffs, like the one we just witnessed in the markets in the last 48 hours. To those investors that sold (parts of) profitable positions in panic, it is worth repeating that downward risk can be managed not only by selling stock, but also by selling time premium on options covered by your stock position. To those investors who yesterday lacked the funds to bottom fish and open new positions, consider buying synthetically (if margin requirements allow). And, finally, to those investors that threw good money after bad while catching falling knives, rationalizing the act by reassuring themselves that they were ‘averaging down’, be careful. When the dust settles, you have not only decreased your average price, but you also increased your total exposure in the stock. Not only might the position sizing balance of your portfolio be disrupted, you also unexpectedly further depleted your available funds to buy new recommendations in the future.
By consistently selling time premium in your covered call positions, you are essentially also averaging down, quarter after quarter, but the important difference is that you keep your position size fixed at the original position of (a multiple of) 100 shares. Managing risk, by routinely selling time premium, also takes away the psychological pressure of ‘having to do something on a big red day in the market’. Peace of mind, strong hands and confidence in your investing method are likely all important ingredients to long-term investment success.
I hope some of the above was helpful for your own investments. Good luck and all the best!
In light of the current market selloff in general and the recent developments in $NNDM in particular, below some reflections. As always, not attempting to lecture, not pretending I know better than anyone else, just trying to help less experienced investors understand several options available, with the personal goal of giving something back to the Gumshoe community.
$NNDM closed yesterday at 7.79$, down 11.17% for the day, down 23.48% for the week and currently 56.46% below its 52week high. For the first time since its uptrend started mid October last year, the stock is considered ‘oversold’, as of yesterday, as measured by the widely used RSI(14) indicator, currently at 29.39.
While in itself, being oversold (or overbought) is not sufficient reason to take action (oversold can get much more oversold, for example), credit spread option traders, who want to collect time premium to generate additional ‘passive income’ (I never liked that term), often open trades when a divergence arises between the long-run trend and the short-term overbought/oversold reading: sell put OTM time premium when the stock is oversold but still in an uptrend (which is essentially a bullish outlook), sell call OTM time premium when the stock is overbought but still in a downtrend (bearish). I consider $NNDM still being in the former situation right now. I would not consider a 50% pullback of a volatile microcap in the tech sector abnormal.
So, what to do moving forward?
I can imagine that when a newsletter promises 100x returns over a decade, some people jump on the recommendations in the hope of getting a 10x return in one year. Unfortunately, such linearities do simply not exist in the stock market. This position could turn into a longer waiting game than expected, which could conflict your time horizon for trading stocks (certainly when you are younger, and there is nothing wrong with that), so alternative number one is simply cutting your loss. The hypothetical stock buyer in my original post bought 100 shares of $NNDM at 14.53, so selling the position at 7.79 would be a 674$ dollar loss (-53,6%).
On the basis of the last trade prices yesterday, taking of my option position in $NNDM would imply:
Sell May21’21 strike 10 call for 1,45 credit
Buy May21’21 strike 20 call for 0,45 debit
Buy May21’21 strike 10 put for 3,60 debit
Total combo: 2,6 debit or 260$ paid
Add my original 125$ to set up the position to the 260$ to take off the position and the conclusion is that I would lose 385$ on the trade (compare that loss with the stock buyer ‘s loss above!).
But, since my number 1 investing rule is to never sell a position directly, let’s quickly move on to the opposite of selling, which in this case would be averaging down:
1) The stock buyer buys 100 shares at 7.79, now owning 200 shares at (14.53+7.79)/2=11.16. The cost basis of this position is 2232$ now.
2) Buy 100 shares synthetically, for example:
Buy May21’21 strike 7.5 call for 2,1 debit
Sell May21’21 strike 7.5 put for 1,8 credit
Total combo: 0,3 debit or 30$ paid
Note that you pay 7,5+0,3=7,8 for the shares via options in May, which is (almost) equal to buying it today at 7.79. Actually, I think there is a small opportunity here, because you should always discount a payment in the future to its present value. Theoretically, I could short $NNDM today, put the money in a bank account (assuming a positive interest rate) and cover the position in May via my options, capturing the interest payment. It is essentially a money printing machine! However, there are two disadvantages of buying synthetically over buying stock outright:
– you do not collect dividend payments (not an issue for $NNDM anyways)
– when, in May, you want to avoid being exercised (because for example you are short of funds in your account), you have to roll the position to the next expiration, say August. Due to the wide bid-ask spreads on these options, you might have some slippage in rolling your position.
But, in my opinion, these two disadvantages pale compared to the advantage of buying synthetically, which is the reduction in invested funds. Adding the two synthetic positions together shows that I would have only needed 125+30=155$ to establish my position so far (obviously my margin requirements have gone up by selling another put, but I assume margin is kept under control). Professional traders trade synthetically all the time as it dramatically improves their return-on-investment (ROI).
3) A third alternative is what I would call ‘bottom-fishing, option style’, i.e. only sell the put:
Sell May21’21 strike 7.5 put for 1,8 credit (180$ received)
If the stock is below 7.5 in May, you take on the obligation to buy 100 shares, for which you essentially pay 7.5-1.8=5.7$/share. Remember that my original synthetic covered call in $NNDM was having a cost basis of 11.25$/share for the first 100 shares, so I am facing a situation where I could be long 200 shares at (11.25+5.7)/2=8.48$/share. If the stock is above 7.5 in May, I only collect the time premium of 180$, reducing my cost basis to (11.25-1.8)*100=945$, now not owning 200 shares but only 100 shares at 9.45$/share.
Which of these three alternatives would you choose? I know for sure that the younger me would have gone for option 3 yesterday. However, I decided to do none of the above and I’ll try to explain why.
There is an important difference between looking at your investments ‘bottom-up’ or ‘top-down’. The former means that when something exceptional is happening to an individual stock in your portfolio (like $NNDM being currently oversold), you have to take action. For a very long time, I was taking this approach. But if you take a helicopter view at your portfolio and you combine risk management with broader money management, you can rationalize that averaging down is not the right thing to do right now, even if circumstances look exceptional. For the sake of the argument, the reasoning could go as follows:
Imagine you are managing a 100k portfolio. Imagine you decided to spend 20% of that money on building the microcap part of your investments. For diversification reasons, you want to own at least 20 microcaps. Well, then you cannot spend more than a 1000$ on any individual position. Recall that, while averaging down, the stock buyer needs 2232$, which is unacceptable from a money managing point of view (even the original 100 shares are too expensive, at 14.53$/share, only 69 shares should have bought at the time I started this microblog). But also for the option investor, contemplating alternative 3, the scenario where $NNDM is below 7.5 in May could cost me 1696$ for 200 shares. Again, too much if you are disciplined in your money management (you could argue that I should roll my options to avoid being exercised, but for someone holding stock for years, rolling every quarter every position in my port would be a daunting task!). Note that, maybe in a year from now, should the exact same situation as today occur, I might have green light to go for alternative 3, as by that time my cost basis will be reduced further. I think dynamics like these are a great example of what makes option investing so fascinating.
So, in sum, the only thing that I will do at this stage is enter a limit buy order at 0.1 to buy the May21’21 strike 20 call back (remember it is at 0.45 now). There is no point of waiting, maybe for more than a month, to collect the very last 10$ of the 370$ that originally were to be collected. When that happens, I will evaluate again. $NNDM is reporting earnings next week, so that is another high-risk event for the stock and I do not expect the call to trade for 0.1 before that. Eventually, I will sell OTM call premium again to further manage my risk, maybe at strike 20, maybe rolling down to strike 15, we will see.
Good luck everyone, try to take advantage of the opportunities arising now but don’t overtrade and manage your risk carefully. All the best!
I would have to read this 2-3 times or more. Thank you . Is there a method to reach you via chat.
TTP,
Thank you for the informed take on NNDM! Once again, new to options, but thought it was a smart move a month ago to sell a put to obtain the stock at a lower price. I was conservative on the strike price (12.50) at the time, or so I thought. Got in 200 shares at $2.25 premium, making my price $10.25 if exercised. Then the price fell. Eek! I rolled those positions out another month in hopes that it doesn’t fall lower than $7. I may have to deploy your strategy to save myself. I didn’t realize when I bought NNDM what a heavily shorted stock it is also. Hard to fight that! Thanks again for your expertise…it’s appreciated!
I appreciate your detailed reflections, once again, TTP.
I, too, decided to try out a synthetic covered call maneuver. But started small, just one so far, and wound up being a little slow getting around to it. THIS week, that delay turned out to be fortuitous!
Hi SillyRabbit, lacasaless and timcoahran,
@SillyRabbit: I am sorry, I am not professionally certified to provide you any advice. My sole ambition is to keep this microblog alive, here in this tiny corner of the Gumshoe universe (as I promised myself to not start commenting in other threads). I hope to make some people enthusiastic about learning more about options, that is all. Feel free to follow along in the future!
@lacasaless: Nice that you are starting to integrate options in your investment strategies! I also try to initiate new positions as much as possible using (cash secured) puts, certainly the low priced ones.
You probably regret taking on 2 positions immediately, as scaling in would have worked better last week, but (if it provides any comfort) I am in exactly the same situation. I maybe did not stress that enough in my previous post, but I really would have liked to average down on $NNDM!
It is just that, over time, I have become very disciplined in risk and money management. I would be much more nervous about breaking my own investing rules than about what is actually happening in the markets. And although I was certainly too optimistic, thinking that SPX would at least hit 4000 and likely, in that scenario, overshoot maybe 10% or more to the upside, I think both you and I see a possible path to making our position profitable again (an insight which prevents us from panic selling and allows us to stomach market volatility better). It comes down to letting the passing of time work in our favor, which one can only do by selling time premium. That is what thinking theta positive is all about!
(for readers unfamiliar with theta: it is one of the so called ‘option greeks’, indicating the dollar amount of daily time decay of an option: if you only have stocks, your position is theta neutral; if you buy a call or a put, your position is theta negative, because every option has time premium which decays over time in a non-linear way (provided you are not too far ITM or OTM), excelerating as you approach expiration; if you sell a call (like in a covered call strategy) or sell a put (like lacasaless did), your position is theta positive and you benefit daily of the passing of time.)
Call premium on $NNDM options is currently depressed of course, so waiting for at least a 15-20% bounce might be recommendable. And actually, since you have 2 contracts, you can really tailor your call writing to your own preferences. Maybe agressively sell one call at strike 10 and let the other 100 shares free? Or sell two calls at strike 15? The important thing is that these are all choices that you can make because you have learned to use options in your investing. You have now more control over your investment than the standard buy-and-hold stock investor. Good luck!
@timcoahran: honored that my post inspired you to try synthetic covered call investing yourself! I hope it works for you as much as it works for me, certainly in building and managing a portfolio of volatile low-priced microcaps. All the best!
TTP,
I was thinking about selling a call on one or both of my positions, so I’m happy to know my thought process seems to be on track. As always, appreciate your input!
Ooo – i like that take on Theta! Amazing how much more clear something can seem – just after hearing it stated another way.
Also your response to getting exercised: that it’s not the end of the world, you just set up another one.
Aahh, the option greeks! Yes, getting a good understanding of them is a hurdle every student of options needs to take. Luckely, they are more important for the short term trader than for the long term investor. There was a time — first when I was trading calendars and condors on weekly index options, and later when I decided to try gamma scalping– that I solely relied on the greeks to manage my positions. Although I am not a pilot, it certainly felt at times like landing an airplane in the middle of the night using your instruments only!
The thing with the option greeks is that they are all highly dynamic, definitely close to expiration. If you are basing your decisions on using them, it is crucial to understand that they really only offer you a snapshot of your position the very moment you look at them. When price is volatile, ten minutes later, it can be a whole different story. I read that, yesterday, $GME dropped 50% in 23 minutes! What a horror for the moneymakers trying to keep their positions in that stock delta neutral, hahaha!
A quick update on $OPTT, for the sake of transparency. Yesterday, my GTC limit order took off the call covering my synthetic position (see original post), collecting 93% of the total call time premium:
Bought May21’21 strike 10 call for 0,1 debit
This increases my purchase price from 3,7$ to 3,8$ for the moment. The stock is under selling pressure, so right now is not a good moment to roll out, i.e. sell new call premium in the next expiration month available, which is August. Let’s wait for a bounce to see if time premium gets more interesting on the call side.
Since my money management rules, described earlier, allow me to still add some money to the $OPTT position, I decided to use today’s weakness to turn to the put side and bottom-fish option style:
Sold May21’21 strike 2,5 put for 0,4 credit
This can possibly decrease my purchase price from 3,8$ to 3,4$ (an 11% reduction), if the stock trades above 2,5$ at expiration in May. Should it trade below 2,5$, I am averaging down, taking on the obligation to buy 100 shares at 2,5$, essentially only paying 2,1$ (a 30% discount to where it is currently trading), due to the credit received today (of course, in the latter scenario my purchase price of the original position remains 3,8$).
This small adjustment to the position mainly illustrates how you can shift your attention of selling time premium from the call side to the put side (and vice versa), staying in sync with market fluctuations, as it speeds up the process of reducing your cost basis further and manage your risk.
Take care!
TTP,
I really like your approach to keeping track of the premiums as non-emotional numbers, credit & debit. So I’ve set up a little spreadsheet to facilitate doing the same, complete with monthly totals, etc.
I found easy clarity in your piece about Theta. I invite you to do a similar piece on each of the other Greeks, too. While I’ve read repeatedly of each of the others, I always have to go back and look ’em up again. But not Theta!
I’m beginning to think The Foole reads Gumshoe too! (I s’pose it makes sense – they’re huge and probably try to cover everything). I noticed that a whole batch of their secret picks got disclosed on here just before the Feb peak. Coincidence? And now suddenly they’re pushing real hard that they’ve got some super options strategy they’re calling “Trifecta.” I haven’t looked at it, but the name sounds like it has three parts. I wonder if they’ve copied your “synthetic Covered Call” ?!
Hi Tim,
Exactly, I routinely write down my collected time premium in a spreadsheet too. My aim is to see quarterly growth of total time premium collected, without violating my rules about not selling calls too close ATM.
Many people underestimate the power of the following: buy x stocks (synthetically or not), sell time premium on these x stocks and use the time premium to buy stock x+1; next expiration, repeat, now selling time premium on x+1 stocks and buying stock x+2; and so on. There is a strong non-linearity in this: it takes 3 stocks longer to help financing stock 4, than it takes 4 stocks to help financing stock 5 (assuming the stocks are comparable in price and volatility, of course).
About MF pushing a super options strategy: mmm, I would be very sceptical, as such a strategy simply cannot exist. I would be very surprised if the Trifecta refers to the option strategy itself, like the three legs of the synthetic covered call strategy, rather than to the method of stock selection prior to opening the option position. They probably have developed another screener where three conditions need to be met simultaneously before a position is considered. Once that is done, I would not be surprised that they simply suggest to buy a long call or, to make it a bit more advanced, a simple debit call spread.
But I could be wrong, of course, and that would be fun! So, can any other Gumshoe member enlighten us about TRIFECTA?
All the best.
Quick update on $NNDM, very similar to my recent update on $OPTT: on Monday, 46 days before expiration, my GTC limit buy order on the covered call from the original position was triggered, collecting 97% (3.6/3.7*100%) of total time premium:
Bought May21’21 strike 20 call for 0,1 debit
Hence, purchase price of $NNDM increases from 11.25 to 11.35. Stock buyer benchmark is 14.53. Stock currently trades at 7.89.
Obviously, not the right moment to sell new call premium, the Aug20’21 strike 20 call sells for 0.35 credit at this moment. I might put in a GTC sell limit order for that specific call at 1.15 credit (aiming for a 10% reduction of purchase price), curious to see if that triggers in the coming weeks.
Meanwhile, on the put side:
My post of March 5 on averaging down on $NNDM happened around the first bottom, now it looks like the stock might form a double bottom in the 7.5-8 range. That means that the May21’21 strike 7.5 put, currently selling for 0.75, is still a siren singing at me, but I must resist, I repeat, not because I don’t like $NNDM, but because of money management rules explained earlier.
Overall, I wouldn’t worry too much about $NNDM, all price action is still happening above a rising 200MA in a highly correlated microcap correction environment. This is not the end of the story for this one!
Is the stock market manipulable? For a long time I refused to accept this claim, unwilling to blame the market for my own mistakes. But sometimes the evidence is quite overwhelming. A good example happened on Friday, when Pinterest ($PINS), a stock I happen to own in my own lockbox portfolio, turned out to be my biggest loser of the day, down 9,72%, a daily decline the stock hadn’t experienced in the last six months or so.
According to the Motley Fool and other related financial media, the reason was obvious: some report published at Seeking Alpha was hinting at decelerating revenue growth (an argument that, by the way, another analist denied later on the day).
https://www.fool.com/investing/2021/04/16/why-pinterest-stock-fell-sharply-today/
Foggy explanation.
I’ll try to do better.
I think it has everything to do with the topic of this microblog, namely the difference between buying options (theta negative) and selling options (theta positive). The majority of retail traders buys options, their counterparty being institutional market makers that sell options to them. The latter have every incentive to see as many open option positions expire worthless as possible.
Last Friday was expiration day of the April monthly option cycle.
The maximum pain (max pain) is an option concept identifying the strike price at which the total sum of open calls and puts that expires out-of-the-money is maximized. In other words, intuitively, it identifies the strike price at which the transfer of money from option buyers to option sellers is greatest, the point where most possible intrinsic value is driven to zero.
Friday the max pain for $PINS was at strike 77$ (see attached graphs).
But there was a problem.
$PINS opened at 84$.
There was some work to do.
Where did $PINS close?
At 76,22$
QED.
What does it mean for us retail investors?
Focus on the long-run. Ignore daily price swings. Don’t follow your portfolio intraday. Switch your candlestick charts from daily to weekly (or monthly). And try to sell some option premium yourself.
All the best.
Can someone help me how to attach an image to a comment? Or is that not possible? Thanks!
That’s an interesting new (to me) metric: max pain.
Totally makes sense, though.
TTP, you’re definitely moving THIS student around to the correct side of Theta!
Of course one can connect the two explanations and question the timing of the Seeking Alpha report, on expiration day and given the max pain situation of the stock in the option market. Are such coordinated institutional actions possible? Do market makers order ‘research’ articles at will?
I’m trying to follow up on your personal money management rules, often mentioned “as described earlier.” I can see that they were developed over time, and you use them to avoid getting swayed by the heat of the moment. But I’m not doing well at finding the specifics.
One was “about not selling calls too close ATM.”
And there were places where one allowed or prevented you from putting more money into a position.
If you’d be interested in sharing the complete set – I’d sure read ’em!
Hi Tim,
Thanks for your question. It is always hard to write down very specific rules when one mostly trades discretionary (see also Travis’ attempt, a couple of weeks ago in a Friday File, to specify his sell rules during a correction). The money management rule I am referring to ‘as described earlier’ is the simple idea of placing an upper bound on the amount of money invested in every single position. That upper bound depends on how much conviction I have in the future of a company, in combination with my beliefs about how the market will regard the company moving forward. I would go up to 2% of portfolio value in setting up a high conviction position (like $PINS), 1% for medium conviction (like $NNDM) and 0,5% for the riskiest bets (like $OPTT). That indeed sometimes restricts me from averaging down when the cost basis of a position is not yet sufficiently decreased due to selling call option time premium, which I, by the way, only do in my microcap portfolio (and not in my mid/large cap lockbox).
On the choice what strike to sell, my aim for every position in general is always a triple digit return. At least 2x as part of the broader investment goal of doubling my portfolio every 5 years is, although certainly ambitious and far from guaranteed, in my opinion, not unrealistic, provided you know what you are doing (Travis’ exceptional transparancy in sharing his portfolio results in the latest Friday File was really inspiring in that respect!). Ideally, I buy a stock at, say, 10 and sell quarterly call time premium at 20. If the stock stays at 10 on average, I have 20 quarters to reduce my cost basis with 50% to 5, which is not unrealistic. If the stock does better, I’ll reach my target sooner and easier. If the stock does worse, I’ll have more work to do, likely averaging down with cash secured put writing at some point and managing that additional position further. Note that, once the 2x target is reached, I do not close the position, even not if my position is ITM and I risk being exercised. Time premium is maximal ATM and decreases gradually as you move further ITM. Rolling out can still make sense, provided your strike is not too far ITM and transaction costs are not eating away too large a share of your collected premium.
I am not a big fan of fully specified trading systems, although I tried several in the past. When I was swing trading CANSLIM, I had precise rules for scanning, entry, exit, stop-loss and position sizing. Rules in, emotions out. Three years and around 300 trades later, I was actually profitable (a single digit annual return though), but very frustrated. The majority of trades were losses with an average holding time of only a couple of days. A few large winners, where I was fortunate with entry timing, were holding the entire system together! When I was trading calendars on weekly SPX and RUT options, I also had fully specified rules on setting-up the position and adjusting it, this time completely determined by the evolution of the option greeks (mostly delta). It was the opposite situation: in most weeks I made a modest gain, only to give it all back (and more) on occasion (usually when the index moved higher sharply). I never managed to make money consistently with index options.
In many ways, fully focussing on long-term investing now, I am writing what I consider the last chapter of my own investment story. It is obviously also going to be the longest.
All the best and thanks again for your reactions to my posts.
TTP,
I was getting ready to withdraw the rules question, because after combing through the whole conversation I was able to glean several individual details. But this answer is more complete, thanks.
I was also going to ask why you re-bought back the calls at 0.10 – but figured that one out myself!
Now I’m surprised to learn that you don’t sell Theta on your mid and large cap positions. So I’m trying to guess why. Perhaps these are core stability positions, to not be disturbed? Or being less exciting to speculators, the rates aren’t as good – maybe not worth the management hours? Or, upon re-reading, I also see that you have them in a lockbox situation. That could explain it right there.
I, too, try to hold things long, and minimize the wheelin’ -n- dealin’.
Yes, indeed, all your arguments play a role, most notably the lockbox idea. Your emotions are the greatest enemy of your own investment success. But doing covered calls on my mid/large cap portfolio would also be simply too expensive. I think you need to manage at least 7 figures to do that properly, supposing you also want to be well diversified. Just looking at my own portfolio, several names (AMZN, MELI, SHOP, …) are expensive (out of curiosity, I just calculated the average price per share in my lockbox (of currently 33 positions): it is 393$/share, so simple back-of-the-envelope calculation: 393$/share x 100 shares x 33 stocks requires 1.296.900$).
Of course that doesn’t mean you cannot do other, preferably theta positive, option trades besides covered calls. Most notably credit spreads of course (bull put spreads (bullish) or bear call spreads (bearish)). I have done numerous of these in the past. But since you are typically setting-up credit spreads a couple of weeks out, it is essentially a short-term directional bet, independent from any kind of long-term position investing. Moreover, it is incredibly hard to find an edge in these short-term directional trading strategies (even with the use of a real-time option scanner) as the risk/reward is often not very attractive.
No, for now, I am happy with my option selling on small/micro caps only, after all the most speculative part of my portfolio. The collected time premium acts as my main risk management tool (remember I don’t use stop-loss orders). Moreover, it provides a quarterly hedge against volatility (no need to buy index puts or trade the VIX). And finally, it fertilizes new positions (3 stocks paying for stock 4, 4 stocks paying for stock 5, …). It is for sure a slow process, but Rome also wasn’t built in a day!
I love chess and I love options and the fact that I love both is, in my opinion, not a coincidence. As there are many parameters to consider when setting-up an option position (call or put, buy or sell, strike selection, expiration date selection, number of contracts, single- or multi-leg positions) and as you can tweak your choices to current market conditions, it constantly feels like you are in a strategic interaction –call it a game, if you will– with Mr. Market as your opponent.
There is at least one important difference between chess and options though. Powerful chess engines can guarantee victory, but, unfortunately, a similarly powerful option engine, telling you exactly what to do at each moment, does not (and cannot) exist. In the world of options, with all its trade-offs involved, an unambiguously best move cannot be found (and should it exist, market makers would arbitrage it away immediately).
So what we are left with is an open game, where you have to balance rationality with emotions, and where your only guide can be what you believe are sound investing principles (have a long time horizon, diversify sufficiently, learn options and think theta positive!).
I started this microblog on February 17 this year, right near the peak of the market, and selected two little volatile stocks ($NNDM and $OPTT) as the main characters for this story.
Well, this first quarter was certainly eventful. Mr. Market drove $NNDM from 17.89$ down to 5.39$ and $OPTT from 7.3$ down to 1.83$ (peak to bottom) in less than 3 months.
Hip hip hooray for my entry timing and stock picking skills!
But here is the catch: the longer your time horizon is, the less your timing matters. And when you are integrating options in your investing approach, rest assured that you can deal with a couple of (initially) bad stock picks.
My first move in $OPTT was buying 100 shares at 3.8$/share (I am using single contracts here for convenience, you can scale by multiplying everything by factor k, according to your own normal position size) via a synthetic covered call position on a day where $OPTT closed at 5.02$. I then later added 100 shares at 2.1$/share via a cash-secured put position, which expired in-the-money (ITM) last week. Here is my third move, completed yesterday:
Sold Nov19’21 strike2,5 call for 0.6 credit
Sold Nov19’21 strike2,5 put for 0.8 credit
Total combo: 1.4 credit or 140$ received
In option lingo, I sold the November 2,5 straddle. In general, selling straddles is a very risky option strategy, as a big move in either direction can cause a huge loss. Luckily, in my specific situation, things look very different. I did essentially build a profit tent over my second stock position with 2.5$ as its centre, a position that will remain profitable as long as $OPTT stays in the interval [1.1$-3.9$] (strike + and – credit) before expiration. What happens if that is not the case? Downward risk is limited as the stock cannot go under 0. The biggest risk is that $OPTT one day, on fantastic news, jumps to, say, 10$. I’ll then have to sell 100 shares for 2.5$ (rather than for 10$). But the good news is that I do not have to buy the shares back at 10$, as I own them already (so, I am not selling the call ‘naked’) with a cost basis of 2.1$/share. And my original position (with cost basis 3.8$/share) is left uncovered and hence has unlimited upward profit potential.
There are only 2 possible scenarios in November that Mr. Market can present me with: (1) $OPTT trades above 2.5$ or (2) $OPTT trades below 2.5$. Let’s discuss each in turn.
In scenario 1, I will have sold 100 shares with a cost basis of 0.7$/share (2.1$-1.4$) for 2.5$/share, which is a 257% gain. I can then use these 1.8$/share profits to lower my initial cost basis from 3.8$/share to 2$/share. That would also immediately mean, since $OPTT trades above 2.5$ in scenario 1, that my remaining position in $OPTT has turned profitable, remind you, within a year and despite a 75% drawdown of the stock! That’s exactly how options can be used to manage risk!
In scenario 2, I will own 300 shares (100@3.8$/share, 100@2.1$/share and 100@1.1$/share) and likely sell covered calls against 200 shares at strike 2.5 moving further.
A final remark: you may wonder why I chose November and not August as expiration month? Doesn’t time premium decay fastest in the last three months before expiration?
That is true, but since I would (slightly) prefer scenario 1 over scenario 2, I am simply giving $OPTT some more time to recover. You also don’t have to trade every position every expiration cycle. Travis wrote an interesting thought on investing/trading slowly in last week’s Friday File. I very much recognize that.
Take care everyone.
ps. on $NNDM I do not have much to report. Call premium is still too low to sell a covered call against my position and I also still did not average down via a cash-secured put, although I am watching the November and December strike 5 puts closely.
Greetings, TTP.
Several weeks ago, i enjoyed reading your helpful (math) comments in another thread.
I’ve been away on a great Alaska vacation, hiking, climbing, sea kayaking, paragliding (even twisting my ankle) – all some of the things that make living here so worthwhile! Now i’m returned, reviewing portfolios, and deciding which synthetic deals to make in July. Your articles and way of thinking have proven most useful!
(Apologies to anyone who doesn’t want to see my idle personal chit chat in this public forum. It’s the forum we’ve got, and i try to stay in this back corner out of the way.)
Good to hear from you, Tim, thanks for your message! I’d love to visit Alaska with my family one day, it sounds great. Here in Europe travel between countries is still restricted with regulations changing by the week, so our holiday plans are still uncertain. But for sure, I’ll be going offline for some time in the near future as well.
Strong performance by popular mid and large caps in the last two months! Equity curve of my lockbox portfolio is now back to the levels recorded in February. Small caps are underperforming still, but, importantly, (unrealized) losses are for about two thirds hedged by the collected time premium of my theta positive trades over the same period. As always, I keep trying to increase total collected time premium quarter over quarter, looking to reinvest (and collect more new time premium) in the most promising small cap names, usually discussed somewhere here in the stockgumshoe universe.
All the best!
$NNDM: with elevated implied volatility (because earnings report today), strike 5 nearing ATM (yesterday’s close 5.39) and an oversold RSI(14) reading (29.21 to be precise), maybe a good time for some action, so:
Sold Nov19’21 strike 5 put for 0.8 credit
To be continued…
What to think of the MILE-LMND 19-1 stock deal? At yesterday’s closing price of $70.5 per LMND share, it apparently values 1 MILE share at $3,71. Seriously? How many months are we after the SPAC deal and the consequent mania running it up to $20? Did the insiders know from the beginning? Also no more covered call writing on the position for me (because I do not own 1900 MILE shares). Crooked deal.
we’ve just been scammed 🙁
The more LMND shares drop in value by the time the deal closes (Q2, 2022), the cheaper the deal becomes and hence the bigger the holdup on MILE shareholders. What a perverse situation! For sure, I’ll vote against the deal, like many retail investors will, but I am afraid it is already arranged by the big boys.
I had only some warrants of MILE. I guess if something’s going to wind up worthless – i already took that risk, when buying warrants!
Now it looks like the cheapest way out.
I think Trav mentioned somewhere, that he’s in the same boat.
Rolling out the cash secured puts on both $NNDM and $OPTT in order to avoid gamma fear and (early) assignment risk this week. Below the specifics (for whoever might be interested):
NNDM:
Buy Nov19’21 strike 5 put for 0,05 debit
Sell Feb18’22 strike 5 put for 0,7 credit
Total combo: 0,65 credit
OPTT:
Buy Nov19’21 strike 2,5 put for 0,5 debit
Sell Feb18’22 strike 2,5 put for 0,75 credit
Total combo: 0,25 credit
thank you for sharing
Hi SillyRabbit,
You are welcome. I will analyze both positions more extensively in February, when I am exactly one year in both trades. The goal of this microblog has always been to demonstrate how selling options can be used to manage risk within a long term positional investing strategy (and not to ‘pick up pennies in front of a steamroller’ as is often believed). It is therefore necessary that I post the specifics of each move, although I would understand that people are wondering what exactly is the relevance of posting these numbers. I simply hope to create something of value over time and over the content of the entire microblog, much more than in every single post as such. Thanks for following along!
Best wishes.
Hi Theta,
Last time we spoke was way back in July. You said you would be going offline for a while, and then i did too again. If you ever do make it to Alaska, i would be delighted to shake your hand and buy you a beer! Also, i had guessed that you were somewhere in Europe, though i don’t immediately remember what the clues were. It’s fun to learn that that guess was good.
I’ve been doing some of your ideas, with wins and losses gradually averaging toward the good. Like you said, ‘Rome wasn’t built in a day!’ In the big picture, this is a bit like compounding. Always glad to see your posts.
Tim
Hi Tim,
I do not remember giving any clues before, but I have one for you today as I am living in the city where option contracts were invented and first traded (in the beginning of the 17th century)! How fitting, isn’t it?
Yes, ‘time in’ rather than ‘timing’ the markets is what will make the difference eventually. There are no shortcuts, nor magic formulas. Investing is boring and exciting at the same time. I couldn’t imagine a life without.
All the best.
Today I am celebrating the first anniversary of my little microblog, comfortably hidden in one of the dustier corners of StockGumshoe’s polygonal universe. Unknowingly, it looks like I have provided generations far into the future with a tale of what stock market mania anno 2021 looked like: intoxicating 100x promises on SPACs and crypto for everyone!
Back to the facts:
02/17/2021
NNDM: 14.53$
OPTT: 5.02$
02/17/2022
NNDM: 3.9$ (-73%)
OPTT: 1.12$ (-78%)
The purpose of my writings was/still is to demonstrate how simple option selling (covered calls and cash secured puts) can be more than just ‘picking up pennies in front of a steamroller’ as is often believed. Through several option trades, all documented in real time on the blog, I reduced my cost basis, in 1 year time, on NNDM to 9.9$/share (a 32% reduction) and OPTT to 2.23$/share (a 43% reduction (to be fair, for OPTT I averaged down as sold puts were assigned early)). Collected option premiums provide, at the same time, a meaningful risk reduction (reduction of cost basis), a hedge for the portfolio (due to the negative delta of the sold calls) and a source of income to reinvest and create a flywheel (2 positions pay for a 3rd, 3 positions pay for a 4th, etc.). I apply it consistently on most of my microcap investments.
Moving forward, with OPTT and NNDM at these depressed prices, my arsenal is currently limited. Two weeks ago I was assigned early on the deep ITM sold puts on OPTT. I will now start selling covered calls on 2/3 of the position, leaving 1/3 uncovered. Since 2.5$ is the lowest strike, currently so far OTM, there is no meaningful bid on a 3-6 month timeframe. I’ll likely try to sell a year out if I can reduce my cost basis by 10-15% (a deceleration of cost basis reduction is unavoidable at this point, also because I will not commit more capital to the position). For NNDM I rolled the puts out again (on Feb 8), leaving the upside still uncovered for the time being:
NNDM:
Buy Feb18’22 strike 5 put for 1.15 debit
Sell Aug 19’22 strike 5 put for 1.5 credit
Total combo: 0,35 credit
No idea what the future will bring or how long this correlated correction will last. I’ll stick to my plan, never hoping but rather patiently waiting for the tide to turn. Best wishes!
Yesterday’s price jump in OPTT triggered my GTC call sell orders (on 2/3 of the position):
Sell Jan20’23 strike 2,5 call for 0,4 credit
I left quite some money on the table as the same calls sold for 0,65 later in the day, but that is the price to pay when using GTC orders, I guess.
In any case, collecting 0,4 on a 2,23 cost basis is a 18% reduction, in line with what I was aiming for this year (see my previous post).
Hi TTP,
Can existing options contracts get their strike adjusted somehow?
I had sold (back on 2/1/22), what i sure thought was a [SIRI Jun 17 ’22 $6 Call].
Now i see it’s a $5.75 strike!
I know direct buy orders can be automatically adjusted for things like ex-dividend dates passing. Could this be something similar? Hard to imagine i wrote it down incorrectly, when none of my others have such typos (and i always double-check when making database entries). Also, the decimal .75 strike value looks uncommon, at least among the ones i’ve seen here in the U.S. The whole Jun 17 chain has them now.
I tried to look up whether the underlying had had a reverse split or something – but didn’t find any clues there…
Tim