Value for our proposition

Paul Madison on

Last night at the COOL_Club someone asked "... why not go for the $166.55 at 10% - it's still $166.55" If I remember correctly, this comment referred to looking at selling a covered Call on Apple, the net premium collected would have been $165.55 but the APR worked out to be only 10%.

So this question speaks to why I use a 20% APR as a minimum threshold return when I sell options.

Let's start with an example in "real" life. If I own a $30,000 vehicle and someone wanted to rent it from me for $100 a day. I would most likely say sure. However if I also own a "Bugatti Veyron Super Sports" (viewed by some as the world's most expensive car at $2,400,000) and that same person says that they would rather rent the Bugatti for $100. I would most likely politely decline.

Why is that? In both cases I am getting $100 but what we have to take in to account is what our risks are with the transaction. With the $30,000 vehicle, my risk might be a scratch or dent that might be $500/$1000 and there is a small probability that will happen, that seems like a risk worth taking. With the Bugatti, a simple fix could be multi $1000s or even more. Now the risk/return profile does not look as interesting to me.

The risk we take when we sell Covered Calls is a "loss of opportunity" if the stock jumps significantly then we will be called away and we will have missed that large jump in stock price. To make sure I am adequately being compensated for taking that risk I want a good a return on my asset and that is where I have set a floor of 20%. So far in my trading I feel that floor has worked well for me.

There are some $100 bills we see lying around that we need to walk on by

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

Dan Hess on

Paul

Your example below raises to me a question pertaining to selling covered calls. Let me try to explain.

When selling covered calls there is a possibility of a gain or loss from both the stock holding as well as the option that was sold. This will vary widely due to many factors some of which are the Beta of the stock as well as the Implied Volatility. Thus once you own the stock shares and sell an option on the stock there are several potential outcomes that seem important to consider. I see these as:

1) % Return if the stock price is unchanged
2) % Return if stock is assigned
3) Annual % Return if stock price is unchanged
4) Annual % Return if stock is assigned

1 seems to correspond to your minimum $100 with the percentage being upon the option premium minus commission divided by the stock value at option write time minus the option premium plus commissions.

2 provides a measure of return if the stock is assigned and thus factors in the gains from both the option premium plus the stock price appreciation including commissions.

3 and 4 converts 1 and 2 to an annual % including dividends.

So as your comparison of the $30K and $2.4M cars suggests your total investment needs to be considered in determining what is an acceptable return. So I am wondering should we not consider the total investment and look at this in terms of a % reflecting your investment? i.e. A $100 premium on a low Beta or low volatile stock may have a much lower percentage return than on high Beta or more volatile stock.

Let me state I like your simplified approach that strives for an APR of 20% along with the stock potentially being assigned at a price at which you are willing to sell, but wonder if the simplicity may be hiding some potential risk.

I am thinking one needs to have some minimum %/dollar targets for each of the 1, 2, 3 and 4 cases I described above.

Can you clarify what I may be missing related to this?

Thanks
Dan Hess

On 8/9/2012 9:45 AM, Paul Madison wrote:

Last night at the COOL_Club someone asked "... why not go for the $166.55 at 10% - it's still $166.55" If I remember correctly, this comment referred to looking at selling a covered Call on Apple, the net premium collected would have been $165.55 but the APR worked out to be only 10%.

So this question speaks to why I use a 20% APR as a minimum threshold return when I sell options.

Let's start with an example in "real" life. If I own a $30,000 vehicle and someone wanted to rent it from me for $100 a day. I would most likely say sure. However if I also own a "Bugatti Veyron Super Sports" (viewed by some as the world's most expensive car at $2,400,000) and that same person says that they would rather rent the Bugatti for $100. I would most likely politely decline.

Why is that? In both cases I am getting $100 but what we have to take in to account is what our risks are with the transaction. With the $30,000 vehicle, my risk might be a scratch or dent that might be $500/$1000 and there is a small probability that will happen, that seems like a risk worth taking. With the Bugatti, a simple fix could be multi $1000s or even more. Now the risk/return profile does not look as interesting to me.

The risk we take when we sell Covered Calls is a "loss of opportunity" if the stock jumps significantly then we will be called away and we will have missed that large jump in stock price. To make sure I am adequately being compensated for taking that risk I want a good a return on my asset and that is where I have set a floor of 20%. So far in my trading I feel that floor has worked well for me.

There are some $100 bills we see lying around that we need to walk on by

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

Laurie Frederiksen on

Dear Dan,

The COOL Tool is meant to be a simple tool for people to use, especially with the Virtual simulator, to get started learning about selling options. Many of the simple basics that Paul talks about are still a bit confusing to a new person. Many of these things become more clear as you try making options selections yourself.

You make good points, but the COOL Tool is not by any means an exhaustive investment analysis tool. Neither are many investment tools including SSG's and Manifest Investing Dashboards.

Tools for more sophisticated analysis may develop over time, depending on demand. Thank you for your observations.

Laurie Frederiksen
Invest with your friends!
www.bivio.com

Become our Facebook friend! www.facebook.com/bivio
Follow us on twitter! www.twitter.com/bivio

Paul Madison on

Hi Dan,

I appreciate your feedback and your very thoughtful and detailed questions. And on one level, you are quite right but let me share some other perspectives on your comments.

Laurie's comment is also correct that we are trying to simplify this process for the people new to selling covered options.

But it actually goes beyond that. This IS the way I view what I am doing with covered options and I have been extremely active with them for the last two years. I have a little more elaborate tools that I built and use than the COOL Tool but the process is the same and, at least for me, I believe it is correct.

I view selling covered options as a way to extract some income against my assets while my assets go through the daily ups and downs of the market. This volatility is the manna for the day-trader which I am not and the bane of our existence for fundamental investors, which I consider myself.

On stocks that I own that are not covered up with a covered call I would never go through the process of deciding what my negative return on that asset would be if I failed to make a sell decision at a market top (something you are suggesting we should be doing when we cover up the stock with a call).

I always look at two things on my underlying stocks, I look at what my current gain/loss is (this is more to think about overall tax considerations than anything else) but more importantly what drives my decisions to sell is what I believe the potential for that stock is over a relatively short time frame of 12-24 months (I personally believe it is not possible in today's market to manage against 5 yr expectations). If the short term return falls to around the 10% level then a strategy of covered calls seems appropriate. If the projected return is significantly below 10% (like low single digits) then I often won't sell calls, I will just get out.

So covered Calls is a way to generate some income by "renting out" our asset at what we believe are short term market tops. I strongly adhere to the philosophy of only using strikes that I am quite happy to let the position go, if it is called away, I actually view being called away as a positive (not a negative). At the point of putting the Call on my other option would have been to sell my position since I was concerned the stock might correct in price. By selling a call that is Out-of-the-Money and being called away then I am improving myself by selling at a higher price (the strike is higher than the market was when I sold the Call )and I collected the premium.

At the point of being called away the market is above my strike price and so I have a "lost opportunity cost" but I no more worry about that then I do when a stock jumps $10 the day after I did an outright sell. My philosophy is opportunities pass me by everyday and I do not measure my performance against those.

I have two "portfolios" that I have been managing, the first I have been using covered options for two years and the second for the last year. I believe the second represents a "more current" refinement of my process and reflects what I believe is attainable. So let me talk about what my stats are for that portfolio. These are the combined results of Covered CALLs and Cash Secured PUTs.

- 3% of the trades expired worthless so I got to keep all the premium and achieved the original APR (average of 55% APR).

- 89% of the trades I have closed by buying to close and roughly 95% of those have been with positive gains. The APR average when the OPTION was sold was 46% with 18 days to expiration. By buying back I improved the APR to 77% and the options were on for an average of 8 days.

- That leaves only a small 8% that have actually been exercised. And although I keep track of how I bettered myself by selling the option rather than doing the fundamental trade at the time of the option, the real way I look on the performance of those is the net buy cost and or net sell cost when exercised. It is no different at that point than a normal buy or sell of a stock and how you would evaluate that trade.

- These techniques give me an "income" stream on the portfolio equal to 1% per month or 12% APR. That return is over and above any return on my underlying assets.

I hope this helps and I really appreciate your question and thoughtfulness about the topic. I by no means believe my approach is the only or definitive way to look at this and I can understand how you could quickly try to make it more complex. But this "simple" approach has worked extremely well for me and the trading group that I work with.

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

On Thu, Aug 9, 2012 at 1:15 PM, Dan Hess <danhess@nc.rr.com> wrote:

Paul

Your example below raises to me a question pertaining to selling covered calls. Let me try to explain.

When selling covered calls there is a possibility of a gain or loss from both the stock holding as well as the option that was sold. This will vary widely due to many factors some of which are the Beta of the stock as well as the Implied Volatility. Thus once you own the stock shares and sell an option on the stock there are several potential outcomes that seem important to consider. I see these as:

1) % Return if the stock price is unchanged
2) % Return if stock is assigned
3) Annual % Return if stock price is unchanged
4) Annual % Return if stock is assigned

1 seems to correspond to your minimum $100 with the percentage being upon the option premium minus commission divided by the stock value at option write time minus the option premium plus commissions.

2 provides a measure of return if the stock is assigned and thus factors in the gains from both the option premium plus the stock price appreciation including commissions.

3 and 4 converts 1 and 2 to an annual % including dividends.

So as your comparison of the $30K and $2.4M cars suggests your total investment needs to be considered in determining what is an acceptable return. So I am wondering should we not consider the total investment and look at this in terms of a % reflecting your investment? i.e. A $100 premium on a low Beta or low volatile stock may have a much lower percentage return than on high Beta or more volatile stock.

Let me state I like your simplified approach that strives for an APR of 20% along with the stock potentially being assigned at a price at which you are willing to sell, but wonder if the simplicity may be hiding some potential risk.

I am thinking one needs to have some minimum %/dollar targets for each of the 1, 2, 3 and 4 cases I described above.

Can you clarify what I may be missing related to this?

Thanks
Dan Hess

On 8/9/2012 9:45 AM, Paul Madison wrote:

Last night at the COOL_Club someone asked "... why not go for the $166.55 at 10% - it's still $166.55" If I remember correctly, this comment referred to looking at selling a covered Call on Apple, the net premium collected would have been $165.55 but the APR worked out to be only 10%.

So this question speaks to why I use a 20% APR as a minimum threshold return when I sell options.

Let's start with an example in "real" life. If I own a $30,000 vehicle and someone wanted to rent it from me for $100 a day. I would most likely say sure. However if I also own a "Bugatti Veyron Super Sports" (viewed by some as the world's most expensive car at $2,400,000) and that same person says that they would rather rent the Bugatti for $100. I would most likely politely decline.

Why is that? In both cases I am getting $100 but what we have to take in to account is what our risks are with the transaction. With the $30,000 vehicle, my risk might be a scratch or dent that might be $500/$1000 and there is a small probability that will happen, that seems like a risk worth taking. With the Bugatti, a simple fix could be multi $1000s or even more. Now the risk/return profile does not look as interesting to me.

The risk we take when we sell Covered Calls is a "loss of opportunity" if the stock jumps significantly then we will be called away and we will have missed that large jump in stock price. To make sure I am adequately being compensated for taking that risk I want a good a return on my asset and that is where I have set a floor of 20%. So far in my trading I feel that floor has worked well for me.

There are some $100 bills we see lying around that we need to walk on by

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

Dan Hess on

Paul

Thank you very much for the very comprehensive response to my question.

A 1% income stream certainly shows excellent results and demonstrates your approach is working quite well.

I do look forward to your explaining of how you utilize Implied Volatility, you mentioned a few sessions back. I say this because what prompted my question was the observation of low Beta stocks I owned providing rather low APR's.

Thanks again

Dan

On 8/9/2012 4:55 PM, Paul Madison wrote:

Hi Dan,

I appreciate your feedback and your very thoughtful and detailed questions. And on one level, you are quite right but let me share some other perspectives on your comments.

Laurie's comment is also correct that we are trying to simplify this process for the people new to selling covered options.

But it actually goes beyond that. This IS the way I view what I am doing with covered options and I have been extremely active with them for the last two years. I have a little more elaborate tools that I built and use than the COOL Tool but the process is the same and, at least for me, I believe it is correct.

I view selling covered options as a way to extract some income against my assets while my assets go through the daily ups and downs of the market. This volatility is the manna for the day-trader which I am not and the bane of our existence for fundamental investors, which I consider myself.

On stocks that I own that are not covered up with a covered call I would never go through the process of deciding what my negative return on that asset would be if I failed to make a sell decision at a market top (something you are suggesting we should be doing when we cover up the stock with a call).

I always look at two things on my underlying stocks, I look at what my current gain/loss is (this is more to think about overall tax considerations than anything else) but more importantly what drives my decisions to sell is what I believe the potential for that stock is over a relatively short time frame of 12-24 months (I personally believe it is not possible in today's market to manage against 5 yr expectations). If the short term return falls to around the 10% level then a strategy of covered calls seems appropriate. If the projected return is significantly below 10% (like low single digits) then I often won't sell calls, I will just get out.

So covered Calls is a way to generate some income by "renting out" our asset at what we believe are short term market tops. I strongly adhere to the philosophy of only using strikes that I am quite happy to let the position go, if it is called away, I actually view being called away as a positive (not a negative). At the point of putting the Call on my other option would have been to sell my position since I was concerned the stock might correct in price. By selling a call that is Out-of-the-Money and being called away then I am improving myself by selling at a higher price (the strike is higher than the market was when I sold the Call )and I collected the premium.

At the point of being called away the market is above my strike price and so I have a "lost opportunity cost" but I no more worry about that then I do when a stock jumps $10 the day after I did an outright sell. My philosophy is opportunities pass me by everyday and I do not measure my performance against those.

I have two "portfolios" that I have been managing, the first I have been using covered options for two years and the second for the last year. I believe the second represents a "more current" refinement of my process and reflects what I believe is attainable. So let me talk about what my stats are for that portfolio. These are the combined results of Covered CALLs and Cash Secured PUTs.

- 3% of the trades expired worthless so I got to keep all the premium and achieved the original APR (average of 55% APR).

- 89% of the trades I have closed by buying to close and roughly 95% of those have been with positive gains. The APR average when the OPTION was sold was 46% with 18 days to expiration. By buying back I improved the APR to 77% and the options were on for an average of 8 days.

- That leaves only a small 8% that have actually been exercised. And although I keep track of how I bettered myself by selling the option rather than doing the fundamental trade at the time of the option, the real way I look on the performance of those is the net buy cost and or net sell cost when exercised. It is no different at that point than a normal buy or sell of a stock and how you would evaluate that trade.

- These techniques give me an "income" stream on the portfolio equal to 1% per month or 12% APR. That return is over and above any return on my underlying assets.

I hope this helps and I really appreciate your question and thoughtfulness about the topic. I by no means believe my approach is the only or definitive way to look at this and I can understand how you could quickly try to make it more complex. But this "simple" approach has worked extremely well for me and the trading group that I work with.

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

On Thu, Aug 9, 2012 at 1:15 PM, Dan Hess <danhess@nc.rr.com> wrote:

Paul

Your example below raises to me a question pertaining to selling covered calls. Let me try to explain.

When selling covered calls there is a possibility of a gain or loss from both the stock holding as well as the option that was sold. This will vary widely due to many factors some of which are the Beta of the stock as well as the Implied Volatility. Thus once you own the stock shares and sell an option on the stock there are several potential outcomes that seem important to consider. I see these as:

1) % Return if the stock price is unchanged
2) % Return if stock is assigned
3) Annual % Return if stock price is unchanged
4) Annual % Return if stock is assigned

1 seems to correspond to your minimum $100 with the percentage being upon the option premium minus commission divided by the stock value at option write time minus the option premium plus commissions.

2 provides a measure of return if the stock is assigned and thus factors in the gains from both the option premium plus the stock price appreciation including commissions.

3 and 4 converts 1 and 2 to an annual % including dividends.

So as your comparison of the $30K and $2.4M cars suggests your total investment needs to be considered in determining what is an acceptable return. So I am wondering should we not consider the total investment and look at this in terms of a % reflecting your investment? i.e. A $100 premium on a low Beta or low volatile stock may have a much lower percentage return than on high Beta or more volatile stock.

Let me state I like your simplified approach that strives for an APR of 20% along with the stock potentially being assigned at a price at which you are willing to sell, but wonder if the simplicity may be hiding some potential risk.

I am thinking one needs to have some minimum %/dollar targets for each of the 1, 2, 3 and 4 cases I described above.

Can you clarify what I may be missing related to this?

Thanks
Dan Hess

On 8/9/2012 9:45 AM, Paul Madison wrote:

Last night at the COOL_Club someone asked "... why not go for the $166.55 at 10% - it's still $166.55" If I remember correctly, this comment referred to looking at selling a covered Call on Apple, the net premium collected would have been $165.55 but the APR worked out to be only 10%.

So this question speaks to why I use a 20% APR as a minimum threshold return when I sell options.

Let's start with an example in "real" life. If I own a $30,000 vehicle and someone wanted to rent it from me for $100 a day. I would most likely say sure. However if I also own a "Bugatti Veyron Super Sports" (viewed by some as the world's most expensive car at $2,400,000) and that same person says that they would rather rent the Bugatti for $100. I would most likely politely decline.

Why is that? In both cases I am getting $100 but what we have to take in to account is what our risks are with the transaction. With the $30,000 vehicle, my risk might be a scratch or dent that might be $500/$1000 and there is a small probability that will happen, that seems like a risk worth taking. With the Bugatti, a simple fix could be multi $1000s or even more. Now the risk/return profile does not look as interesting to me.

The risk we take when we sell Covered Calls is a "loss of opportunity" if the stock jumps significantly then we will be called away and we will have missed that large jump in stock price. To make sure I am adequately being compensated for taking that risk I want a good a return on my asset and that is where I have set a floor of 20%. So far in my trading I feel that floor has worked well for me.

There are some $100 bills we see lying around that we need to walk on by

Paul Madison

TheCOOLClubDude@gmail.com

www.bivio.com/COOL_Club

Mail