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Saturday, August 18, 2012

 

Atlanta Musings and Covered Calls

First things first.  You are all probably wondering what the redwavemusings view of Paul Ryan as VP candidate is.   Really now, isn't it obvious?  We finally have a candidate, the only one of the four, with real policy prescriptions, real comprehension of the fiscal and entitlement disaster we are facing into, and a serious, yet affable approach to politics.  He is also a proven candidate in terms of electability.  He is a 7 term Congressman from a district which actually leans left.  Obama carried the district in 08, yet Ryan won more than 60 % of the vote, as he has the last 6 times.   In short, those progressives who thought Ryan's selection would make it easier for Obama because they could Mediscare him are whistling past the graveyard.  Already the polls show a little change in momentum toward Romney.  This could build as the affable young Wisconsin pol makes his way around the country.

As for the Ryan budget, the Journal had a good piece today by Daniel Mitchell called "What's Really in the Ryan Budget."  Mitchell explains, "The most important headline about the Ryan budget is that it limits the growth  rate of federal spending, with outlays increasing by an average of 3.1% annually over the next ten years.  If spending is left on autopilot, by contrast, it would grow by 4.3% (or nearly 39% faster).  If President Obama is re-elected, the burden of spending presumably will climb more rapidly."  With tax revenues projected to rise 6.6% annually, we could regain some control of our fiscal house if the Ryan Plan were implemented.

The Ryan budget is also misrepresented by the Dems with respect to Medicare.  Ryan's plan actually saves Medicare by reforming the system for future recepients now under age 55.  The administration plan, on the other hand, is to raid Medicare to fund Obamacare.  They did this in a useless political attempt to present Obamacare as revenue neutral which is preposterous.   The upshot will be that Obamacare will cause shortages in medical practitioners and ultimately lead to the rationing of care, particularly for senior citizens (by the so-called "death panels").

If you hear about this at all in the mainstream media, it will be to repeat the misinformation trotted out every Sunday morning by the Administration mouthpiece and resident windbag, David Axelrod.  But Musings readers are too smart to fall for that, right?
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Six days in Atlanta was interesting.  Once the South's first and only truly cosmopolitan city, Atlanta is a sprawling, if slow paced (by NYC standards), urban area with very good hotels and restaurants, lots of good bars of all kinds, a decent, if earthy, jazz club (Churchill Grounds), and all of the usual big city problems, in particular, the omnipresent, brazen panhandlers whose M.O., as in San Francisco, is direct and confrontational.  I wonder how much Administration class warfare rhetoric and the explosive growth of transfer payments (some 70 million now receive food stamps) is responsible for emboldening the nation's growing begging industry.   There are people on the streets truly in need, so I understand and sympathize with that situation, but there are way too many able bodied hustlers out there too.

I stayed at the Marriott Marquis downtown, which is a huge hotel with a very nice layout, especially on the atrium level - very conducive to conference socializing.  There were two good Irish Pubs in the area, Meehan"s and Gibney's.  Ray's Seafood is an excellent fine dining stop downtown, and there are the usual reliable upper end chains like Morton's.  A short cab ride away is the excellent La Pietra Cucina and a little longer cab ride to the Floataway Cafe is worth the trip. 

Like many of our better convention destinations, Atlanta has an excellent rail system that gets you to and from the airport for about one-tenth of what a cab would cost.
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We have long been predicting that Israel would eventually have to take preemptive action against Iran to keep it from developing a nuclear weapon.  The Israeli's have recently given several signals that time to do that is growing short and no one should be surprised when it happens.  Still, the Obama administration counsels against taking such action, pursuing a sanction strategy with more holes in it than a fish net.

The Administration's passivity in this regard is worse than just lousy policy, it's criminal negligence.  What are they waiting for, a nuclear weapons test?  What if the first test bomb is exploded over Tel Aviv?  The Israeli's literally can't wait much longer, nor should they.  Time is almost out.
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 In Part 1 of our series on the uses and abuses of stock options (calls and puts), we illustrated how such options work and the mechanics of trading them.  Options are created when a participant "writes" an option, usually to hedge an existing investment, and another market participant chooses to take the other side, either as his own hedging device or as a speculation.  Since options are derived from stock postions, they are of a class of instruments called derivatives.  Options may also be written based on indexes like the S&P 500.  We'll talk about those in a future installment.  Today, we will talk about the most often recommended option strategy, and one that is responsible for the writing of many of the options in the market's open interest at any time, the sale of covered calls.

If you own a stock, what you really own is a stream of cash flows in the form of dividends, and any future proceeds you can achieve by selling the stock.  Some investors, who are more interested in dividend income than capital gain income, are often advised to supplement their dividend income by selling covered calls.  Here's how it works.  Let's say you own 1000 shares of XYZ, trading at 25, and that's your cost basis too, so you are even.  The stock is paying a not so generous 1% (at market) dividend or 6.25 cents per share quarterly.  That means your $25,000 investment is yielding 62.50 per quarter, better than your local savings bank but not enough to keep you in bordeaux for 90 days. 

One way to assure more trips to the local winery would be to sell covered calls against your position.  Let's say you are willing to part with the stock for a gain to 27.50.  So you "write" 10 calls (100 shares each) at 27.50 expiring, say, in January.  The more time you allow to expiration, the more likely the call might be exercised (since it gives the stock more time to go up) but the greater the premium you can obtain for the call.  Let's say you ask for 2.00 per call, a not unreasonable premium for 5 months for a stock to move up more than 2.5 points.  But no one is willing to offer 2 so ultimately, you cancel the order and put it in at market.  The market offer turns out to be 1.75 and the ten calls are written and sold.  So you bank $1,750 (1.75 times 1,000 shares)  minus the commission, which is quite a bit more than you get from the dividend.  The premium came from the time you allowed to expiration, the proximity of the market price (25) to the exercise price (27.50), and the perceived volatility of the stock.  The longer the option, the closer the exercise price, and the more volatile the stock, the bigger the premium.  If you were willing to let the stock go for 25, you could command even a greater option price.  Think of it from the buyer's side.  To break even, the buyer must see the stock eat up not only the differential between the market and the exercise prices, but also the price of the option.  So as the buyer, I need to see the stock at 29.26 to make the exercise of the option profitable.  Obviously, I should be willing to pay a little more for a call at 25 than a call at 27.50.

So let's go back to being the seller.  What can happen.  The stock could go down or stay close to where it is.  If the stock never exceeds 27.50, no one will exercise the options you sold and they will expire worthless in January.  You keep all the money and the stock, and pay taxes on the gain in the option (1,750 minus commission).  Then I can do the whole thing over again, looking at the then current market price to determine a reasonable strike price for the next options I will write.  What happens if the stock goes above 27.50?  The options will be exercised at a time of the buyer's choosing but no later than the exercise expiration date.  I will get 27.50 for the stock and pay a capital gains tax for the gain on the stock (2,750 minus commissions) as well as a tax on the option income.  I can then buy new stock in XYZ or some other company and repeat the exercise.

If you have enough shares of enough stocks, you can make a pretty good living selling options, and indeed, many mutual funds exist using this strategy.  When brokers explain covered call selling strategies to their clients, many jump to the initial conclusion that this is relatively risk free income.  A good broker will explain the downsides.  What are they?

 First, your stock may go down a lot, and because you have sold options, you may not be able to get out of the position safely.  You don't want to sell the stock and leave the options in place, because your options are then naked (if the stock rebounds, you won't be able to cover the exercise by delivering stock, you will have to settle in cash and there is no theoretical limit to what you can lose).  Let's say, in the above example, that you look up in November and XYZ has sold off to 19.  You have a 6,000 unrealized loss in the stock, and even if you can buy your options back for say, $0.10, your $1,650 gain in the option doesn't offset the loss when you go to sell the stock.  You can buy back (cover) the option and sell another option, but you will have to lower your strike price to 20 to get any meaningful proceeds, and that means that when that option is exercised you will still have a loss.

Second, XYZ can skyrocket.  You will watch regretfully as gains you could have had instead go to the buyer of your options - you are going to get 27.50 and that's it.  You can try to do what I did with Enron, buy back your options at a loss and sell new ones with a higher strike price and much longer time to expiration to capture additional premium.  But in doing this, you are still betting that the stock will come back to earth.  Chances are, you will simply add to your losses, until you eventually throw in the towell and let the stock be called away.  For a great illustration of how this works/doesn't work, go back a couple of years in the archives and find my Enron story.  Experience has proven that when this happens, you should grit your teeth and let the stock be called away.  At least you will realize the gain you expected when you sold the options.

Your good broker should explain that covered call seliing is really an anti-volatility play.  Big moves in your underlying stock in either direction hurt you.  On the other hand, the best option premiums go to the most volatile stocks.  Yet, for those with enough underlying stock, access to reasonable commission schedules, and with a disposition to take the profits that this strategy allows, covered call selling is a viable income enhancement strategy.  Doing it in your IRA account allows you to defer the taxes as well.  However, I decided not to include the strategy in my investing formula and stopped all covered call selling years ago, before I started reporting transactions in this blog.  Though I value dividends, my strategy is aimed at achieving capital gains more than income.  My formula results in enough trading to keep me interested without the constant attention that options trading requires and with far less aggravation.

Next - index options

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If you read the papers, you may not know that the writers of articles seldom, if ever, pen the headlines attached to those articles.  Those are contributed by the often clever editors who lay out the pages.  Headline writing was one of the really fun tasks I enjoyed when I edited the sports pages of the Haverford and Bryn Mawr College News.  So you can understand why the following WSJ headline caught my eye:

Houston's Strip Clubs Hit By New 'Pole Tax'

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On 8/3, we bought 100 shares of Archer Daniels Midland (ADM) at 25.48.  ADM 's outlook is surely impacted by the drought and by the prospects of a backlash against ethanol.  So it is a value buy.  On 8/6, we sold 1300 Frozen Food Express (FFEX) at 1.60.  We paid 3.44 on 9/15/09 for 700 and 2.13 on 9/30/11 for 600.  These losses won't help taxwise since they are in the IRA.  What is helping is that FFEX is performing better both as a company and as a stock, and we will start booking gains soon.  That's why we don't sell all at once.  On 8/8 we sold 900 shares of Sirius (SIRI) at 2.28.  We paid 2.00 on 6/23/08.  On 8/15, we sold 200 shares of Pulte Homes at 12.64.  We paid 8.70 on 6/29/10.  We sell into rallies and there is a pretty good one going on now, in case you haven't noticed.  We have two more sales to report on the next post.

 With the announcement that FSI International (FSII) is beiing taken over by a Japanese company for 6.20, we now have three companies on the buy/hold list pending buyouts (PLFE and Shaw Group are the others).  The effect of this (besides the usual dancing in the streets) is that the prices of those three should be pretty stable until the transactions are concluded.  For all practical purposes, such holdings are cash, though I don't count them as cash, but I consider that right now, our portfolio is a bit cash heavy and that's OK.  One exception is that there is a bigger than normal arbitrage premium available for Shaw Group, perhaps reflecting some risk that regulators might not like the transaction as is. 


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