Fresh all time highs today

One minor detail, in this scenario, without knowing the exact premium, most likely by rolling up, actually money goes out of the option seller.

True.

The original covered call represents selling some of the stock’s upside. If you do that, and the stock then rises above your strike, it is nearly impossible to recover that lost upside. But what Jim suggests is buying back the diminished time value and selling some more ATM time value.

If you roll out far enough, the time value difference might be comparable to the lost upside from the original covered call.

The other risk of rolling is that the stock reverses and is below your strike at the original expiration. By rolling you’ve locked in the loss.

That extra time to make a decision–optionality–is also worth a bit.
You also mentioned flour, which turns a young man’s thoughts in Spring to futures:

  • A future is the obligation to buy or sell at a particular price on a particular date

  • A European option is the right but not the obligation to buy or sell at a particular price on a particular date

  • It takes a short one paragraph logical argument with no fancy math, to determine the fair price of a future (based on arbitrage)

  • It takes a long argument with fancy math to determine the fair price of an option (e.g. original Black Scholes argument).

Apparently three words, “not the obligation”, i.e. optionality, is the sticking point.

Total aside:
Is the ‘cost of optionality’ the difference of a futures price and an associated options price?
Is there any way to play that, for example one can buy and sell ‘volatility’ in various ways, is there a way to trade ‘optionality’?

Jim, you allude to the use of leverage in your option strategies. I just addressed this question to Fidelity concerning the use of “leverage,” and the rep confirmed what I was thinking. There are two kinds of leverage. One, where you put up less money to control more stock, such as DITM LEAPS. Then, there is the leverage of buying on margin, borrowing money from Fidelity based on my holdings. When you say 1.5/1, which kind of leverage are you referring to? The rep told me that I have considerable buying power on margin that I could tap into….let’s just say for the sake of argument, 8 figures. I also have cash on the sidelines that I use for living, emergencies, etc, or maybe a rare optionality event with a few $ on something safe (Verizon, for example). (about sub 7 figures). But, the rep also emphasized that I can’t tap into that margin power without first using the cash position to buy the options…then, when that is exhausted, it will turn next to the margined securities (beaucoup BRK shares)to cover the trade. So, what’s the point? Why have emergency cash, if I must first put that up as collateral? I need and want that cash to always be freely available so I guess what I was groping for was a way to borrow some money (nothing crazy) and leaving the cash component alone on the side.

By rolling you’ve locked in the loss.

That’s why I typically don’t like selling long-term covered calls. Most of my covered calls (except REIT’s or utilities), are very short-term, not beyond 1 month. If I have to roll up, then I do that closer to the expiration.

In some ways rolling up (not when you are super confident of the price action) is basically reaction to missing out the gains. When you sell covered call be at peace that your stock will be called away.

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There are two kinds of leverage. One, where you put up less money to control more stock, such as DITM LEAPS. Then, there is the leverage of buying on margin, borrowing money from Fidelity based on my holdings. When you say 1.5/1, which kind of leverage are you referring to?

The first. It’s buying a position which has leverage, not borrowing money to buy a position you don’t have enough money for.

Where does the 1.5X come from? You sell half your stock and with that money buy a DITM call which has 2X leverage.
1X (stock) + 2x (call) averages out to 1.5

The rep told me that I have considerable buying power on margin that I could tap into…

Which they will graciously charge you only 8.325% interest rate. And they don’t even give you a dinner first.

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The rep told me that I have considerable buying power on margin that I could tap into…

Which they will graciously charge you only 8.325% interest rate. And they don’t even give you a dinner first.

And they can call in the loan at pretty much anytime - and you can assume it will be at a time when the market is down and raising cash is not in your best interest.

tecmo

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Which they will graciously charge you only 8.325% interest rate.

Yikes! That’s highway robbery! Check out Interactive Brokers:

https://www.interactivebrokers.com/en/trading/margin-rates.p…

A $500k margin loan has a 1.18% interest rate.

Tails

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Jim, you allude to the use of leverage in your option strategies. I just addressed this question to Fidelity concerning the use of “leverage,” and the rep confirmed what I was thinking.
There are two kinds of leverage. One, where you put up less money to control more stock, such as DITM LEAPS.
Then, there is the leverage of buying on margin, borrowing money from Fidelity based on my holdings. When you say 1.5/1, which kind of leverage are you referring to?

What I was referring to was using call options.
If you own (say) $75 in stock and $25 worth of in-the-money call options that have 3:1 leverage built in,
you’re long 1.5 times as many dollars worth of stock as you have dollars invested and at risk,
compared to the number of dollars worth of stock you’d control just buying the stock for the same amount of money.

Don’t ever use broker margin.
As others noted, brokers can (and do) take it away from you at any time for any reason or no reason.
And when they do, that will NOT be a good day to be a forced seller.

They don’t necessarily sell only the amount needed to cover any margin liability, either: they can and sometimes do sell 5-10 times as much as needed.
Interactive Brokers, interestingly, has a caveat that they themselves may be the counterparty on those forced sales.
I suspect they have a small but aggressive “pounce” department waiting for such opportunities.
(not that there is anything specific wrong with Interactive Brokers–at least they’re up front about it)

The loan effectively built into a call option you buy is at a much higher implied interest rate than a broker margin loan.
But that option “loan” can not be called in any circumstance, even if the stock market is closed for a month and all security prices are zero.
Money well spent.

Jim

  • 3:1 is a relatively risky/expensive call option pick, but it’s just a math example to show what I meant by 1.5:1 overall leverage.
    A more prudent selection might be (say) Jan 2024 $170 calls, which offer 2:1 leverage at an implied interest cost of about 3.95%/year.
    Or did as of Tuesday, last time I checked.

Note, the way I calculate it, that’s about 4% implied interest on the portion borrowed, not 4% on the whole block of shares controlled.
So, for an option like this with 2:1 built in leverage, the stock price would have to rise at about 2%/year to cover the fact that you’ve entered a position at a worse breakeven.
Note that that rate is lower than most inflation estimates for the next couple of years.

I expect this happy situation not to last.
At some point, either long dated call options will cease being available, or the implied interest rates will be prohibitively high, or some tax will remove the benefit.
There is no point paying 7%/year to buy stock that you think will rise in price at 7%/year.
But for so long as the cheap opportunity lasts, and during moments Berkshire’s valuation is attractive: I’m a leveragin’ fool.

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The other risk of rolling is that the stock reverses and is below your strike at the original expiration. By rolling you’ve locked in the loss.

This is actually a really good outcome.
If the stock price falls a bunch, the call option written (whether the first one or the second one) plummets in market value.
Since I’m short, that’s a mark to market gain for me.
So I’d close it at that point. The majority of the profit in a fraction of the time.
The net profit to date is good in the situation of a price drop whether I changed contracts or not.
Next time the stock price is high I can start the whole process all over again, if I still want to be a net seller.

Or, phrased another way:
Yes, I’ve locked in the smaller loss on the first contract by rolling, but at the same time given a bigger gain on the second one.
I would rather have (-3 realized and +4 unrealized) than (-3 unrealized).

Assuming my stock is called away (as I always do in this situation, until shown otherwise),
the overall breakeven price on every BRK share I own or control is now ~$100k less than it was a week ago as a result of this trade.
Switching from one contract to another when relative prices shift is not necessarily a trivial advantage.

Oddly enough, the overall cost of my Berkshire is negative these days.
My realized (and spent) profit to date exceeds the market value of the current position.
So, this trade made the negative number more negative.

Jim

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(1) Wait till next time the stock is cheap. Say, a valuation corresponding to P/B under 1.35.
Buy some call options, using a block of the cash you usually have, equal to (say) 50% of the number of shares you always own.
(2) Wait till the next time the stock is at or above its typical valuation level. Say, valuation corresponding to P/B over 1.5.

Jim, when I previously ran a backtest on this type of strategy (see 2nd to last post below), I struggled to produce much benefit (including with optimized/data mined thresholds). The general principal behind this strategy makes logical sense, but I struggle with not being able to see the benefit in backtest. Do you have reason to believe it’ll be more effective going forward than it has been in the recent past? Or perhaps how your application of this approach differs to what was done in the backtest? (Since I know you’ve had great success with this general idea in the past)

Note, this test was applied to simply buying stock rather than call options, but I assume the options (and accompanied leverage) would not alter the story much. (but let me know if you think otherwise)

https://discussion.fool.com/method-to-improve-entry-price-350398…

Jim, when I previously ran a backtest on this type of strategy (see 2nd to last post below),
I struggled to produce much benefit (including with optimized/data mined thresholds).

The folks over at the MI board tested my speculation and concluded it would have worked reasonably reasonably well.
And bear in mind that it’s not a crew normally interested in the merits of any single stock.
https://discussion.fool.com/backtest-of-brk-trading-idea-3419219…
Lots of interesting viewpoints in that thread.

And it’s just an over simplification of what I’ve been doing for many years, which has worked.
I don’t use hard cut-offs for when to buy more, but it’s the same idea.
Size the position based on the cheapness.

Not that it’s magic.
Leverage is leverage. What the leverage giveth in good times, the leverage taketh away in bad.
If the net trend is up over time, and you don’t have any reason to bail on short term dips, and the cost of the leverage is low, you’re going to make money.

The underlying reasoning for the trading system is simple: when things are cheap, short term prospects are unusually good.
And vice versa, of course.
So, when it’s cheap, buy more (borrowed money or not). When it’s not cheap, own less.
https://discussion.fool.com/if-you-want-to-look-at-models-of-ber…
So it’s no big surprise that you can make money with this strategy:
Wait till it’s cheap.
Buy extra.
Wait till it’s not cheap.
Sell the “extra”.
Repeat.

The extra returns might not be great, but it’s hard to imagine any asset on which that wouldn’t work,
provided the asset doesn’t actually lose value and you have some good-enough yardstick for cheapness.
IRR ought to get better.

Jim

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So, writing a call that gets you an exit better than that shouldn’t be that bad a deal.
e.g., January $330 call is bid $25.90, getting you an exit of $533850 = $355.90 per B if the stock is called away.

As it happens, I may need to raise a bit of cash this year so took this tip and sold the above mentioned call today for $26.25. Either result should be acceptable.

Thanks.
StevnFool

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Since I’m short, that’s a mark to market gain for me.

Math error?

Here is the example. Sells BRK-B $310 call when the shares are at $300, stock moves up to $320, now rolling up the call strike price from $310 to $320, and the stock settles at $295.

In this case there is no mark to market gain, but a loss. Why?

The original $310 call premium and second $320 call premium together has to be higher than the cost of buying back $310 call. In real life, it is not possible to pull that, given how the IV, volatility and option pricing works.

by switching from one option to another the amount of my loss has been very much less than the amount the stock price has gone up.
The gap in the strike prices from 310 to 325 was far greater than the gap in the price of the options I bought and sold.

This is interesting, but also complicated and I am confused.

Is it possible to make a predictable living selling high time value options and buying low value options? That is, is there a monte carlo simulation in which under some not insane assumptions of price movements over time that your expectation value is a net income from trading into low time value options from high time value options?

Or is it the case that this is still a (purely?) directional bet and, since as you have described it you are net negative on average on holding calls that you will make money when the stock price trends down and lose money when the stock price trends up?

I can’t tell from the narrative whether this is a way to harvest noise, the financial version of a Maxwell’s demon, or not.

TIA,
R:)

Is it possible to make a predictable living selling high time value options and buying low value options?

No, basically. The options market is pretty fairly priced, as a rule, with certain assumptions.
There is no free money lying on the ground, based on the information in the options market.

Rather, the opportunities that arise come from the option market mainly come from information outside that market.

  • A call option can be used as a simple cheap uncallable loan.
    The person selling you the call is trying to make money on a spread or hedge, but as a side effect he/she/it is lending you money in potentially a very attractive way.

  • Prices vary. Sometimes option premiums are high, notably when the market has been jumpy lately. Sometimes weirdly high.
    Other times they are low, or weirdly low.
    Certain opportunities work very well only in one or the other of those two situations, like a hard or soft insurance market.

  • The option market, in essence, has no idea what anything is worth. The price is almost entirely based on recent price action.
    So, if Berkshire has experienced a given amount of price volatility lately, an at-the-money option good for X months will be the same price whether Berkshire is trading at 1x book value or 2x book value.
    As Mr Buffett noted, a stock with a flattish price which suddenly drops is considered riskier after the drop, not as having higher margin of safety.

Cash-backed put writing can be like that: very easy to make money (sometimes a worthwhile amount, sometimes not) if you have an idea what something’s worth, and choose your moment.
Especially when the market is jumpy and premiums are high.
Imagine stock XYZ is trading at $100, and you know it’s almost certainly worth around $120.
Somebody is willing to pay you 25%/year on your maximum cash at risk to let them force you to buy it at $80 any time they like.
What exactly is the downside?
It may or may not be the best investment opportunity you have that day, but it will make you money either way, with differing time frames.
The reason these opportunities arise is because the option market doesn’t know or care what it’s worth.

  • Things which don’t make systematic investing schemes, but just happen once in a while and you can avail yourself of them.
    That’s what this one was, in effect. I was willing to sell at a given price with some date flexibility.
    Then the going price rose past that level and I decided I wasn’t that keen after all!
    But the market was offering me a way to sell at an even higher price (or take a bigger cash payment), as long I was a little bit more patient.
    Both of the new outcomes seemed better to me than both of the old outcomes, so I changed horses.
    You couldn’t build a long term trading strategy around this in any obvious way.

There are a few systematic mispricings, but they’re not usually very big.
For example, to hedge an S&P 500 position you could buy put options on the index or put options on everything in the index.
Those two option positions should therefore be the same price, but they aren’t…there’s a systematic long term bias.
It’s hard for the big money to arbitrage it away because the quantities don’t work out nicely and there isn’t enough liquidity in every position.

Arguably the biggest mispricing is that premiums are sometimes too low across the board and sometimes too high.
If a bolt-out-of-the-blue plunge is what you’re worried about, the probability of that plunge
doesn’t vary through time nearly as much as the cost of insuring against it does.
Want to buy an option but you don’t really care precisely when?
Do it after the market has been flat for a couple of weeks.

Jim

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