Friday, May 12, 2006

Finer Points on Writing Option Contracts

I am liking the idea of writing calls and puts closer to expiration. The time decay is uneven. The closer to expiration, the faster the decay. When selling, time decay is good, just as it is bad when buying. So, the best annualized returns usually occur on the shortest dated contracts. I haven’t found an exception to this rule. Also, short dated contracts minimize exposure to dividends and their effect on contract prices. Plus, short contracts are more likely to capture short swings in stock price. For example, Apple and Armor Holdings, which I have held for 30 days, are falling apart. One week ago, they were looking good. The longer you hold the underlying stock, the more likely something fundamental is going to change. Oil could break down in the next 90 days as natural gas has (though not likely), but you will be locked up if you write for September, although, if it moves away from you (down if you are writing a call), the cost of closing out gets cheaper. I closed out of my GM options and reloaded at a higher price to capture some more premium to help offset the loss on the underlying. BTW: you saw that Jim Cramer came out with a BUYBUYBUY on GM on Wednesday (AFTER the 30% move)? He is predicting $40 in 12 months. Sounds like a good reason to be short to me.

I would like to be able to capture the most gain from writing in the shortest period possible. Even 0.60 per contract looks good when over just 10 days, on an annualized basis. Do the numbers in my spreadsheet and you will see what I mean.

What about the precious metals? I am thinking of selling half my PCRDX and VGPMX. I will definitely pull that trigger if gold hits $800 and maybe sooner. Precious metals have become very speculative meaning that when they go down, they will go down fast. I would like to capture some gain before then, and buy back in after the correction.

Covering Shorts on GM

Well, I couldn’t stand the pain of being short GM any longer, so I took cover.

This morning, I put in orders to buy calls for GM to protect my hiny from any more abuse.

I bought (8) June 30 call contracts for 0.50 each and (10) September 30 call contracts for 1.10. If the worst happens, and GM goes to 30 in the next 30 days (could happen with as many people want to see GM work out, and also, the US market index funds must buy GM as more people buy into those index funds), I sell the June 30 for maybe 2.00 and the Sept 30 for maybe 3.00. This will give me around $3200 in coverage, which just about offsets my losses on the short positions from today, with GM at 25.80 (30-25.80 = 4.20 x 800 = $3360).

On the other hand, if the market gets its senses back and GM goes back down to $20, I will lose the call contracts that cost me $1500, but also be able to continue writing sell orders on my 800 GM shares at about $1000 per month. So, this won’t work out as well as I originally hoped, but at least I don’t lose my rear (and will be adding to profits after two months).

If GM does get to $30 and I sell out my positions, I will be buying naked put contracts against GM, that is for sure.

Next time I try one of these covered puts, I will buy my long dated call at the same time to stop losses at 15%. I would already be in the money if I had done that with stock at $20 in mid-April (a 50 cent Sept contract at 25 then would now be paying $2). It takes about 5 months to pay back a 15% loss (at 3% gain a month on writing the put), but I can live with that. This also points out the difficulty of any bet on the short side, which you already appreciate. The market is biased to the long side.

Brian

P.S. GM proudly made the big announcement this morning that they are raising prices on new cars because they are losing too much at current prices and having to dump unsold cars on the rental fleets. Good luck! This will shrink their market share even more, creating even more labor problems and closing more production that must be capitalized regardless. If they weren’t selling enough cars at the lower prices, how does raising the price help? They don’t have a variable cost structure so this can’t possibly work. They will sell even fewer and will find themselves with as many excess vehicles but with lower total revenue at fixed expense. STUPID!!