(A Version of this article appeared in TheStreet)
I’m not a very well read person but one book that I couldn’t resist reading was “The Psychology of The SImpsons.”
It was actually a gift given by a psychologist who knew that The Simpsons was one of my few passions, but apparently didn’t know that reading was one of my dreads. That psychologist also introduced my wife and I to one another, so I should have, perhaps, been somewhat wary of new gifts.
Honestly, I don’t remember a single thing about the book or its contents, but I’m sure that it had some incredible insights that have broad applicability.
But these days, really all I care about is trading and right now my thoughts are focused on modifying my trading in a covered option strategy to that of a not too long ago era, as there is indication of a transition in market sentiment and most importantly, in market volatility.
My least favorite situation is to have uncovered positions and lately that is an increasing occurrence.
Most don’t particularly like to think back top 2008, but there were lots of lessons to be learned.
Back during the 2008-2009 correction when volatility was really high and option premiums were also substantially higher while the market was falling, it was actually very easy to stay ahead of the market, if you channeled Homer Simpson and sounded like Nancy Reagan..
Just say “D’oh.”
If you don’t know what “D’oh” means in the Simpsons Universe, click here, because for some things I do trust Wikipedia.
For my purposes, “D’oh” is an acronym for “Digging out of a hole.” The way it is practiced should be the antithesis to the exasperation in which it is usually uttered.
In just a little over a month it will be the fifth anniversary of the market lows that saw the culmination of a market that went from all time highs to having lost more than 50% of its value.
That coincided with the time that I started a covered call strategy in earnest and not just on a portion of my portfolio. That was serendipitous timing and certainly not planned. No one saw the plunge that was about to come our way.
I don’t want to draw parallels between this market, which is barely down 4% and that of 5 and 6 years ago. But I do want to discuss some of the trading strategies that were incredibly useful in outperforming during a terrible market.
The first thing to understand is that the primary objective during a down market is to not go down as much as the overall market. It doesn’t take too much thought to realize that it’s easier to fall from $100 to $80 than it is to rise that same $20 going from $80 to $100. Mountains are much harder to climb than they are to fall off from.
By virtue of selling options and collecting premiums you are already at an advantage in a declining or sideways moving market, but the real advantage comes from continually being able to sell those calls even when your positions are far below their cost basis. For those that have now been doing this for a while you have seen how accumulating premiums really can add up, but they have to be given the chance to accumulate.
There are differences between now and 2008.
The first is that there were only monthly and longer options available back then. Additionally, there were fewer and more widely spaced strike levels. Finally, volatility was already high, while it is just now showing some evidence of growing.
Why are those three items important?
First the basic “D’oh Strategy.
Digging out of a hole implies that there is action and not simply passivity awaiting a fallen stock to rise higher, especially in a downward moving market.
The idea is to start delivering option income from a non-performing asset that is no longer expected to be carried along with what was once a higher moving market.
During a higher moving market option premiums tend to be low, sometimes very low. That means it’s difficult to get an acceptable premium on shares that are well under their cost basis if you use the cost basis as your strike level. Even using a near the money strike often gives a premium that’s just too low and certainly an adverse risk-reward proposition.
So instead, you let your asset sit and do nothing while waiting for it to pop higher. That expectation is more realistic during a bull market than it is during a bearish phase. During a bull phase you would feel like an idiot if you traded your shares for pennies, so you let actions take second place to passivity in many cases.
A reckless few, and I do so on occasion, will collect a few crumbs and use near the money strikes, but that has a very unfavorable risk – reward profile and rolling over can easily erode potential profits.
But during a bear phase, as option premiums start to rise along with volatility, there come instances when you will see premiums starting to get a little more attractive even for strike prices that are a level or two above the current price. Now however, instead of a level or two representing unobtainable or unrealistic price objectives as in 2008, and therefore, very low premiums, the range of strike levels now offers many more realistic prices and more appealing premiums.
The idea is to capitalize on those higher premiums, but to reduce the risk of assignment by using higher strike levels. During a bear phase the expectation of a pop higher in price is lessened, although it can still occur. While you may feel like an idiot in a bull phase for taking pennies, during a bear phase you may feel like a genius for finding some additional income. You will especially feel like a genius if you can ride your shares higher and still collect those premiums.
In a bull market you want your shares to be assigned and quickly. In a bear market, if you are already holding shares you want the premium income, but don’t really want the assignments. You just want to be in the game and have a chance to play.
Your expectation is that your shares, if you’re lucky, will either stay where they are or go higher, but in a down market you also are prepared, perhaps even expecting further declines, although any additional premiums you can squeeze out of the holding will ameliorate the drop.
If and when a pop in price does occur, you simply evaluate the relative benefit of rolling over the existing option, preferably to an even higher strike price. Doing so will reduce the net premium, as any classical rollover, but may even result in a trading loss on the option in the event of a sudden price rise. The idea with rolling over and hopefully to a higher strike, is that you continue to want to be in the game and have an opportunity to get more premiums and eventually exit your position intact, rather than at a loss.
Back in 2008-9 when only monthly options were available you would find yourself getting locked in for a longer period of time than you might like to tempt fate. With the weekly options you can be more nimble and responsive to changing share prices. However, as forward month volatility further increases, there may be opportunity to use a longer time period and a further out strike price to guarantee a greater premium and minimize the need to aggressively monitor and trade the position.
In the 2008 era the guideline that I used was to select those positions that offered either a monthly 1% premium for a strike price 10% greater than the current price or a 2% premium for a strike that was 5% above the current share price. It’s still too soon to know if those parameters may have application in the current market as premiums may develop in a new higher volatility environment, but you can bet that I’ll be looking for potential guidelines.
As a recent example, some of you may own shares of Anadarko. If you do you know all too well of the swift plunge shares took when a judge ruled on an old case regarding a firm that Anadarko bought and calling for a $14 billion settlement.
Dropping from $88 to $78 in a bit more than an instant there was no opportunity to get a decent premium to make call sales worthwhile, even if owning unusually large positions.
While the market was still in its 2013 bullish phase I did buy additional shares using the “Having a Child to Save a Life” strategy to offset some of the paper losses, but as the market started to weaken I’m less excited about committing more money to a specific position in order to underwrite some of the losses.
However, volatility for this company increased when the company announced that it was going to appeal the decision and believed that damages were more appropriately in the $3 billion neighborhood. Shares then spiked to about $3 to $80.80. At that point, a weekly $82.50 contract had a $0.31 premium.
Not much, but better than nothing, although it comes with a potential risk of losing shares at well below cost. That’s fine if you want a tax loss, but it’s too early in the year and tax gains requiring such offsets may not be as readily achieved this year.
The next week, as the previous options expired, an $83 call was sold for $0.30 when shares were about $81. However, for a brief time that week, following word of an activist investor taking a large position, it looked as if the $83 strike would be exceeded, so I was prepared to buy back the options and then roll them to a higher strike level.
Instead, following the rest of a weakening market, shares retreated and those contracts were rolled over to a new weekly $84 contract for an additional $0.41 net premium at a time that shares were trading at about $81. While the share price was the same as it was just a week earlier the premium was growing nicely having gone from $0.30 to $0.47.
The story is still one in progress and continues until an acceptable endpoint, but at least you go out fighting.
That’s what volatility can do for you but you have to be on top of the trades, especially if a strike price is being taken out right before expiration.
Trading Alerts will look something like this:
DOH: STO Anadarko (APC) $85 Feb 7, ’14. Currently $81.00. Premium to sell $0.48 bid.
or, in the case of a rollover trade:
DOH: Rollover Anadarko (APC). BTC $84 Jan 31, ’14. STO $85 Feb 7, ’14. Currently $81.00. Premium to buy $0.08 ask. Premium to sell $0.40 bid. NC $0.32
Remember, sometimes the trade may result in a net debit (ND) rather than a net credit (NC)
Life can be summarized as below (or you can just ignore this):
Ultimately, a market decline, if it comes, is certainly not something to be feared. For those exercising a covered option strategy it may actually become the best of times and better prepare your portfolio for the next bull market.