Subject: Re: An options strategy
Mungofitch wrote:
The difference about margin calls is the key salient difference between the two, and makes them night and day situations in terms of risk, which is what is important here.

I agree this is the most important. And I would tend to believe you that the implicit cost of the leverage in calls is a bit higher than a margin loan rate. It is, after all, as Jim points out, a less risky way to get leverage, it SHOULD cost more.

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Since my last post, I wrote a simulator of covered calls. From the simulation I concluded that

IF the stock price fluctuations are random, log-normally distributed, AND the options are Black-Scholes priced, AND there is zero friction: no bid-ask spread on options prices, no fees for transactions, THEN the expected return from covered calls is precisely zero!

I would be interested in knowing if Jim agrees with that or at least finds it not implausible. I would be interested in knowing if Jim thinks this kind of result is even relevant to investing decisions one might make.

The warnings I take from this work are sufficient to stop me from chasing Covered Calls. For what it is worth, here is why.

1) I CAN'T TELL WHEN CALLS ARE OVERPRICED. To make money on average from selling Covered Calls, the calls have to be selling for a high-enough price to make you more money whey you win than you lose when you lose. Price matters, you can't be selling Covered Calls at too low a price and make money on them. I don't know how to tell when the calls are overpriced.

2) I CAN'T TELL WHEN THE UNDERLYING STOCK WILL NOT GO UP. To make money selling Covered Calls, you have to only do it when the stock price will not go up. If the stock price goes up, you will lose money selling covered calls. Clearly, some people think that the stock SOMETIMES GOES SIDEWAYS FOR A WHILE and further THAT THEY CAN TELL WHEN IT WILL KEEP GOING SIDEWAYS FOR A WHILE LONGER. I do not have faith that I can do this, and have read lots of studies saying things like "being out of the market on its best 10 days in the last 5 years would have reduced your returns by 87%" or somesuch. If the stock is worth my owning continuously because I don't know ahead of time WHEN one of those 10 days will come along, then selling that upside for weeks at a time in the form of covered calls doesn't make sense to me.

3) COVERED CALLS STRATEGY IS PICKING UP NICKELS IN FRONT OF A STEAM ROLLER. A strategy of selling covered calls provides many small wins when the strategy pays off, punctuated by a smaller number of larger losses when the strategy doesn't pay off. Going further out of the money on the calls you sell DOES REDUCE YOUR CHANCES of losing money on the transaction. It also reduces the value of the nickels you are picking up in front of the STEAM ROLLER down to only pennies. Our brains are not made to evaluate variable payoffs in a way that will produce reliable money making strategies. The profitability of casinos around the world should teach you at least that.

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Why you might do covered calls anyway:

1) You really do think you can time the market, that you know when the stock is going to keep going sideways for a while. And maybe you do. But remember that you can be right 10 times in a row, picking up 10 pennies, and if you are wrong one out of 10 times but you lose a quarter, you are engaging in a losing strategy.

2) You have good tax reasons for not just selling your position when you don't believe in it but expect you might beleive in it again within a few months. Selling covered calls is LARGELY (but not perfectly to be fair) the same as selling your stock and buying it back later. But if you are trading in a taxable account, you do take a real hit from realizing gains and paying taxes years earlier than you might have to with a covered call strategy.

ANYWAY, If you believe there are dynamics to stock price motions that you can detect even though no one else can write an algorithm to find them, then maybe you can make money with covered calls. If you don't know how to tell whether a call looks expensive or not, this will make it less likely that you can make money. I trade in an IRA so I have no tax reason to consider covered calls, which is lucky, because I DO think the market makers know more math than I do and I DO think it is easier to "know" Berkshire will be worth a fair amount more 5 years from now than it is now, then it is to "know" that for the next three weeks or two months Berkshire is not going to go up.

I know my posts are too long for the amount of value they add, I'm working on it.

R: