Better than covered calls (IMO)

I have been posting this on another forum. Thought I'd copy it to here as well:

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Covered calls are promoted as a cashflow panacea/certain income by certain wealth seminar promoters. I have always begged to differ.

Once again though, I am at pains to point out that they do have their place, under certain circumstances.

It seems the feature that is attractive to people is the positive theta. In other words, people want a stream of income.

The problem with covered calls depends on the situation.

1/ If a call is sold on an existing share holding, there is always the risk of your shares being called away. If you have significate capital gains realized by this transaction, a taxable event would have been precipitated and the tax man will have his hand straight in your pocket and will take more than the call premium you recieved.

No problem you say. I can roll up and/or out or close out the position. This is true, but this always beggs the question: "Why not a pure option play instead?" This way your longterm shareholding is not involved in the risk profile.

The downside of the pure option play (sold put) is that you will need extra cash to cover the put. In the event of a gap down, you will end up with more stock, possibly that you do not want.

2/ If the call is sold and the shares bought at the same time (buy write), you are intitiating a stand alone strategy. Many beginners do not understand the risk profile of such a strategy....limited upside and undefined, but very much larger possible downside.

Once again the same question: ""Why not a pure option play instead?" The risk profile is identical.

Again, theoretically, defence is possible, but with stocks there is always the risk of gaps. Particularly when there is attractive IV (and therefore premium)

There has been sooooooooooo many traders blown out of the water this way.

Credit spreads are not a hell of a lot better, particularly with near expiry/low IV options....risk/reward is crap.

When writing options we are looking for premium income, but we want to minimise risk.

Individual stocks carry substantial risk, only rank novices don't realize this. (sorry if this sounds harsh but its true)

Answer: Index options!

With index options the individual stock risk from adverse news etc is virtually negated, and you are only exposed to overall market risk. This market risk is easily defended against with the underlying future or ETF or bought options.

The person who wants to retire and write options for a living would do well by looking at these.

Suitable strategies:
Naked writes
Written straddles/strangles
Buttereflies/Condors

Not forgetting, these can be legged into fairly safely, sans individual stock risk and possibility of large gaps.

Discuss?

Cheers

Going deeper:

You all know I trade the US markets so the information I post relates directly to that. However it is transferable to the ASX as options are available for XJO.

Firstly lets look at the underlying indexes and the instuments available to trade them.

There are 5 tradeable indexes in the US. There are a couple of ways to trade the indexes so I'll mention them first, then the option available

1/ the S&P 500. This is tradeable with futures contracts (es the emini contract is the most popular) and via an Exchange Traded Fund (ETF), ticker symbol SPY.

Option series available on
SPX (the actual cash index)
es (the futures contract)
and on SPY (the EFT).
Any of these options can be hedged interchageably with any of the above underlying instruments.

2/ the S&P 100. This has a futures contract, but is not very liquid. The ETF symbol is OEF

Options series only available on
OEX (the actual cash index) - also has a europeon expiry series, XEO

3/ The Dow Jone Industrial Index. This is tradeable via ym (the emini future) and DIA (the ETF)

Option series available on
DIA ( the EFT)
the futures option is available but illiquid

4/ The Nasdaq 100. This is tradeable with futures contracts (nq is the emini contract) and QQQQ ( the ETF)

Option series avilable on
QQQQ (the ETF)
the future option is available but illiquid

5/ The Russel Midcap 2000. This is tradeable with futures contracts (er2 is the emini contract) and IWM ( the ETF)

Option series avilable on
IWM (the ETF)
the future option is available but illiquid

Of these The russell 2000 has the highest IV's (and SV's) so I like trading this one on a risk/reward basis.

More to come.........

There are a few inherent advantages of index options over equity options if you want to be a professional option writer.

1/ They are chronically overvalued. This means that their implied volatility is almost ALWAYS a few points higher than their statistical volatility.

This also means that the underlying index will move around just that bit less than what is implied in the premium we receive. Said the other way round, we are always recieving just a little bit more premium than what is warranted by actual statistical volatility.

I may seem to be labouring this point a bit, but over the long haul this amounts to AN EDGE! And isn't that what every trader is after?

2/ Less risk for naked positions. The disadvantage of writing uncovered/unhedged equity options is the enourmous risk of disaster. Same goes for buy/writes

With equity options there is always the risk of a humungous gap...up or down. Imagine if you'd written a ****load of naked calls; and that stock was subject to a hostile takeover/bidding war or that lousy arthritis drug they've been pushing caused someones death and had to be withdrawn from sale, just as you'd written 1000 put contracts

This risk makes it a bit silly to write naked or covered call(synthetic naked put). Yes I do it...VERY occasionally. But only when reward/probability outweighs risk. This is rare.

Indexes are not subject to these shocks...unless someone goes and nukes Wall Street But this is (hopefully) infinitely rarer than what happens with equities. A gap is something you cannot defend against.

3/ Naked calls/puts a viable strategy. Lets face it. Only the trader with a death wish writes naked calls. Even those who routinely do covered calls, shun naked puts as too risky! Go figure! They have the identical risk profile.

But as mentioned above, with indexes, risk is infinitly smaller (though still present) and easily defended as the risk of large gaps is practically non-existant. Naked writes become viable.

4/ European expiry. This does not apply to all index options. But it applies to XEO and I believe XJO options are european. No risk of early exersize.

****

These attributes all add up to being the ideal vehicle for the professional premium collector. Make much much more sense than bloody covered calls.

Strategies next....

Thanks for a great thread Wayne.

Always good when someone makes you think outside the box and suggests different ways to trade.

Looking forward to your next posts.

thanks for this Wayne,

certainly food for thought. I'm looking forward to the next instalment.

Rod.

This is great stuff Wayne!

Ive never seriously looked at options but this may be a way of getting started.

Keep up the good work; youre a true philanthropist!

wayneL said:

1/ They are chronically overvalued. This means that their implied volatility is almost ALWAYS a few points higher than their statistical volatility.

Click to expand...

Does the statistical volatility you calculate include those occasional events such as Oct87, Sept01,....? Could this account for the discrepency with IV?

The biggest advantage of writing index options (for ASX) is that the INTERVAL is lower than anything else. I have posted on intervals before. Basicly the lower the interval, the less margin required when the position moves against you. Some traders were writing LHG options when the interval was 12%. This means that your RISK MARGIN was high enough to allow for a 12% stock price move. XJO is usually 2%. This is the difference between having to come up with an extra $2k or an extra $20k.....kinda important eh?

Although index I.V's are higher than H.V, they are VERY LOW compared to stocks.

Covered calls are LOWER RISK than a plain buy & hold strategy, so bagging of it should not go overboard. The problems arise when people are told they can get 8% a month on their money. If people already have shares, and want to improve the return while reducing the risk, covered calls are perfect. You will get around 5% p.a extra (0.5% per month lol)

markrmau said:

Does the statistical volatility you calculate include those occasional events such as Oct87, Sept01,....? Could this account for the discrepency with IV?

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Mark,

I'm not quite sure of what youy are getting at but will try to answer.

Statistical volatility has a set, defined lookback period, usually 20 or 30 days or less. So in that sense, no it does not include those events.

If you are asking what happens to the relationship between IV and SV in these type of events? It varies depending on the circumstances. There are undoubtably instances where this relationship reverses. But nearly 100% of the time, as far back as I can ascertain (about seven years) overvaluation is the norm.

These events certainly present a case for "hedged" strategies such as butterflies. But insurance comes with a cost. It is an overhead. Long term it is up to the individual trader to determine whether to be permanently hedged or employ defensive mechanisms as the need arises.

Money Tree said:

The biggest advantage of writing index options (for ASX) is that the INTERVAL is lower than anything else. I have posted on intervals before. Basicly the lower the interval, the less margin required when the position moves against you. Some traders were writing LHG options when the interval was 12%. This means that your RISK MARGIN was high enough to allow for a 12% stock price move. XJO is usually 2%. This is the difference between having to come up with an extra $2k or an extra $20k.....kinda important eh?

Click to expand...

A good point about margin requirements. Perhaps you could comment on this as we discuss individual strategies, as I am not up to speed on ACH margin requirements.

Money Tree said:

Although index I.V's are higher than H.V, they are VERY LOW compared to stocks.

Click to expand...

This is true. But my whole thrust here is the edge inherent in the chronic overvaluation.

A couple of further points on this:

XJO SV's are generally ~8%, which is similar to the Dow and S&P500. However Nasdaq SV's are ~12% and Russel SV"s are ~15%....which is a bit better. But still lower than a lot of stocks.

But consider that there is far greater potential for left field price shock with stocks, even Blue chips. The most recent case in point being Telstra (who's SV/IV wasn't very high at the the time). We don't have this risk with indexes...unless we start shooting IBM's at each other (forunately rare)

This being so we can write closer to the money, safely, than we can with stocks, with less risk, and still get overpaid for it. A good deal IMO.

Money Tree said:

Covered calls are LOWER RISK than a plain buy & hold strategy, so bagging of it should not go overboard. The problems arise when people are told they can get 8% a month on their money. If people already have shares, and want to improve the return while reducing the risk, covered calls are perfect. You will get around 5% p.a extra (0.5% per month lol)

Click to expand...

Another good point, and an important one to make. Covered calls DO have their place in the grand scheme of things. The key here being in what you said about people "already" owning the shares.

Cheers

wayneL said:

Statistical volatility has a set, defined lookback period, usually 20 or 30 days or less.

Click to expand...

So isn't that basically the reason IV is always higher than statistical volatility (particularly if only looking back at last 20/30 days)?

There is always the probability of some event (it doesn't have to be Sept 11, it could be a hurricane, downgrading of GM bonds, bush opens his mouth unscripted....) that could suddenly increase the volatitlity - and hence you have to pay (or are paid) a risk premium for this.

Or is this factored in elsewhere?

You used the term "chronic overvaluation". How big a jump in an index (say SP500) would be required to make the statistical volatility match the IV?

markrmau said:

bush opens his mouth unscripted.

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hehehe...funny....but topical.

markrmau said:

So isn't that basically the reason IV is always higher than statistical volatility (particularly if only looking back at last 20/30 days)?

There is always the probability of some event (it doesn't have to be Sept 11, it could be a hurricane, downgrading of GM bonds, bush opens his mouth unscripted....) that could suddenly increase the volatitlity - and hence you have to pay (or are paid) a risk premium for this.

Or is this factored in elsewhere?

Click to expand...

Mark,

I'm sure this is the logic used to justify the overvaluation.

But the self same factors in also apply to individual stocks. Stocks also have their own individual factors which regularly increase volatilty suddenly, such as profit warnings, executive movements, litigation, product issues etc. Yet individual stocks don't exhibit this chronic overvaluation. So this cannot be the true reason.

To be honest I don't know why it is, it is just so...and it is there to be exploited so why not exploit it.

This is a good point about sudden volatility increase though, and no one should be decieved into believing this will never happen. It will.

The point is that it can be defended against. Even in Sept 2001, we did not get an unmanagable, undefendable gap in the indexes. In fact what small gap we did get was in the direction of an existing trend. No disaster scenario there.

We will get into strategies for trending/non trending markets...and defences later.

You used the term "chronic overvaluation". How big a jump in an index (say SP500) would be required to make the statistical volatility match the IV?

Click to expand...

IV's are usually between 25-50% higher than SV's

Cheers

Good thread Wayne. Enjoying it very much.

Using Volatility:

Option volatilties are quoted as a percentage. But what does this percentage mean?

If we look at the calculation for statistical volatility, it might give us some clues

In either amibroker or metastock code the calculation is :

(StDev(log(C/Ref(C,-1)),20) * sqrt(252))*100

This gives us the figure of 1 standard deviation, calculated over the last 20 days price movement, but extrapolated out to give us an annualized figure.

Said another way, the figure is 1 standard deviation of a years price movement, based on the last 20 days.

What does this tell us?

It gives us a way to measure present statistical volatility against previous values. It shows us whether vols are high or low, rising or falling.

It also gives us a comparison against Implied volatility. This can tell us a storey as to what the market is thinking/expecting and whether premiums are over or undervalued. As mentioned before, we can observe that Index options are chronically overvalued.

Seeing it is a statistical measure, we should be able to use it as a tool to select an appropriate strike, as close to the money as posssible, to maximise premium, and as far away from the money as appropriate, to minimize the occurance of defensive adjustments.

We can't use it this way in it's annualized cloak because......it's annualized.

Generally we wnat to write options about a month out...20 trading days. What if we "monthize" this statistical information, giving us, in percentage terms, 1 standard deviation for 1 months data, calulated over the month period.

We can then use this figure to intelligently select our strike prices.

ergo: (StDev(log(C/Ref(C,-1)),20) * sqrt(20))*100

Example: The current 20 day "annualized" statistical volatility of QQQQ is 10.2%....The monthized figure is 2.9%.

Now we can use some standard t/a AND this 2.9% (remember this is one standard deviation only) to select strikes.

There is no rule here on exactly how far OTM your strikes should be. Just information to make more intellegent choices.

Cheers

Looking forward to the next installment. The stuff about covered calls is interesting and got me thinking. A lot of gurus (Peter Spann f'rinstance) use it as a very safe strategy but you are right the risk is the same as a naked put. Even the asx talks about only using covered calls when you are new.

The only thing safe about it is that you know you have the capital if the share drops through the floor as you have actually bought the shares.
MIT

I started in the markets writing covered calls before progressing to writing puts, then trading equities and now trading ETOs long (yes risk wise did it a little backwards). I wish someone had sat me down and explained IVs, greeks etc when I was starting, and the possibility of writing oppys on the indicies rather than just equities.

Fantastic thread and food for thought.

WayneL

When are we getting the next installment??

malachii

malachii said:

WayneL

When are we getting the next installment??

malachii

Click to expand...

Yer I'll have to get my @rse into gear I s'pose

Stay tuned

When writing calls over say, XJO, is the contract based on 1 of the indice, and not 1000 like a stock?

Is it possible to buy XJO and write calls over it, and if so, what gearing level will margin lenders generally go to?

blbarclay said:

When writing calls over say, XJO, is the contract based on 1 of the indice, and not 1000 like a stock?

Is it possible to buy XJO and write calls over it, and if so, what gearing level will margin lenders generally go to?

Click to expand...

Answers at Wayne's World
3rd post from the bottom at the link below - actually you should read the whole thing
Enjoy!!!

https://www.aussiestockforums.com/forums/showthread.php?t=674&highlight=xjo+synthetic&page=4