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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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?
------------------------------------------------------------------------------------------------------
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.
------------------------------------------------------------------------------------------------------
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.
----------------------------------------------------------------------------------------------
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
----------------------------------------------------------------------------------------------------
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'
--------------------------------------------------------------------------------------------------
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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Friday, August 03, 2012
Musings on Option Plays
We got two anonymous comments posted to our last entry. I am sorry but I still have not figured out how to get blogspot to display comments where they can be easily found and seen. But they are there. The second one - a quickie - pointed out that Docks in New York has a great raw bar like Philly's Oyster Bar, and jazz twice a week, notably for Sunday brunch. I have long been a Docks customer at their East Side location, which is convenient to my office. I would also point out that it has a lively and comfortable cocktail bar as well.
The first comment took issue with my posting of the Moore excerpts from the WSJ and my stand against the greens and in favor of industrialization. One part of the comment criticised Moore's complaint about green energy subsidies and compared them to the costs of Middle East wars, which greens claim have been fought to secure oil supplies. I would certainly dispute that propaganda, but even if it were true, the only reason we need to import foreign oil is that the administration, catering to Green anti-industrialism, has refused to do the simplest things that would supply our needs from the Americas, including the Keystone Pipeline, restarting off-shore drilling, and commissioning nuclear plants.
I really don't want to get into another rant on this subject (and I am reserving judgment on the conversion of a global warming skeptic whose conclusions were printed to much fanfare in the Times this week, though I like his methodology - but we'll wait for the peer review), but people seem to get upset about my stance and feel compelled to try to convert me. I don't understand why anyone cares what this layman thinks is causing or not causing global warming, but people do. My advice to them is get over it. Frankly, I don't care whether global warming is man made or not, it would not impact my policy choices either way. I am in favor of industrialization and modernism, simply because it erases poverty and combats hunger and disease, and makes the world more comfortable. If the price for that is that the earth heats up a degree or two, fine. I think there might be as many or more positives as negatives from that, and anyway, I doubt these things are particularly within our control. The earth has been much warmer in its history and also much colder. There was a time in earth's history when a day was about 16 hours long and a year about 480 of those shorter days. Some day, a day will be even longer than 24 hours. Will longer exposure to alternating sunlight and darkness change earth's temperature? Maybe. The point is that today's conditions are no more the natural state of things than any other set of conditions in earth's history. Man will have to adapt or follow other species into extinction if and when conditions become more harsh. We won't improve our chances by retreating to Walden Pond, that's for sure.
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One request received not long ago was for some info and opinions relating to stock options - calls and puts, that is, and why they are not part of the redwave investing strategy. When are they appropriate and for what purposes? So we'll start with a short primer, and continue for a couple of posts.
A call is an option to buy a hundred shares of a stock at a given price (the strike) within a certain time, ending at the expiration date. A put is an option to sell a hundred shares of a stock at a given strike price for a limited period of time. Where do puts and calls come from? A market participant may decide to "write" an option and puts in an ask price. If a bidder emerges and a transaction occurs, the option becomes part of the market inventory, called the "open interest."; At any given time, the inventory of puts and calls is available from whatever exchange handles that particular option. The ratio of puts to calls transacted is closely followed by technical analysts for clues to the market's direction. Some believe that a decent put to call ratio is a bullish sign, because too much call interest is considered a sign of a frothy market.
Option pricing is very tricky business, and there are a number of theoretical calculations and computer programs developed to try to assign values to options, depending on the relationship of the strike price and the market price, the time left to expiration, etc. The best known valuation calculation is the Black - Scholes method.
Here's an example of the call buying experience. Let's say a stock is trading at 50 and you are bullish in the short term. So you buy 10 call options at 55 expiring in October. You have just bought options to buy 1000 shares. If the option was trading at 1.50, you just paid $1,500 plus commissions to control this right to buy. Today the option is "out of the money" because it is trading below the strike price. Say you've made a good call and the stock shoots up to 57 in September. Now you are two points in the money. The option price might go to around 2.30 or so, to reflect its enhanced value, but also reflect its nearing expiration. The fact that option prices drop as you get closer to expiration is called "time decay." Think about what has happened. You started off paying about a 6 and a half point premium - you were 5 points below the strike price and paid an additional 1.5. The stock went up so you are ahead, but the premium decayed to 0.3. The stock is two points over the stock price but the option price is only 2.30.
This is why the game is so hard. Even if you get the direction of the stock right, you still face time decay, which accelerates as the expiration date nears. Let's say you decide to realize your gain and sell. You will get $2,300 minus commissions when you sell the options. If you deal with a discount broker, the round trip commissions might be around $60, so you will net $740, all of it taxable. Alternatively, you could exercise the option and require the seller of the option to deliver the 1000 shares of stock to you at a price of $55. Of course you will now have a paper gain of 2000 on the stock to offset the price you paid for the options. But almost no one exercises options until expiration day. They simply buy and sell the options.
Puts work exactly the same way except in the opposite direction - the buyer of the puts hopes the stock will go down.
What happens if an option expires out of the money? It is worthless. This is the fate of an awful lot (probably the vast majority) of options written.
Next post, we will talk about the one viable option strategy for the ordinary individual investor - covered call writing.
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Last night was one of those great jazz nights that will stick in my memory for a long time. First I went to my usual Wednesday night 5 PM Birdland show where David Ostwald had a very good ensemble that played two great sets of tunes associated with Louis Armstrong. Then I took the E train three stops to the West Village and the Blue Note where I had a reservation to see Jane Monheit. She was in top form and had the full house thoroughly entranced. Especially good was a new version of Michele LeGrande's "What Are You Doing for the Rest of Your Life?', which will, I think, be on her next CD. She is there through Sunday, and I would make the effort to see her and her excellent trio this weekend if you can.
August will be a great month for NYC jazz. Even Iridium has a good show - Pat Martino headlines the 23rd-26th. Birdland has Steve Kuhn this weekend and the last weekend of the month, a tribute to Charley Parker starring the trumpeter Tom Harrell with Vincent Herring (alto sax) and George Cables (piano). Our friend Brandon Wright will lead a quartet August 18 at Oceana Restaurant. Bucky Pizzarelli joins the Marlene Verplanck Quartet at Kitano, August 23. On August 7, the Cedar Walton Quartet starts a two week run at Dizzy's. And Jazz Standard has the Freddy Cole Quartet Aug. 9-12. This is barely scratching the surface.
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On July 25, we bought 25 shares of Roper (ROP) at 94.30, a "zero buy." On the 27th, we bought 20 more shares of TIP for the IRA at 120.93. Monday, we sold 100 shares of News Corp. (NWSA) at 23.36, that were purchased 2/9/09 for 6.97. We'll take the profit according to formula, and not worry that the stock has an additional pop when it splits into two companies. We have most of the position left. Yesterday, we sold 100 shares of Presidential Life (PLFE) clearing the IRA of that issue. Presidential is the subject of a pending takeover at 14, but we took 13.91, since the commission plus the 9 dollars we gave up is less than what E Trade will charge to execute the takeover transaction. We paid 8.84 on 6/17/09.
Monday also brought good news concerning Shaw Group (SHAW), part of our "Tulane portfolio." Shaw will be bought out by Chicago Bridge and Iron at a nice premium.
The first comment took issue with my posting of the Moore excerpts from the WSJ and my stand against the greens and in favor of industrialization. One part of the comment criticised Moore's complaint about green energy subsidies and compared them to the costs of Middle East wars, which greens claim have been fought to secure oil supplies. I would certainly dispute that propaganda, but even if it were true, the only reason we need to import foreign oil is that the administration, catering to Green anti-industrialism, has refused to do the simplest things that would supply our needs from the Americas, including the Keystone Pipeline, restarting off-shore drilling, and commissioning nuclear plants.
I really don't want to get into another rant on this subject (and I am reserving judgment on the conversion of a global warming skeptic whose conclusions were printed to much fanfare in the Times this week, though I like his methodology - but we'll wait for the peer review), but people seem to get upset about my stance and feel compelled to try to convert me. I don't understand why anyone cares what this layman thinks is causing or not causing global warming, but people do. My advice to them is get over it. Frankly, I don't care whether global warming is man made or not, it would not impact my policy choices either way. I am in favor of industrialization and modernism, simply because it erases poverty and combats hunger and disease, and makes the world more comfortable. If the price for that is that the earth heats up a degree or two, fine. I think there might be as many or more positives as negatives from that, and anyway, I doubt these things are particularly within our control. The earth has been much warmer in its history and also much colder. There was a time in earth's history when a day was about 16 hours long and a year about 480 of those shorter days. Some day, a day will be even longer than 24 hours. Will longer exposure to alternating sunlight and darkness change earth's temperature? Maybe. The point is that today's conditions are no more the natural state of things than any other set of conditions in earth's history. Man will have to adapt or follow other species into extinction if and when conditions become more harsh. We won't improve our chances by retreating to Walden Pond, that's for sure.
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One request received not long ago was for some info and opinions relating to stock options - calls and puts, that is, and why they are not part of the redwave investing strategy. When are they appropriate and for what purposes? So we'll start with a short primer, and continue for a couple of posts.
A call is an option to buy a hundred shares of a stock at a given price (the strike) within a certain time, ending at the expiration date. A put is an option to sell a hundred shares of a stock at a given strike price for a limited period of time. Where do puts and calls come from? A market participant may decide to "write" an option and puts in an ask price. If a bidder emerges and a transaction occurs, the option becomes part of the market inventory, called the "open interest."; At any given time, the inventory of puts and calls is available from whatever exchange handles that particular option. The ratio of puts to calls transacted is closely followed by technical analysts for clues to the market's direction. Some believe that a decent put to call ratio is a bullish sign, because too much call interest is considered a sign of a frothy market.
Option pricing is very tricky business, and there are a number of theoretical calculations and computer programs developed to try to assign values to options, depending on the relationship of the strike price and the market price, the time left to expiration, etc. The best known valuation calculation is the Black - Scholes method.
Here's an example of the call buying experience. Let's say a stock is trading at 50 and you are bullish in the short term. So you buy 10 call options at 55 expiring in October. You have just bought options to buy 1000 shares. If the option was trading at 1.50, you just paid $1,500 plus commissions to control this right to buy. Today the option is "out of the money" because it is trading below the strike price. Say you've made a good call and the stock shoots up to 57 in September. Now you are two points in the money. The option price might go to around 2.30 or so, to reflect its enhanced value, but also reflect its nearing expiration. The fact that option prices drop as you get closer to expiration is called "time decay." Think about what has happened. You started off paying about a 6 and a half point premium - you were 5 points below the strike price and paid an additional 1.5. The stock went up so you are ahead, but the premium decayed to 0.3. The stock is two points over the stock price but the option price is only 2.30.
This is why the game is so hard. Even if you get the direction of the stock right, you still face time decay, which accelerates as the expiration date nears. Let's say you decide to realize your gain and sell. You will get $2,300 minus commissions when you sell the options. If you deal with a discount broker, the round trip commissions might be around $60, so you will net $740, all of it taxable. Alternatively, you could exercise the option and require the seller of the option to deliver the 1000 shares of stock to you at a price of $55. Of course you will now have a paper gain of 2000 on the stock to offset the price you paid for the options. But almost no one exercises options until expiration day. They simply buy and sell the options.
Puts work exactly the same way except in the opposite direction - the buyer of the puts hopes the stock will go down.
What happens if an option expires out of the money? It is worthless. This is the fate of an awful lot (probably the vast majority) of options written.
Next post, we will talk about the one viable option strategy for the ordinary individual investor - covered call writing.
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Last night was one of those great jazz nights that will stick in my memory for a long time. First I went to my usual Wednesday night 5 PM Birdland show where David Ostwald had a very good ensemble that played two great sets of tunes associated with Louis Armstrong. Then I took the E train three stops to the West Village and the Blue Note where I had a reservation to see Jane Monheit. She was in top form and had the full house thoroughly entranced. Especially good was a new version of Michele LeGrande's "What Are You Doing for the Rest of Your Life?', which will, I think, be on her next CD. She is there through Sunday, and I would make the effort to see her and her excellent trio this weekend if you can.
August will be a great month for NYC jazz. Even Iridium has a good show - Pat Martino headlines the 23rd-26th. Birdland has Steve Kuhn this weekend and the last weekend of the month, a tribute to Charley Parker starring the trumpeter Tom Harrell with Vincent Herring (alto sax) and George Cables (piano). Our friend Brandon Wright will lead a quartet August 18 at Oceana Restaurant. Bucky Pizzarelli joins the Marlene Verplanck Quartet at Kitano, August 23. On August 7, the Cedar Walton Quartet starts a two week run at Dizzy's. And Jazz Standard has the Freddy Cole Quartet Aug. 9-12. This is barely scratching the surface.
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On July 25, we bought 25 shares of Roper (ROP) at 94.30, a "zero buy." On the 27th, we bought 20 more shares of TIP for the IRA at 120.93. Monday, we sold 100 shares of News Corp. (NWSA) at 23.36, that were purchased 2/9/09 for 6.97. We'll take the profit according to formula, and not worry that the stock has an additional pop when it splits into two companies. We have most of the position left. Yesterday, we sold 100 shares of Presidential Life (PLFE) clearing the IRA of that issue. Presidential is the subject of a pending takeover at 14, but we took 13.91, since the commission plus the 9 dollars we gave up is less than what E Trade will charge to execute the takeover transaction. We paid 8.84 on 6/17/09.
Monday also brought good news concerning Shaw Group (SHAW), part of our "Tulane portfolio." Shaw will be bought out by Chicago Bridge and Iron at a nice premium.
