Selling More Puts

In my last post, I mentioned selling puts to generate income. This strategy seems to me to be increasingly more attractive. There has been tremendous volatility in the market, which has been reflected in the price of options. The potential returns on cash are quite high, perhaps over 25% on an annual basis, and there is also some protection against buying too securities before dips. I'm thinking of transferring additional cash into the portfolio to take advantage of this, particularly as cash yields on savings accounts are declining more and more.

Here are some things to consider:

Do this for only stocks that I am willing to own. The worst case is that the price declines so much that I am forced to purchase shares at a loss, even after accounting for the premium. I had better be willing to own the stock at that price.

Determine a price that I am absolutely willing to pay. Even options with strike prices over 20% below the current trading price are paying high premiums, so it makes sense to look at prices that I think would be a steal.

Look at only actively traded stocks. Otherwise, the bid-ask spreads will be too great and the price for closing a position will also be high.

Look for contracts 3 to 6 months to expiration. This balances a higher time premium and ensures that cash will not be tied up for too long.

The market dipped significantly today before making a breathtaking rally at the close. I took a sampling of today's closing put prices, and despite the rally, the premiums available are still very juicy (all prices are at the bid):

GE Mar 09 Expiration:
$10 Strike: $1.00
$12.50 Strike: $1.55
$15 Strike: $2.35

American Express Apr 09 Expiration:
$10 Strike: $1.20
$12.50 Strike: $1.80
$15 Strike: $2.65

Freeport McMoRan Feb 09 Expiration:
$17.50 Strike: $2.23
$20 Strike: $3.10
$22.50 Strike: $4.15

Nokia Apr 09 Expiration:
$10 Strike: $.95
$11 Strike: $1.25
$12 Strike: $1.60

I wrote another 2 $10 Strike March puts on GE this morning.

GE at $10 seemed like a good trade to me. The stock would have to drop almost 40% from today's levels in order to trigger it. The likelihood seems low of that occurring. Selling it yields $1 per contract payable immediately. If GE drops to $10, the option is exercised, and I would have to buy 100 shares of GE at $10. But I've already collected a $1 per share premium, so I am still earning money. Moreover, GE pays $1.24/share in dividends, so the implied yield at $10 would be over 12%. Overall, it seems like a relatively easy way to make 10% ($1 premium on $10 strike) on cash in 4 months. The worst case is that GE falls below $9, but in that case, I would own GE at $9, which I am pretty sure I would be willing to do.

What's the worst that can happen?

This depends on whether the alternative is to sit on cash, or if the alternative is to buy the stock. If the alternative is to sit on the cash, then the worst case scenario would be if GE shares collapse, and trade at $5 on March 20. Then I would be forced to buy the stock at $10, and the $1 premium I collected wouldn't be enough to cover the losses. This is mitigated by the fact that GE pays $1.24 dividends which they recently affirmed for 2009. Management guarantees have been pretty useless lately, but assuming they are correct, the $1.24 translates to a 24.8% annual yield. The mitigating factor is that the dividend yield will be very high, and I would own the stock at a ridiculously low price.

If the alternative is to buy the stock, then the worst case scenario is if the market rebounds dramatically and GE doubles to $34. GE was trading above $34 as recently as April, so this scenario isn't that far-fetched. In that case, I would miss out on the return. I would still collect the premium from the option, which will expire worthless, but I would have missed out on a 100% gain had I simply bought the stock. I can always close my put position as well, as an increasing stock price will reduce the price of the put. I could then take my cash and use it to purchase shares. Of course, if I bought the stock at $17 and it drops to $5, that would be a far worse result.


When I made this trade this morning, GE had fallen quite a bit and the option was trading at $1.45. I sold two puts and collected about $280 in premium after commission. Assuming that GE doesn't fall below $10 in March, that's a 14% return in a little over 4 months. I selected an extremely low strike price and I'm assuming there will likely be no exercise. I could have selected a higher strike price and collected an even higher premium. Overall, this seems like a good way to take advantage of all of the current volatility in the market.

Anyways, I will be out in Costa Rica for the next week, so will be taking some time away from the market. Hopefully, nothing too crazy happens in the meantime.

Options and Commodities

I've been short of time to post recently, so here's a quick update on where things stand. While there's been little blogging activity, there has been plenty of trading activity. I added another $12k on October 24.

Here are my recent trades:

Autodesk (ADSK) - 11/06/08 - SOLD 1 $20 December put at $2.50

Autodesk (ADSK) - 11/06/08 - BOUGHT 100 shares at $19.77

Nokia (NOK) - 11/06/08 - BOUGHT 100 shares at $14.67

Freeport McMoRan (FCX) - 10/24/08 - BOUGHT 100 shares at $23.53

NVIDIA (NVDA) - 10/23/08 - BOUGHT 100 shares at $6.60

Freeport McMoRan (FCX) - 10/23/08 - BOUGHT 100 shares at $26.03

Heartland Payment Systems (HPY) - 10/15/08 - BOUGHT 100 shares at $18.69

Nokia (NOK) - 10/15/08 - BOUGHT 100 shares at $15.03

Intel (INTC) - 10/14/08 - BOUGHT 20 $18 October puts at $0.30

I've also been investigating other potential investments aside from stocks, including options and commodities. I think both will likely play a larger role in the portfolio.

Options

I made a speculative option trade in Intel back in October. I honestly wasn't sure of what I was doing, and I made some silly mistakes.

The attraction of options is leverage. Buy an option instead of the underlying stock, and the price movements of the stock will be magnified by the option. The flip side is that while your upside is multiplied, the downside risk is also greater.

In the case of the Intel options, I made a bet that their earnings report would be better than expected. The problem was that I decided to purchase options in their expiration week, thinking that the potential return would be greater. Instead, they just expired worthless.

In any event, this made me list out the specific instances in which I would make an option trade. With so much volatility in the market, I think it actually makes sense to sell some of that and collect the premium. Here are the instances in which I would make option trades:

1. Sell puts.
This is like getting paid to wait to buy something at a lower price. For example, I have sold 1 put contract of Autodesk at $20, expiring December 17, 2008 for $2.50. 1 contract is 100 shares, so selling the put netted me $240 in cash upfront ($250 from the put less the $10 or so in transaction fee). If Autodesk is $20 or less at contract expiration on December 17 (about 6 weeks from now), the contract is executed, and I will have to buy 100 shares of Autodesk at $20. I'm quite willing to purchase at that price. However, since I got the $240, I'm really buying the stock for about $17.60 instead of $20. If the stock is above $20, the put expires worthless, I don't have to do anything, and I keep the $250 premium. I can write another put that expires in Jan. 09 or March 09 and do it again. I plan on doing this a lot more in the future.

There are three issues:

1. Need to have the cash on hand to buy the stock.
   
2. If the stock drops by a lot, let's say to $15, then I still need to buy the stock at $20. I would be at a loss immediately. However, if I had bought the stock at $20, then I would be down even more, so this is fine as long as I'm willing to own the stock.
   
3. Charles Schwab's online platform doesn't support this unless you have the highest/most speculative permissioning on options trading, which I don't. That means I need to phone orders in, which is annoying, but OK as long as I use limit orders.

2. Sell out-of-the-money covered calls.
This is the opposite of selling puts, for stocks that I own and would like to sell. I could have done this with EBAY. Instead of selling at $17, I could have written covered calls on the calls and earned the premium as well. If the stock rises above the strike, I sell it and get the premium as well. The problem is if I really want to sell. For example, if EBAY were to fall more (as it has), then the option would expire and I keep the premium, but the stock is now worth even less.

3. Buy long-term calls (LEAPs).
I would consider these for some of the more high growth plays, such as AAPL, GOOG, or VMW. It's very expensive to do this right now with all of the volatility in the market.


Commodities

I was reading Hot Commodities by Jim Rogers, and it struck a chord for me. At a high level, his argument is that commodity market movements are purely based on supply and demand. When demand exceeds supply, prices will go up. When prices go up, there will be more investment dedicated to discovering and increasing supply. However, these actions take time for the new supply to hit the market. Meanwhile, as long as demand stays high, prices must go up. Rogers believes that we are currently in a long-term bull market for commodities (although I'm not sure how his views have changed in light of activity of the past few months).

Historically, commodities have performed better when equities have come down, because they are still tangible assets that have utility. So whether this is crude oil, natural gas, aluminum, wheat, corn, copper - if there is demand for it, then price will be dependent on supply. In the face of a global downturn and a credit contraction, commodities have dipped dramatically because of concerns that the demand simply won't be there and that there isn't enough money to inflate prices. It seems unlikely to me that demand would lessen. The growth of countries like China and India will simply be pushed out a few years. The demand for commodities won't just go away. Moreover, for certain commodities such as crude oil, there just hasn't been much in the way of new discoveries of supply.

There are a variety of ways to play this. I am barely a novice myself, but this is how things break down for me.

1. Direct investment in commodities.
I'm not touching this until I understand this better. I can't do it through Schwab, and I don't know enough about specific commodities to do this effectively. In time, perhaps.

2. Investments in commodity stocks.
This is more intriguing to me. I look at businesses that deal heavily in specific commodities and invest in them. For now, this is preferable because I can better understand the companies, and they may very well pay me dividends to own them. Freeport McMoRan (FCX), for example, deals primarily in copper (80% revenue), with interests in molybdenum and gold. A look at their Q3'08 investor presentation shows how their cash flow would be affected by swings in the price of these commodities. A change of $0.20 in the price of copper (per lb), for example, would mean a change of $575M in operating cash flow.

FCX is one of the leading players in copper, and they pay a 7%+ dividend and have a strong balance sheet. They have about $7B in debt, but there are no significant debt maturities until 2015, so they should be able to weather the current crisis easily. In terms of reserves, they claim to have 93.2 billion pounds of copper, 41.0 million ounces of gold, 2.0 billion pounds of molybdenum, 230.9 million ounces of silver and 0.6 billion pounds of cobalt as of the end of 2007. Some of their mines are located in potentially unstable places, like the Democratic Republic of Congo. Any incidents, however, would likely be tempered by offsetting price movements in the commodity itself.

3. Commodity ETNs.
The largest of these is DJP, with holdings of 19 key commodities and over $2B under management (assuming the price declines in the last few months haven't been too devastating). The other choice is Jim Roger's ETN RJI, which tracks his index of 35 commodities, but it has much less assets under management.