Why dont value investors write more covered calls?
 

Seems to me that if most value investors go into a position with an idea of true intrisic value and will sell and move on when the company reaches that value, much like buffett recently did with petrochina, then they should be writing calls whenever they enter the position at the price they targeted as IV.

Re: Why dont value investors write more covered calls?
 

This assumes that their valuation would not change based on news.

Re: Why dont value investors write more covered calls?
 

not necessarily.

writing covered calls may force the investor to hold the position longer than he wants to, tying up capital. this is especially true for long-term calls. and writing short-term calls won't bring in much additional revenue if the target price is significantly higher than the market price.

if the investor believes the company is undervalued, he also believes the call is undervalued (assuming its priced "correctly" given the market price of the stock)

events between the writng of the call and its expiration may change the company's value significantly. for example, assume you own stock in company C because you believe its worth $50 if event A happens or $20 if it doesnt happen. you believe the probability of it happening is 50% and the stock is currently priced at $30. owning the stock is clearly correct, but writing covered calls at a price you believe is too low would be silly.

Re: Why dont value investors write more covered calls?
 

Buffett wrote puts on KO once when the price got low, but not low enough to buy more. And he's got billions in long dated index puts (ten years or more) that essentially force him to buy the index if the price drops 30% or so. The problem with writing puts like this is tying up capital. In Buffett's case he's got insurance float that might give him some long term flexibility about commitments like this.

But I've never heard of him doing covered calls. I've never done them because my stocks are too small to trade options on. But the essential concept is intriguing. As SuperWhale and StinkyPete point out, it doesn't work on any speculative positions whose value may change dramatically based on news.

Typically covered call writers write very short dated covered calls. This means they have to be written close to the current stock price, to capture any significant premiums. But if you buy KO at $60 thinking it's worth $90, you need to write calls at $90. But even the short dated $75 KO calls are only pennies. So $90 calls even out a year or more would likely be worth only a tiny premium.

So I think it only works if the stock is getting near your IV estimate and then you can write calls every month until the stock is called. Assume you bought KO at $40 thinking it was worth $65. Right now you could make 35-45 cents a month writing $65 calls. Or you could write $62.50 calls for about $1.25.

Either way, it's a rare situation and won't add to your results much.

Re: Why dont value investors write more covered calls?
 

Just short puts. Why write covered calls? Aren't transation costs more?

Re: Why dont value investors write more covered calls?
 

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But if you buy KO at $60 thinking it's worth $90, you need to write calls at $90.

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No you don't, you should write them short term at $65 or $70 and gain all the time and volatility premium. Reasoning is that if you thought the stock would go to $90 quickly you wouldn't have bought the stock in the first place, just the calls.

I wrote coverd calls on MSFT for a bit over two years till I sold it all recently. The calls were all short term OOTM (one month after the prior ones expired) I ended up paying for the entire position in the stock with the premiums.

Jimbo

Re: Why dont value investors write more covered calls?
 

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Seems to me that if most value investors go into a position with an idea of true intrisic value and will sell and move on when the company reaches that value, much like buffett recently did with petrochina, then they should be writing calls whenever they enter the position at the price they targeted as IV.

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Because people are greedy. Everyone I've asked about this says something to the effect that if they buy the stock at 50 hoping to sell at 90, they don't want to write calls at 60 or 70, or even 90, truth be told.

When I was working for a chip company, we got lots of options, ESPP, etc so I watched the stock every day and got to know it well. I would say for the 5 years I worked there and held the stock in my personal account, I probably averaged 50% a year selling covered calls.

Re: Why dont value investors write more covered calls?
 

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Buffett wrote puts on KO once when the price got low, but not low enough to buy more. And he's got billions in long dated index puts (ten years or more) that essentially force him to buy the index if the price drops 30% or so.

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He did the KO puts because he wanted to buy the stock cheap. He wins either way. It's an especially good technique to buy huge blocks with, because it doesn't hit the tape and drive the price up.

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The problem with writing puts like this is tying up capital.

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The premium received more than compensates for the carrying costs of tying up the capital.

Re: Why dont value investors write more covered calls?
 

I would probably consider myself more of a TECHNICAL trader on a shorter term basis.....and a VALUE based/FA /bargain hunter stlyed investor over a longer time frame.

I have always preferred to WRITE covered options against my positions...as I would always rather receive these premiums vs. paying insurance in most cases if I am inclined to hedge a certain position

During certain market conditions however(e.g.flat vs. extremely volatile).....there are some obvious exceptions due to the expansion/spread of premium prices

Stephen

Re: Why dont value investors write more covered calls?
 

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Just short puts. Why write covered calls? Aren't transation costs more?

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When you're opening a new position they are, since you're paying a commission to buy the stock and one to sell the call. But, we're talking about selling calls on stocks that you already own.

Re: Why dont value investors write more covered calls?
 

its a delicate game... most valuations obviously involve a bull case a bear case and everything in between, even if they have a target IV its not a very static idea, but more of a directional view on where a company is headed.

implied vol was very low in a mkt trending upward so often value investors over the past 5 years probably didnt want to cap their upside. now that implied vols are at very high levels i'd guess that you are going to see more and more covered call writing as the risk-reward profile improves.

also--if your valuation changes, you can always roll your position to a different maturity or strike... obviously crossing bid offer is a pain but its a more nimble position than you think.

Re: Why dont value investors write more covered calls?
 

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implied vol was very low in a mkt trending upward so often value investors over the past 5 years probably didnt want to cap their upside. now that implied vols are at very high levels i'd guess that you are going to see more and more covered call writing as the risk-reward profile improves.


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are you suggesting that implied volatilities are currently/will soon be higher than actual volatilities? or that implied volatilities were lower than actual volatilities over the past 5 years? what is your reasoning for suggesting that the risk-reward profile is improving?

Re: Why dont value investors write more covered calls?
 

I think he meant implied/actual as the same, but both have been huge since the summer and look like they will stay that way for the near future. It does look like 2-3 month rolling covered calls is the way to go..now if only I could write them.

Also the problem dc pointed out, options dont trade on most of my companies, is the main problem.


This seems like the best idea: "So I think it only works if the stock is getting near your IV estimate and then you can write calls every month until the stock is called. Assume you bought KO at $40 thinking it was worth $65. Right now you could make 35-45 cents a month writing $65 calls. Or you could write $62.50 calls for about $1.25."

Re: Why dont value investors write more covered calls?
 

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I think he meant implied/actual as the same

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if that's the case, the risk/reward should be the same, no?

Re: Why dont value investors write more covered calls?
 

by that I think he meant there are now high returns available for people willing to take on high risk. if you remember back in may/june, even risky debt was selling at extremely low yields.

Re: Why dont value investors write more covered calls?
 

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implied vol was very low in a mkt trending upward so often value investors over the past 5 years probably didnt want to cap their upside. now that implied vols are at very high levels i'd guess that you are going to see more and more covered call writing as the risk-reward profile improves.


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are you suggesting that implied volatilities are currently/will soon be higher than actual volatilities? or that implied volatilities were lower than actual volatilities over the past 5 years? what is your reasoning for suggesting that the risk-reward profile is improving?

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with a few exceptions, implied vol generally trades above realized vol. in times of panic, implied vol almost always trades above historical vol.

Implied vols now are way higher now than they have been over the last 5 years. the option market prices a one std deviation move in the S&P over one trading day to be ~1.75% over the next year. Over the last 5 years this number has been right around 1% or less.

If you are doing a buy write, you are selling an option. If the implied vols are high, the option is more expensive.... So when you are selling something more expensive, your risk reward looks more attractive.... You are selling something that you can get more juice for now than you could before... Of course, times are different now and you run the risk of not participating in big upward movements in the market if you decide to buywrite. That being said, if the markets turn around and start to trend higher, implied vols will decrease so you can always buy back the option you are short and make money on just the fact that the vols went down.

Re: Why dont value investors write more covered calls?
 

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But if you buy KO at $60 thinking it's worth $90, you need to write calls at $90.

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No you don't, you should write them short term at $65 or $70 and gain all the time and volatility premium. Reasoning is that if you thought the stock would go to $90 quickly you wouldn't have bought the stock in the first place, just the calls.


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The problem is you don't want to be called out of a stock that you think is worth $90 for $65. You can always buy back in, but can lose if the stock gaps up to say, $75 on good news. Even if you don't lose when you get called out, you are increasing transaction costs, converting long term gains to short term gains and losing your ability to defer taxes, one of the most powerful advantages of buying and holding. Essentially when you defer taxes you are getting an interest free loan from the government to invest. Covered calls aren't a free lunch, you are effectively selling upside at it's intrinsic value while making your investment less tax efficient.

It is attractive to think you can make high annualized profits if you get called out quickly. But we are talking about value investors. If I buy KO at $60 thinking it's worth $90 now, that means a year from now I will likely think it's worth $105. Just buying and holding, keeping tax rates to a minimum and deferring taxes can produce very high rates of return in an investment like that. Sometimes covered calls may work great, but my guess is that most time's it's better to hold, otherwise it would mean that calls are typically over-priced.

Re: Why dont value investors write more covered calls?
 

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implied vol was very low in a mkt trending upward so often value investors over the past 5 years probably didnt want to cap their upside. now that implied vols are at very high levels i'd guess that you are going to see more and more covered call writing as the risk-reward profile improves.


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are you suggesting that implied volatilities are currently/will soon be higher than actual volatilities? or that implied volatilities were lower than actual volatilities over the past 5 years? what is your reasoning for suggesting that the risk-reward profile is improving?

[/ QUOTE ]

with a few exceptions, implied vol generally trades above realized vol. in times of panic, implied vol almost always trades above historical vol.

Implied vols now are way higher now than they have been over the last 5 years. the option market prices a one std deviation move in the S&P over one trading day to be ~1.75% over the next year. Over the last 5 years this number has been right around 1% or less.

If you are doing a buy write, you are selling an option. If the implied vols are high, the option is more expensive.... So when you are selling something more expensive, your risk reward looks more attractive.... You are selling something that you can get more juice for now than you could before... Of course, times are different now and you run the risk of not participating in big upward movements in the market if you decide to buywrite. That being said, if the markets turn around and start to trend higher, implied vols will decrease so you can always buy back the option you are short and make money on just the fact that the vols went down.

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Jason, you realize we are talking about value investors, right? And that value investors rarely care about volatility? Typically value investors like options in situations where they have a good estimate of the likelihood of a specific business event happening, and the resulting value created from that event, and that allows them to value options regardless of what volatility is.

And I think the reasons I covered in my response to Jimbo address why most value investors don't use covered calls.

Re: Why dont value investors write more covered calls?
 

Desert Cat's last two posts exemplifies my response above, people are greedy. That's why they don't do covered calls.

Re: Why dont value investors write more covered calls?
 

wow I totally forgot about the taxes. I guess it makes sense when you think a stock is approaching IV and you are ready to dump and move on, but yeah, the fact that your money grows tax free is huge.

Re: Why dont value investors write more covered calls?
 

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otherwise it would mean that calls are typically over-priced.

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Correct, particularly on the first day after expiration of the prior months calls. I really didn't know that a value investor implied a "long term" investor. I agree about the tax implications but if you have been in the stock for over a year already (like my MSFT example) getting called out has no tax implications and you would have still had the short term gains.

Sure covered calls are not for everybody or for every stock, it is just that people on this board (especially people who have never written a single one in their life) dismiss them out of hand, often without considering when they are practical and profitable. Not saying this is you, it just appears to be the general consensus. Like everything else in the market writing them successfully takes some time, some work and some guesswork about both the market in general as well as the specific stock.

Jimbo

Re: Why dont value investors write more covered calls?
 

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wow I totally forgot about the taxes. I guess it makes sense when you think a stock is approaching IV and you are ready to dump and move on, but yeah, the fact that your money grows tax free is huge.

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All you have to do is roll your calls forward before expiration. There's a chance they may get exercised early, but it doesn't happen often.