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Monday, August 09, 2010

 

Covered Calls - The Enron Story

We actually have lots of issues to comment on, but the outcry from commentors (such as they are - judging by the counter, our readers are all on vacation) has been for the long promised discussion of why the seemingly safe strategy of covered call writing actually is not quite such a simple way to modest returns.

The classic M/O espoused by advocates for call writing as a way to enhance stock returns is to buy the stock, then sell call options on some or all of the shares at a strike price above your cost basis. If the stock stays below the strike price, you pocket the call proceeds. If the stock rises above the strike price, you let them call the stock away from you. This limits your upside stock appreciation, but it certainly eases the sell decision, and adds a cash return to any dividend the stock might be paying. if the stock retreats later, you get another chance to begin again by buying it at the lower price.

You do need to understand a few practical nuances. First, call writing does not garner much cash in quiet markets or with stocks that have little or no volatility. Second, unless your discount broker has a very low option commission or you have a large number of shares to write against, it is also difficult to net much cash on the option sale. Third, almost all option exercises occur at the last minute before expiration. The feeling of watching your stock go up way beyond the exercise price while you sit there helplessly with the choice of buying back the option at a loss or waiting out the expiration, is unpleasant, to say the least.

When my discount broker accounts were small, and little new cash was coming in, and not being a trader, I decided that call writing could at least provide some fresh cash to use to grow the accounts. I picked a number of the sexier stocks I owned where the call premiums were reasonable and began to write options. Eventually, with the market rising, I was facing options expirations where the stocks were going to be called away. Like a lot of people, I was not happy about losing so much of the stock appreciation, even though I had an overall gain. So I employed a strategy that is widely used to avoid or postpone call exercises.

The most dramatic of these stocks I wrote option contracts on was the ill fated Enron Corp. The story behind this stock was a doozy, spoiled only by the fact that its results were substantially fraudulent. Less an energy company than an "energy trader" and market maker, the fact was that such markets were largely "Madoff like." Energy trading was largely a mirage, and so were the profits Enron claimed.
In addition, the CFO of the company was dishonestly cooking the books to favor affiliates in which he was given a personal financial interest. There were signs along the way, of course, but...well Enron carried an investment grade rating until the day it collapsed. Sound familiar?

Anyway, the story begins on February 3, 1998 when I bought 100 shares at 40.9375, following a favorable write-up in Forbes magazine. By 2/26/99, the stock was riding high at 65. The stock was paying a 25 cent quarterly dividend, but I decided that the price of the stock might be ahead of itself and that I could enhance the return by selling covered calls, especially since my discount broker's commission was pretty reasonable ($25). If the call expired worthless, the commission would only apply one way, and the call price assumed lots of volatility. On March 18, I sold a call expiring in July with a strike price of 75. The option price was 2.5625 and the net proceeds were $231.24. Not bad, since if they called the stock away, I would have a long term gain of over $27 per share. However, by mid July, the company announced a 2 for 1 stock split, and the price took off for the 80's. Looking back, I should have taken my $75 and let them exercise, but instead, on July 14, a fateful Bastille Day, I executed an "extend" transaction, which I had learned to do with "in the money" covered calls.

I bought back the July 75 call, then selling for 8.75, and immediately sold the January, 2000 80 call for 9. The transactions, including commissions, cost a net of only $25, and for that, I upped the strike price 5 bucks per share, and bought another 6 months til exercise, with a stock heading for Pluto. If it retreated, fine. If not, I could let them call the stock away for 80. I was very happy with this transaction, as I should have been.

I wasn't so sanguine when January, 2000 rolled around. By this time, the stock had split, I had 200 shares and they were trading around 60! Of course, the miserable bastard who had bought the options I wrote in July could call them away from me for 40. This meant that I would now forgo $4,000 of the stock profits in exchange for the lousy $200 of option proceeds I had. Some risk free strategy call writing turned out to be.

Of course, that was the wrong way to look at it. I would still have had substantial stock profits(over $3,000) to go with my $200 plus in dividends. Time to let it go. But I made a 180 degree wrong decision. Figuring I would just go back in and buy the stock anyway, I instead paid 31.875 to retire the two options - $6,400 - and kept the stock. Of course you remember that first quarter 2000 represented a significant market peak.

Of course, this setback only made me that much more determined to recoup, and the retreating Enron price provided some good opportunities. Owning the stock allowed me to sell more options and speculate on a retreating price. On March 28, 2000, we wrote 2 July 80 calls getting 8.25 and bought them back two days later for 7.00. On May 8, we opened a new position by selling 2 July 45 calls at 30.875 and bought them back the next day for 28.50. On May 11, we sold the July 50 calls for 28.25 and bought them back May 22nd for 24.375. So we were making option money, and Enron's stock price was hanging in near 70. Our overall position was still OK.

And so it went. We executed a number of other good round trips, first selling the options, then covering, until we had made the $6,400 back. It was then that I figured Enron was finally fairly valued and bought some more stock. Of course, you know the rest. The stock collapsed in late 2001. We took a loss on the shares, of course. So the irony was that we came out on the options and lost on the stock, after a ride that took us to the stratosphere and back before we sold out at about a dollar or so a share. In all, we wound up with a small profit trading Enron options, and only a small offset to what we lost on the stock. But much of the recoupment in Enron options came from a more aggressive trading strategy after the passive option writing strategy had ended badly. This caused me to rethink and I curtailed call writing on all my stocks. Instead, we started to evolve the trading formula we employ today.

Earlier in my investing career, I proved to myself that a part time investor could not succeed in options trading as a speculator, and Enron proved that even with the covered call writing approach, dangers lurked. Since then, I have not been tempted to use options, even though they are popular instruments for many market players.

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The Mets won tonight, and it's not a coincidence that Carlos Beltran was not in the lineup. The guys who have killed the Mets since the All Star break are the washed up injured veterans who came back to play -Beltran, Castillo, and Cora. Thankfully, Cora was released and Tejada was recalled, moves we were asking for for weeks. Castillo was benched and what Tejada does defensively more than makes up for his anemic offense.

As for the outfield, with Beltran in center, the Mets get hurt in two positions since Pagan is not nearly as good a corner outfielder as he is in center. Beltran's balky knee makes him ineffective in center and at the plate, and I would just bench him. In fact, I would look to trade him to a contending team that might be interested, for some prospects. I would assume that Pagan will play center next year with Martinez, Bay, and Francour sharing the corners. Another possibility for the spring would be to try Wright in left field to make room for Murphy at third base and look to move Bay.

Of course, it starts with management and that means Jerry has finally got to be cashiered. Bringing in certain types of managers can make a difference. Look what Buck is doing with the hapless Orioles. Nothing like discipline and demanding performance to focus a ballplayer's mind.
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On July 30, we sold 100 shares of Standex (SXI) at 29.30 that were purchased 5/18/09 for 10.30. On 8/2 we sold 100 shares of Tomkins (TKS) at 20.46 that were purchased 1/21/09 for 6.92. If you don't believe me, look up the purchase prices in the archives. On 8/4, we sold 100 shares of Ladish (LDSH) for 31.57, purchased 8/19/08 at 26. On 8/6, we sold 300 shares of Newpark Resources (NR) for 8.18. We had bought 100 on 10/6/04 for 6.23 and 200 on 12/15/04 for 5.25. Just because averaging down failed with Enron doesn't mean it fails all the time.

We returned briefly to the buy side yesterday, buying 2000 shares of Sirius XM Radio (SIRI) for 1.05. We'll see how this average down comes out. Another average down disaster has been Bank of Granite (GRAN). With the company doing everything it can to hide its quarterly report from view and the FDIC lurking, I decided today to finally throw in the towel before it all becomes worthless. However, this is a thinly traded stock so it has to go out in well timed pieces, not in one big chunk or else I can depress the price. We got off about about 1900 shares today and I will report on those (losing) trades, and hopefully others, in the next post. I would have liked to have delayed taking these losses until next year when I assume tax rates might be higher, but by then, the shares may be really worthless.

Comments:
Great story, the theory behind covered calls is clear - have enough stock and volatility to make the transaction worthwhile. The moral seems to me that you must be satisfied with the original trade strike price in a transaction - let the enron shares go and take the profit. Covered calls are only an enhancer. I too made mistakes with covered calls but made some money too. My lesson is set a price to sell and be satisfied if the price is attained. Interesting is how we learn from mistakes.
Interesting here too that one of Los Metsos problems is lack of discipline. While to forgive is Devine to err is ... (fill in the blank)
Well back to vacation.
As always, Hail Freedonia !!
RT Firefly
 
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