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I read about an options strategy, where instead of buying the stock, (it has to be one you have researched and believe in), you buy a ditm leap on the stock with a delta of 100. The idea is that say the stock is 20, and the leap costs 12.00. Once you reach break even, every dollar increase in the stocks price gives you a 20/12*1.00 increase in the price of the option so you get a much better ROI. I don’t know if this is a good strategy, or if it is easy to find situations like this. I stopped trading options 2 years ago because I have a full time job, and also, due to a disappointing trade. I tried thinkorswim, and I am out of practice using it. I used to use it to do my research. Thoughts?

Thoughts?

That strategy is discussed frequently on this board, especially when BRK is near the low end of its valuation range.

I will use the data helper and hopefully find the discussions.

A randomly selected old post on the subject, pointing out that options do have risks, but a wide range of risks which include some pretty low risk strategies.
http://www.datahelper.com/mi/search.phtml?nofool=y...

A post bragging about how well it has worked out for me, so far.
http://www.datahelper.com/mi/search.phtml?nofool=y...

I usually try to take the tone "this is what I'm doing, but I don't actually recommend it".
“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage,” he said. “Now the truth is — the first two he just added because they started with L — it’s leverage.” -- W. Buffett

Jim

Thank you very much.

“A randomly selected old post on the subject, pointing out that options do have risks, but a wide range of risks which include some pretty low risk strategies.
http://www.datahelper.com/mi/search.phtml?nofool=y...”

Jim & option shrewds,

We’ve recently sold to open a few covered call contracts (June 2024, 400&405)but it’s only amounted to 3% of my full share count/control and only in an IRA. For those of us interested in perhaps bumping up their # of covered calls, how would you advise/encourage an options amateur to find the right balance of writing enough covered calls, but not Too much. Where is the right balance, all assuming you have a pretty good size BRK position? Thanks

We’ve recently sold to open a few covered call contracts (June 2024, 400&405)but it’s only amounted to 3% of my full share count/control and only in an IRA. For those of us interested in perhaps bumping up their # of covered calls, how would you advise/encourage an options amateur to find the right balance of writing enough covered calls, but not Too much. Where is the right balance, all assuming you have a pretty good size BRK position? Thanks

Tough question. I imagine if you asked 100 people you'd get around 150 different answers.

For me, determining the right way to use options, if any, is a very deliberate multi step process.

* First, make sure the underlying security is bulletproof. For Berkshire I'm happy on that front.
* Second, get a good handle on the valuation level. Is it overpriced, more expensive than usual, in the average zone, pretty cheap, or "back up the truck"?
* Given the pricing, and your portfolio size and buying power, and your cash needs, decide how much stock you'd really like to own for the next while until the situation changes. The answer might occasionally be "as much as possible".
* Only at the end, figure out if options might help you in the current situation.

For example, when it's really cheap, it is worth considering deep in the money call options to get a bit of leverage for the expected rebound. This sometimes requires extraordinary patience, but can work well.
When it's overpriced, maybe simply lightening up makes sense: sell some. "A motion to adjourn is always in order". If Berkshire were trading at twice book, I don't personally see a need to own any till the situation improves.
When it's at the high end of the usual range of valuations, to the extent that there is perhaps no reason to expect a positive on year return, perhaps consider writing calls at or a bit above the current stock price.
I'm not saying anyone else would agree with even considering these things, but they are the sort of things one might consider---and the times it might be worthwhile to consider them.

All of these concerns might get modified by a bit by your personal tax situation, but the steps would still be similar

Last thought:
I have made a boat load of money buying low strike calls to get leverage.
I have made some beer money writing calls. It's more of a hobby scale thing. In particular, WRITING options means you have to be prepared for two outcomes.
Even if it made financial sense to open the positions, it would be quite the nuisance to have your entire Berkshire position called away.

Jim

Mark19,

A DITM call, is darn close to buying shares on margin. The advantages of the calls over actual margin is:
1) often the implicit interest rate using the call is lower than the actual interest rate using margin
2) You don't even in theory have to worry about "margin calls" causing your losses to go through the roof. Using calls instead of buying stock on margin limits your possible losses to "only" everything you invested in the call.

Its a strange world where having your losses limited to "only" everything is an advantage, but read the horror stories of margin calls before you go further. LOTS of people lost more than the entire value of their brokerage account and did in fact have to raise money to give to the brokerage to climb back up from zero. At least with DITM calls, you are not subject to margin calls.


By the way there is nothing magic about a Delta of 100. First of all, the Delta of the option you buy will change as the underlying stock price changes and also just as time goes by.

In my opinion, the most important thing to realize is you are PAYINING for margin no matter how you get it. And MARGIN does this: when the stock does better than expected, you MAKE EXTRA MONEY. Yay! But when the stock goes sideways for a while, you lose money on your DITM call, so you are losing money paying for your margin, whereas if you just owned the stock, the price going sideways for a while is frustrating, but not costing you anything.

CONCLUSION: Using Margin is like having a high performance car. When things go well you get there faster, but when things go poorly, the regular cars get there anyway, but you spin out in a turn and slide down the side of a hill. Most of us are not above average drivers, so you do the math.

R:

A DITM call, is darn close to buying shares on margin.

The deepness that, IIRC, Jim mentions results in about 2X leverage. A few papers I have read say that the optimal leverage is just a little above the 2X.
When I look to buy DITM calls on BRK I don't even glance at the delta, just the leverage number and the implied interest rate, to decide which strike to buy.



read the horror stories of margin calls before you go further. LOTS of people lost more than the entire value of their brokerage account and did in fact have to raise money to give to the brokerage to climb back up from zero.

There was a case back in the 1999/2000 tech crash. This lady used high margin and made a huge amount of money, maybe around $200,000 realized profit, all short term taxable. Early the next year the market crashed, she got a margin call and got wiped out. Then she went to file their taxes and the gain was the previous year while the loss was this year, so the loss didn't offset the gain in the eyes of the IRS.

Ray,

How do you do with your options. I ask, because I hear different things. Some say you can't do well with options, and then I see people like Jim making a killing using them.

I made a killing in 1999/2000, then got a bloody nose when the tech bust hit. Elan reports that he has overall done well with 6/3 options, but the volatility is too high for me.

In recent years I've stuck to buying DITM long-dated calls, mostly BRK but a few others as well. Nowhere near Jim's 10's of thousands of option trades.

I do keep close track of the results, and of the performance of the calls vs. the stock itself.
For every $10,000 invested it has grown to $44,000 for the stock and $117,200 for the options.

The average actual leverage has been 2.08X, vs. average estimated/predicted average of 2.8X. Average ITM was 34%.
I think that the difference was because the estimate assume you hold until expiration, which has generally not been the case.

For every $10,000 invested it has grown to $44,000 for the stock and $117,200 for the options.

That is very encouraging. I am reading a book on investing using DITM calls now. It is a good book, well written with many good points. One thing that made me laugh was she said, that people who get rich on their systems, get rich by selling their books or classes. That is what she is doing.

https://www.amazon.com/Money-Options-Strategy-Guar...

Reading the reviews on that book, it looks like almost all of them are bots.

But it is free if you have Prime, so no risk. I've bought a few investing books from Amazon and returned most of them as useless garbage.

Reading the reviews on that book, it looks like almost all of them are bots.

Do bots do reviews now?

It is a good book, but I think it is too basic for you.

It is more geared towards beginners.

Good morning, funny you would bring up that subject. I can tell you from my limited experience, having written one book, while typing with one finger , most of the reviews were friends or people I knew, no bots or scams. AMZN might delete negative or scathing reviews, lol, unbeknownst to me, but I never saw them if AMZN does that? Anyway, if you are snowed in and want a few laughs, PLUS, I get 1.25$$ per book, enjoy. https://www.amazon.com/Only-America-millions-gambl...

A DITM call, is darn close to buying shares on margin. The advantages of the calls over actual margin is:
1) often the implicit interest rate using the call is lower than the actual interest rate using margin
2) You don't even in theory have to worry about "margin calls" causing your losses to go through the roof. Using calls instead of buying stock on margin limits your possible losses to "only" everything you invested in the call.

Hmm, I think the emphasis in the analogy is perhaps a bit off.
It's a bit like saying an aircraft is basically a type of car.
(Except that it flies)

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.

A much better analogy is that buying (in the money) calls is much like getting a two year fixed rate open mortgage to pay for some fraction, say half, of a stock purchase.
The similarities:
The mortgage loan can't be called no matter what happens to the price for the stock, nor the mood of the lender.
In two years, you will either have to come up with the money, or get a fresh mortgage for another couple of years, or of course sell the stock to pay off the debt.
Such a new mortgage might not be available, but very probably will be.
The new mortgage might be at an interest rate you can live with, or might be expensive.
It's an "open mortgage": you can repay it any time by closing your position.
In both situations, the stock might go up or go down, so you might win or lose money. This is a property of the investment side of things, not the debt side.

No analogy is perfect. The limitations of this one:
If you buy calls, you don't have to make any mortgage or interest payments.
If you buy calls, you don't have to own a house or any other asset to use as security to get the loan, and don't have any income requirement to qualify.
If you buy calls, the "loan" does not encumber any other asset...in the analogy, it's as if the lender doesn't register a lien against the property, nor even care if you already have a mortgage or two against it.
In the case that you close for a loss, the maximum loss is the amount you did NOT finance, not the total amount of the stock purchase.

As an aside, I find the cost of "borrowing" using calls is typically higher than the rates at which I could borrow elsewhere, not lower.
But the advantages above make all the difference.

Jim

It is a good book, but I think it is too basic for you.

I take back what I said. As I have gotten more into the book, it really goes into the strategy of buying DITM calls, with a delta of 1 in depth. I would say, read the summary of each chapter, and if it is stuff you know, skip, until you reach material that is new to you.

She has another book about how to make money, buying DITM puts, in a bear market.

Damn. I had written a critique on the book, but ditched it as perhaps being too harsh. But now I gotta resurrect it. Sorry, Mark19.
You can read it for free with Amazon Prime. Took me about 1 1/2 hours.

Read some of the negative reviews. "There’s about two pages of useful information in the whole book and a lot of fluff for volume. It feels like the author wrote every thought that went through her head."
The kindle book is 289 pages long. The useful information is about 1/2 page long -- scattered throughout 100 pages. No focus whatsoever.

She spent a lot of time making an analogy of options on houses to stock options. As if *everybody* throughly understands what the heck options on houses are. </snark>

She evidently "discovered" the 50/200 day moving average as a trading signal. Fantastic. As if that was some new remarkable thing. Couple of dozen pages going through that in excruciating detail.

The laid out rules for the strategy are mentioned only in passing. No clear-cut rules to follow, mainly "for example" handwaving. Also impossible rules like "what strike to buy?"
A: The strike about 40% ITM with Time Value less than 1%. Which, in fact, does not exist. The DEC'2024 200 call has TV ~= 1%. That's like 60% ITM.

She does mention "buy DITM SPY call at least 1 year to expiration with delta close to one." That is one sentence n the midst of a paragraph on page 107 of 289. In the middle of examples of doing options on a $1,000,000 house. No focus whatsoever.

She has another book about how to make money, buying DITM puts, in a bear market.
Alas, not free. What do you want to bet it's the same thing only with puts in place of calls?

This should probably really be on the Mechanical Investing board.

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.

What Jim says can't be emphasized enough! Your broker can call your margin loan or change the required margin at any time! I have FFH as the top position in several portfolios, last friday IBKR changed the required margin virtually overnight, they 'phased' it in over the weekend. I wasn't using any margin loan but if I had it could have been very inconvenient under certain circumstances to say the least. Too bad that there are no LEAPS available on FFH anymore. I made a nice chunk of money during the GFC with calls.

I have not finished it yet. There certainly is a lot of filler. I think you find that in many books. For myself, just learning the strategy, it is helpful. In some ways, I like the simplicity of it, because I don't feel overwhelmed like I did when I read MacMillan's book.

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.

****

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.

****

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:

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 think this is about right. But Black-Scholes does not account for valuation. The stock price in the future is just assumed to be today's price plus a log-normal random variable.

If you accept that the today's valuation has some predictive value for the stock price a few months out then you can gain an edge.

And, you don't have to be always right. Just mostly right.

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.

Another key requirement would be the academic assumption that the investor can borrow without limit at the policy rate, in a way that does not introduce risk.
For example, the leverage provided by in-the-money call options has no value to an investor if that's true. I can't borrow at the policy rate without limit or risk, so the assumption is false, so the calls definitely add a lot of value for me.

But yes, it's a good summary. If you assume that stock price movements are well characterized by random walks, as the options market generally does, then there is no advantage to using them. The options market is extremely efficient in that sense.

But as that assumption is manifestly not true--undervalued things are more likely to go up than down, and vice versa--the fact that the options market DOES make that random assumption means that they are indeed leaving "free money" on the table. Obviously an investor has to have very solid skill at identifying at least one asset which is clearly undervalued or overvalued, but that's far from impossible. In this case I can't say that Berkshire's price is going to move down soon, but I can say with strong conviction that "flattish" or "down" are both considerably more likely than "up" over the next several months. That's relatively obvious information for me, but that the options market isn't considering. Thus I can and do have an edge.

It should be noted that the shorter the time frame is, the closer to random price movements are, and the more accurate the assumptions in B-S are. At the scale of an hour, it's almost perfectly true and the calculator weenies are geniuses. And the reverse: the longer the time frame, the more preposterous the assumption can become. For example, the long-dated index put options that Berkshire wrote. They ultimately turned a tidy profit of over $4bn, which was pretty predictable statistically: the nominal value of an equity index will tend to rise over time, not follow a random walk.

You could press into service a quote meant for a very different purpose: what the wise man does in the beginning, the fool does in the end.

As another possible example: Say Berkshire is trading at $190 per B share two years from now. Would you be a buyer? I sure would. Let's say it's 99.99% likely to be a wildly profitable thing to do. Yet there are people out there today who are willing to pay you cash today for committing to doing what you would do anyway: they'll buy a put option you could write. Put another way, they are willing to pay money for the right to do something--sell Berkshire to you at $190 per B---that is 99.99% likely to be an unprofitable thing to do. This may seem really dumb on their part, and it is, taken as such. But may still make sense for them as a business venture, as they may be doing it across hundreds of stocks, and the assumptions become more true taken across many samples and it isn't worth their time to consider the outliers.

Separately, I believe there are some other corners of the options market which are "inefficient". But in a very much smaller way, so the built-in assumptions are not so unreasonable.

As mentioned, I don't think the "steamroller" analogy is at all apt in the case of writing calls against an existing Berkshire position when it is reasonably richly valued. In particular, technically there is zero chance of an incremental loss...only the risk of having a smaller gain than you might otherwise have had, and a 100% chance of reducing your maximum downside if the firm went bust the next day.

If you want to dismiss that by including the penalty of missing out on long term rises in the stock price after the time period of the option (because you sold and would not otherwise have done so), you're talking about the situation that you WANT a long term position. In that case, you would would presumably simply buy back the stock again. In that situation, you have to assess the odds that you would buy back at a price higher than the [strike+premium] at the moment you considered it richly valued enough to write a call. Pretty low chance, and if you did, the disadvantage would likely be modest (not a steamroller event).

e.g., if like me you think $410 per B is already getting a little rich and you take $25 premium for an at-the-money call, are you going to buy back in at a price above $425? Low odds, I would think. And if you did, you probably wouldn't do it much higher than that, so the disadvantage would be modest. In my own case, I think it's pretty darned likely I could wait a bit and get a re-entry lower than $400, a virtual certainty lower than $425. If so, then even if my call were exercised because the stock soars for a while I'd have made a tidy profit on the whole exercise.

Given the strong odds in my favour of doing it profitably once, it becomes a virtual certainty to be in my favour if done repeatedly over time. It's not picking up pennies in front of a steamroller, it's flipping a coin biased moderately in your favour, with no large downside outcomes. In your favour because you are taking into account the fact that the stock is rather richly valued when you enter the position, and the option counterparty isn't.

I don't write these calls much, as Berkshire isn't in my view sufficiently richly valued enough of the time to make it a good wager. Usually I'm at the other end of things, writing puts against things I consider to be either cheap or at most fairly valued. I've made an average of about $35 per contract over the years doing that. Not much, but it adds up.


Jim

Sold some more ROTH IRA based June ‘24 $440 Strike covered calls for $6.85. If the fish bites, that would be 1.72 P/B, if we assume $260 BV. I could think of worse outcomes if they were exercised.

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