Yeah, once again the old guy skates out onto thin ice! After telling the world that the only good game in town is bonds, here I am talking about the near polar opposite, a security DERIVED from a stock. And I don't like stocks in the first place. So, why even go there?
Well, I'm retired, and have a good deal of time on my hands. And my bond game is slow. Now that's actually a good thing. The whole idea behind them is to take a carefully risk-adjusted position and wait for time to make it all good. It's an excellent game, and has worked through a variety of market conditions. Even in today's ultra-low yield environment, I have consistently found situations where the risk-reward ratios seem very favorable.
Well, options present a whole new world of scenarios, where risk-reward is magnified. The risk is ever-present, but the rewards are occasionally so tempting that I get ... tempted. Here's the kind of thing I'm talking about. A volatile stock (like Transocean, RIG) has an entire world of even more volatile derivatives: calls and puts. I'm not going to give a basic lesson in these right here. Suffice it to say that a call is the right to buy 100 shares of a given stock for a given price and period of time; a put is the right to sell 100 shares for a given price and period of time. As a stock fluctuates, these things swoop! Call prices rise faster (percentage-wise) than the stock does, and fall faster. Same thing in reverse for puts.
I'll only be writing about calls here. Buying one has limited risk, but that risk can involve the entire amount you've invested. Say you buy a call maturing in January of 2018 (this is a LEAP, or long-term option), strike price of 13. Today, with the stock trading around $12.50, that call would cost somewhere around $3. Since the call cannot be exercised profitably at present (the strike price is higher than today's stock price), the call is "out of the money" and the $3 is entirely time value, or opportunity cost. If the stock rises to $16 by 2018, you could exercise it, but make nothing at all. At $19, though, you double your money by selling for a $6 return, netting $3 on an investment of $3). That's a 100% profit. Every $3 additional adds 100% to the profit.
Is buying this option a good idea? Well, I'd call it pretty bad. The stock has to rise 23% before you can break even. You need to be very confident to justify the risk of losing your entire investment.
Selling a call is intrinsically even riskier. You pocket a premium (in this case, perhaps $2.50, since the bid is always lower than the asking price), but accept unlimited risk. If the stock shoots from today's $12.50 to $30 (hey, it traded over $50 a couple of years ago, with a historical high of $171!), you'd lose $18.50 for each $2.50 you took in. Is that a good idea?
You get a completely different concoction when you blend the two, though. Establishing a spread, where you buy one kind of call and sell another, can be vastly less dangerous, but still profitable. For example, you could buy a 2018 call with a strike price of 8 and sell a 2018 call with a strike price of 13 for a net cash outlay of $3. The long call costs more than the short call, but the money coming in from the short call reduces the total cost. They key to a spread is that the long call lets you supply the shares being demanded by the owner of the call you sold. In this example, you could receive up to the difference between the strike prices, or $5 per option pair. Such a spread has a potential maximum profit of $2 (the difference between the two strikes ($5) and the cost to establish the position ($3)).
Is this a good idea? Well, the potential profit is 66%, for a spread that expires in 1.5 years, or 44% annualized. Sounds pretty good, right? BUT, you can still lose it all. How? If the stock closes below 13 in January of 2018, you start making less and less. At $12, you now make $1 on the $3 invested (sell at $12, buy at $8). Still OK. At $11, it's break-even. That's not OK, since you've tied your money up for no gain at all. At $10 it's a 33% loss (-$1 on $3 invested), at $9 it's a 66% loss and at 8 or below, you've lost it all, 100%.
To me, this is still unattractive: a maximum potential gain of 66% versus a potential loss of 100%. To be sure, I think the odds are in favor of the gain, rather than the loss. But who knows?
There is a wrinkle here, though. IF the stock's upside potential looks favorable versus its downside ("if" is a very big word here), then it can pay to establish the long call (lower strike price) first. It too has a potential loss of 100%, but if your hope of upward movement is realized, then all calls will rise in tandem with the stock. For a call out of the money, the rise won't be 1 to 1. For the $13 Transocean call, for example, the stock would probably have to rise nearly $2 for the option to go up $1. But assuming that movement does occur, then the option can be sold for a higher price than today, thus lowering the cost of the newly established spread to $2, down from the $3 it would cost now.
What does this relatively small change mean for the investment? Well, now the potential profit is $3 on a reduced investment of $2. That's 150% upside. That's enormous. Since you're considering this step because you are optimistic about Transocean's price prospects moving forward, suddenly this risk-reward scenario looks pretty good.
Bottom line: I decided to run a sort of lab experiment, based upon the fundamental analysis above. I've been doing this approach (buying long calls, then writing short calls AFTER the stock has risen) for a few weeks. Transocean stock as risen sharply (from $9.50 to $12.50) during this time, a busy engine providing forward momentum. So far I have written 15 spreads, all with this potential for a 150% gain versus possible 100% loss. I still have 20 long calls (bought more recently) with no corresponding short position. Transocean will need to rise about one more point for the next leg to work similarly.
How will this all turn out? I'll keep you posted (and no, I won't delete the post if it all turns to mud).
December 1, 2016. The worm turns! OPEC just announced an agreement to stabilize/reduce output. The entire industry boomed. Transocean stock jumped from under 11 to nearly 14. Prior to the jump, I had bought a total of 35 calls January 2018 with a strike of 5 (average cost $5.83), 10 calls with a strike of 3 (cost of 8.5) and sold 15 calls January 2018 with a strike of 10 ($3.8). So, that original spread was set to yield nearly $3 on a $2 investment, or 150%. My kind of deal. Subsequently, the stock dropped severely, bringing my net option position to flat, and even (briefly) negative territory. As stated repeatedly, this is no game for those with palpitations.
With Tuesday's news, though, the situation reversed drastically. Now the overall position shows a paper gain of $10,000 on a cash investment to date of $17,000. The rise in the value of the 10 calls (to $4.25) enabled me to sell another 15 calls. Since they can be matched with the long 5 calls purchased at $5.83, the net cost for the 15 spreads is $1.58. Assuming Transocean closes at or above 10 in January 2018, the profit will be 215%. I still have 15 unspread long calls. If the stock keeps rising ...
December 5, 2016. Another rise in the stock has enabled me to cover my final 15 long calls with a paired short call. The final sales were priced at $5.10. Now, I can just wait. If Transocean closes at or above $10 a share in January 2018, then I will achieve a maximum return of $24,500 on a net initial investment of 9,323, or 250%. Not bad on a total move upward of roughly 30% in the underlying stock. At this point, the maximum profit looks highly probable, as Transocean is priced nearly 40% above the $10 strike price on the short calls. The position already shows a paper profit of $11,100. I'd be tempted to grab that, rather than wait for the additional $4000 to materialize in a year or so. The problem is that unwinding the position, paying asking prices for the short calls and receiving bid prices for the long calls, would eat up most of the difference. Unwinding in January 2018 will be automatic, and cost-free. So, I'll be patient.
It all sounds so simple; just a hugely leveraged version on the buy low-sell high scenario. Note, though, that I spent several weeks looking at a sizeable paper loss At one point, it was down about 33%. If I had thrown $100,000 or $1,000,000 at the bet, my sleep cycle would have suffered. As it is, the sharp drop seemed small enough to ignore. My reading of the basics (oil supply/production cycle, company internals (revenue vs debt vs capex) made the trade look very promising; so I didn't sweat the highly visible risk.
From here on out, I'll concentrate on the bonds. That's my long-term strength, and I still see signficant opportunities for the company's longer-maturing debt.
January 8, 2017. It should be clear from my blog over the years that I believe getting rich slowly is a better long-term strategy than its opposite. However, if you are determined to play the stock game, looking for companies that are undervalued, and relying upon the market to recognize and eventually reward your insight, then this particular options spread game seems very promising to me. Working with leaps give you up to two years of breathing space. The risks are very clear (shame on me if I haven't put them front and center), but the rewards can be breath-taking.
My own results are far too spotty to suggest a comprehensive investment strategy (like the Bodacious Bond Portfolio). And a year like 2008 could (and, for me, did) ruin your day, week, and year. Still, a disciplined, laddered series of spreads, diversified over industries, might be very powerful. A few winners could overwhelm quite a few losers.
The big question here is whether is it even possible to outguess the market. By that I mean, a stock (or bond), at any given point, represents the best combined judgement of hundreds, perhaps thousands of pretty shrewd people about a company and its prospects. It's fairly arrogant to disagree. Yet, hind-sight lets us see how often, and dramatically, this shrewd consensus misses the mark. Prices leap up beyond reason, and plunge equally beyond reason. The consensus-makers are constantly looking sideways at each other, and betting on what those peers are going to do. Kind of a circle-jerk, if you want to be crude (I do). Pros generally prefer to stumble with the herd than stumble conspicuously alone. The fact that they get graded, four times a year, and in full public view, makes them skittish and a bit stupid.
This gives an individual investor a huge advantage. Nobody cares what you, a boob in the sticks, is doing. So, they won't make fun of you, because you're invisible! That's a very good thing; you can, in theory, be brave without fear of public humiliation.
I'd love to talk to others about this approach, and I might even try to continue my lab experiment past 2018. I suspect that it will, in time, turn into another get rich slow scheme, due to layers of diversification.
