Value Investing Forum

The time element does put a damper on things. But there are definitely advantages.

For one, you can risk a lower amount of capital to get the same exposure to the stock. This can reduce your potential losses.

Secondly, they are leveraged bets so you can profit more from the ones that do win.

But think about it this way. What's that piece of paper (metaphorically speaking) that you own actually worth. Isn't it really only worth the cash payments you receive discounted to present value? For many stocks, they aren't liquidating their assets, they aren't being bough out with cash, they aren't paying dividends and there is no indication that they will ever pay a dividend. So aren't they all just "big if's" and aren't we still dependent upon markets making what we consider to be reasonable assumptions about what these businesses may be worth (provided that they do eventually shake off some cash for owning that piece of paper.)

somrh said:

As another side note, I noticed that one of the assumptions of Black-Scholes is normal distribution. Is this appropriate?

One of the things I've seen frequently as a criticism of the risk models used in finance is the assumption that data is normally distributed. I've read that the Cauchy distribution might be better.

Nassim Taleb (author of black swan) runs a fund that, among other things, constantly sells options on small market changes while buying options on huge market changes (e.g. violations of the normal distributions). They lose 10%+ per year in normal times then during the big moves make 100%+ , or at least that's how it was related to me. They did really well in 2008.

As another side note, I noticed that one of the assumptions of Black-Scholes is normal distribution. Is this appropriate?

One of the things I've seen frequently as a criticism of the risk models used in finance is the assumption that data is normally distributed. I've read that the Cauchy distribution might be better.

somrh said:

Hi Somrh,

I agree that risk should be viewed as "loss of capital" as opposed to volatility of returns.But that can be a slippery slope when it comes to the world of options as they are leveraged assets.From what I have read so far,value investors do not appear to have a problem averaging down sound companies should Mr Market feel naughty.

 

If that is the case,and the scaling in is part of the pre-determined  "trading" strategy,then one should certainly be a put seller as long as they apply sound money management allocations to that particular stock as it realates to their capital and portfolio.Still,I would only sell puts that clear a certain hurdle rate.

 

I do agree that call buying relies on market/stock timing and that is no easy task,and the daily erosion of options can be bothersome.For that reason,I typically buy spreads,and may ratio call spreads depending on the level of volatility.On should have a very good understanding of the delta/gamma dynamics before ratio-ing options.

One other use of options that I do think Ben would like is using index options to hedge some of the market risk out of a portfolio.One must feel somewhat confident that his portfolio has a high correlation to the index(S&P 500),and a similar beta in order to have an effective offset.This is my predominant use of options..

 

Allan

 

 

 

 

 

 

 

 

taowave, welcome. I may have some more specific questions for you when I have time to think through some things.

One of the distinctions that was important to Ben Graham is the distinction between speculation and investing. He seemed to think speculation could be "rational". This, in my view, would be any speculative play in which expected value is sufficient for the risk involved. I would guess that many options strategies fit that.

One of investment's essential qualities is that risk as permanent loss of capital should be minimized. This is why I think buying calls and puts is not investment in Graham's sense since if the prices don't go where you expect in the time of the option, your losses are 100%. And this occurs even if you are completely right about your assessment of the situation.

The reason I think writing, say, covered calls fits Graham's criteria is that you can't lose the premium you gained. There is certainly risk involved (missing out on huge returns) but that isn't a risk to your capital. To give an example consider the following scenario:

It's the late 90's and Joe invested his money in a high growth tech oriented mutual fund that is earning him 20-30% a year while Sally is invested in some boring mutual fund that may only be earning 10-15% a year. Sally is missing out on some great returns but she's also not buying worthless internet stocks billions. So her losses when the bubble collapsed were not as bad as Joe's. It's a case of the tortoise beating the hare.

Obviously it has to be done on a case by case basis and many stocks probably aren't worth selling calls on but some may be and that can generate a decent, lower risk return.

I would imagine there are some more complex strategies that might fit the bill. For example, Graham was fond of risk-arbitrage opportunities. So perhaps there are strategies you've found succussful that are analogous to this.

taowave, welcome. I may have some more specific questions for you when I have time to think through some things.

One of the distinctions that was important to Ben Graham is the distinction between speculation and investing. He seemed to think speculation could be "rational". This, in my view, would be any speculative play in which expected value is sufficient for the risk involved. I would guess that many options strategies fit that.

One of investment's essential qualities is that risk as permanent loss of capital should be minimized. This is why I think buying calls and puts is not investment in Graham's sense since if the prices don't go where you expect in the time of the option, your losses are 100%. And this occurs even if you are completely right about your assessment of the situation.

The reason I think writing, say, covered calls fits Graham's criteria is that you can't lose the premium you gained. There is certainly risk involved (missing out on huge returns) but that isn't a risk to your capital. To give an example consider the following scenario:

It's the late 90's and Joe invested his money in a high growth tech oriented mutual fund that is earning him 20-30% a year while Sally is invested in some boring mutual fund that may only be earning 10-15% a year. Sally is missing out on some great returns but she's also not buying worthless internet stocks billions. So her losses when the bubble collapsed were not as bad as Joe's. It's a case of the tortoise beating the hare.

Obviously it has to be done on a case by case basis and many stocks probably aren't worth selling calls on but some may be and that can generate a decent, lower risk return.

I would imagine there are some more complex strategies that might fit the bill. For example, Graham was fond of risk-arbitrage opportunities. So perhaps there are strategies you've found succussful that are analogous to this.

So from what I've gathered, IB does have a $10 monthly minimum commission fee. So if you only tally up $6 in commissions in a particular month, you still have to pay another $4.

I'm still highly considering it since the lower costs in general may outweigh the commission minimums. I'm pretty sure it would have for last year at least. And the site features seem to be pretty decent.

I'll start a new thread in the short selling forum so we can take that discussion over there.

1. i will look into IB. if they have monthly fees which cause tendency to trade, then that will be too bad.

2. writing put options when i have already create a base position in my portfolio is the only option strategy that works for me, i have realized. and even that needs to be backed by ability to produce cash on demand.

3. selling covered calls – "if one has done a lot of reasearch before buying a company stock, then why limit the upside by selling covered calls" – this is the logic which makes covered calls a no go for me.

4. short selling – i guess it needs more discussion.

Post edited 11:16 am – January 12, 2011 by itconsultant

I think IB is the cheapest. 1$ per trade can let me be flexible with my sizing of trades/positions etc.

Lets talk about shorting. 

Dont ever short purely based on valuation…no matter how high / ridiculous it looks . Thats the first lesson learnt. Check NFLX, CRM, OPEN, LULU etc P/E. They have been overvalued for a long time and have gone up 2x or more even since then. I was shorting NFLX at 100-130$. Today its 180$ and touched 200$. I dont want to play this game. 

Ideal candidates for short are frauds…i think its difficult to spot them. And even that can be tough as seen from David Einhorn's experience of Allied Capital. Took too long. Took a personal toll on him. he came out fine. I dont think i want to do that. 

Next best candidates are ones that are using bad accounting practices and possibly also bleeding money. The company must be a money loser. 

The ones that i see are usually where the thesis is on reduced profits/ margins / sales / more competition in the future. Thats the thesis on NFLX and others. However, these dont seem to be frauds and are not losing / bleeding money. Yes, the valuation is sky high. There is a saying  "the market can stay irrational much longer than you can remain solvent. "

I think the first principle of investing as per Graham/ Buffett is DONT LOSE MONEY. Shorting via puts does not inherently protect your principal. And Shorting stock has way more downside risk and limited upside. The gains are taxed as short term gains. You have to also pay the broker a fee to borrow the stock. 

These are my biggest concerns. 

Of course there are excellent shorters out there. However, I have read most value guys say that their returns would be pretty good without shorting as well. The other reason for shorting is if you are paid to do that in a hedge fund. Investors expect you to be long -short.  Also, investors think that shorting protects capital against catastrophe events like 2008. Yes, it may be true. I am not that good to spot that and I dont want to pay insurance each year for that protection. If so, I would be in cash for some part of the portfolio.

This is an interesting topic and we can continue it on its own thread if there is more interest. 

Hi,

I have been using options for a year now. I have done all 4 types. buying calls, selling calls, buying puts,selling puts.

I use Interactive Brokers and i think its the most cost effective platform.1$ stock trades upto 200 shares and 1$ option as well per contract.

buying calls: I have lost money on this. I did it only couple of times. In fact i was up 100% in a month and had 5 months to go so i held on. I should have either taken the gains or sold a higher strike call that would have reduced my investment. I will use this rarely going forward.

buying puts: i used this to short netflix 4 times last year and SPY once. 3 times i made money on NFLX. Once i lost. that was the last time of buying puts. In fact, i have given up shorting atleast till i know how to succeed on the long side. Shorting is inherently a short term strategy.

Now the interesting and successful part. I have made a decent amount of money selling coveredcalls and cash covered puts. Note,  i do not sell calls on stocks i do not own . I must own the stock and then only i write calls. Similarly for puts, I have cash in my account to back the purchase of the stock for the puts i write.

While i did generate income using this strategy, i did face issues on both.

1) in case of covered calls i was selling to maximize premium. i would write calls  for the near month and at close to current stock price.  Often my stock was called away and i lost out on upside. Lesson learnt. Sell calls 6 months or so out and only at strike prices that you are ready to sell the stock for  ( ideally close to intrinsic value). Maybe sell calls on part of the position. So, sell 1 call if you own 300 shares maybe. Not always possible for small investors who only own 100 odd shares of something. In that case, I would avoid selling calls. 

2) In case of puts, I was hurt even more. Not due to owning stocks that crashed and i had to own them at higher prices. It is similar to what Mal said. Let me give you a painful example. I researched Fossil (FOSL) and loved the company. It was $35 then. Instead of buying some shares atleast, i decided to buy it cheaper via puts. I sold puts at $35 strike and earned $1 in premium. It was for the next month. the stock closed higher and i did not get the shares. this happened for 2 months. then earnings came out. stock was over $40. And then it rose so fast and now its at $70 plus. If i had bought 100 shares at $35, i would have made $3500. Instead i made $100 in premium. !!! 

Lesson learnt : Its fine to buy stock cheap via selling puts. First establish a core stock position. Buy the stock outright first. Then go ahead and sell more puts to buy it cheap. I missed out on Buckle (BKE), Exxon (XOM), Medtronic (MDT) and a few more as i was selling puts to start my position building.

That said, i still earned a good amount by writing puts and covered calls each month using my portfolio and balance cash. Ofcourse it depends on the market. In flat to up markets, this works fine. In down markets, selling puts could hurt you badly. 

I defintely agree. I don't think I'd do the synthetic long strategy at all for the simple fact that your losses are roughly unlimited.

If I ever ventured beyond writing options, it would be for speculative purposes and I suspect I'd so something simple like buying calls and puts to magnify long and short strategies.At least with these losses are cut to 100% and if the bets are well calculated, the risk might be worth it. But even this I'm reluctant on.