Friday, May 06, 2005

Am I an insurance salesman?

I was pretty active today.

While I was looking for options to sell for summer expirations, I notice that TOL May 70 puts were selling for$0 .55, which is a pretty good return on capital for 14 days of risk. I don't feel terribly bullish on Toll Brothers. Toll brothers is a homebuilder, and homebuilders have run up big this year. The great jobs report today can't be very good for Toll Brothers, either. With the job market booming, the fed is more likely to continue to raise rates to pop the "housing bubble", but is there any pending events that could drop TOL 9 points in 14 days? I looked around on the net for news on TOL and didn't see any events coming up, except for their earnings which isn't until after expiration. I don't need to be terribly bullish on TOL to think that it won't drop 9 points in 14 days so I sold those options short. I am a little concerned that there is something I'm missing here, though.

I also purchased some HON common stock for the weekend. Cramer wrote on RealMoney.com that there was unusual call option buying in HON, so I bought some on the rumer that there will be a take-over bid...apparently a lot of other people had the same idea, as it was reported on extensively by CNBC today. I'm not terribly thrilled to be part of the herd buying a stock on a rumor, but I've made money before from what I consider to be similar Cramer calls, and the risk isn't large for this position....Oh great THIS JUST IN! Cramer just said on Mad Money that he would have sold the HON at the end of the day...He didn't outright say this on RealMoney.com...I kind of got the impression that he was saying to buy it for a few days. Oh well...and I was tempted to take my gains today....

Anyway I was looking for stuff to sell for summer expiration months. My favorite candidate is the MO June 60 puts, but I need to get at least $0.70 for those puts, a price that was unavailable today. I did sell DY June 20 puts for $0.40 today. In this stock I have slightly changed my approach, in several ways. Usually I take positions in stocks that I have been following and know something about. I had never even heard of this stock before yesterday evening. In the past I have rarely been able to find even 5 stocks to sell puts on. I would like to establish more positions going forward so I haveto cast a wider net, and am now selling puts on stocks I don't know as much about. This is for two reasons. First of all, I want to be more diversified. Secondly, I mostly follow stocks like GOOG, EBAY, QCOM, INTC, CSCO, LU etc...those are yesterday's stocks. Those stocks belonged to the 1990's (except GOOG of course). Going forward I need to start learning about other types of stocks, because I don't believe the nifty ninety's stocks are going to be the best stocks for the 00's. We'll see how well this turns out I guess.

The biggest change in approach is that I am selling naked options again, instead of selling only bull spreads like in March, April and May. For those unfamiliar with the term "bull spread", let me explain what I mean. If I sell a put short, I am entering into a contract that says I have to buy the stock at the options' strike price from my counter-party at his whim. Essentially I am selling insurance against losses, and my underwriting fee is the option premium. So for example if a stock is trading at $55, and I sell a put with a strike of $50 for say $0.45, I am now exposed to losses of around $5000 for a contract of 100 puts. So I am making 45bucks and being exposed to a risk of losing 5000 bucks. That doesn't seem like a very good deal does it? But that is what I do...I'll make a longer post some other day and explain why I do this.

Now it is unlikely that the stock will drop to zero, but what if the stock drops to say 25? That would still be a sizeable loss of around $2500 dollars. Since I am usually margined, that could very well be a 100% loss on the position. After reading Telab's Fooled By Randomness, I became less comfortable with naked put selling. Telab warns about the so called "Black Swan" events...Rare unexpected events that come along and wipe out traders like me who expose themselves to unlimited losses.

So what I have been doing is this. When I sell that 50 put short for $0.45, I also buy some insurance of my own in the form of purhcasing a 45 put for say $0.15. Now for this position I am only making $30 profit but my maximum downside risk is clearly defined at around $500. This is what I meant by the term "selling a bull spread". Note that even though I am making less money, my return on capital is actually higher. Before using %50 margin instead of the aproximately %25 margin I'm allowed on a naked put sale, it would cost me around 2500 to cary that position, so my return on investment would have been 45/2500 = 1.8%. But now I only need around 500 to cary the position so my return on investment would be 30/500 = 6%.
Another important reason for buying insurance was that I typically didn't have very many positions. Ideally I would need to have 20 to 30 positions to be well diversified instead of only 5. With my capital divided among only 5 positions, I'm especially exposed to extreme price moves which are common in any individual stock. If I had my capital divided among 30 positions then I would have less need for insuring each individual position. Instead I could just buy puts on the S&P to insure the whole portfolio, against an extreme market move, and absorb whatever individual stock risk I suffer on any individual stock since the capital in an individual position would be small.

So why have I decided to go back to selling naked puts instead of bull spreads? By not buying the insurance I can go down to a lower strike, increasing my chance of profit. For example let's look at this month's TWX fiasco. I sold TWX $17 puts for $0.20. I then insured myself by purchasing $16 puts for $0.10. This left me exposed to a maximum of $1.00 per spread for a 10 cent profit per spread. Now this was a stupid spread to enter, because transaction costs are too large for such a small profit...but I'm using it as an extreme example. Well if I had just sold the 16 puts naked for .10 I would have been making the same amount of money, but I would have a lot less to worry about because the risk of TWX dropping below 16 is much smaller than the risk of it dropping below 17. By giving up protection against rare events, like say TWX dropping to say 10 dollars in one day for example, I give myself more protection against common events like TWX dropping a buck maybe. I still plan to insure the whole portfolio against large market drops by purchasing index options.

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