How to use Covered Calls – a guest post

Last month, Nishit wrote about the Short Strangle strategy to make money in a sideways market. Not too much has changed since then. The Nifty is still trading within a range - not giving a clear direction.

Individual stocks in your portfolio may be going nowhere also. Can you generate some profits without selling your stocks and losing out on dividends or bonus issues? Covered Call writing may be just the strategy for you, suggests Nishit.

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We continue with our series of F&O with an article on Covered Calls. Covered Calls basically mean we already own an underlying asset and sell Calls.

The Wikipedia definition is:

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

Let us take an example of Infosys. Infy has been rallying from 2700 to 2950 from the June Series. That’s roughly a rise of 10% for the past past 3-4 weeks. Logic states that if a stock rallies before results, then any good news is discounted in its price. Same logic if it falls before results. This is based on the principle that markets discount all news in advance.

Assuming I have Infy shares constituting 1 lot in F&O, which is 125 shares. If I had written 1 lot Rs 3000 strike price Option of Infy on Tuesday, then I would have got Tuesday’s price of 52. This would entail a premium inflow of Rs 6500 (=125x52).

I have 125 shares of Infy in my account. Now, if my trade goes right and Infy falls, then I get to keep the shares as well as pocket the premium of Rs 6500.

Now if Infy rises, till Rs 3000, I don’t pay anything. This is because Option strike price is Rs 3000. At Rs 3050, I have to pay Rs 50. My inflow is Rs 50 from writing, so no loss no profit.

Above Rs 3050, I start having to pay up. This also means that when market price was Rs 2950, I was covered till Rs 3050 for losses and above that, I sell my shares which I hold and pocket the money. Suppose, Infy hits Rs 3100, then I sell off at a rally of Rs 350 from the bottom which translates to 13% gain in a span of 4 weeks.

A stock like Infy moves max 20% in a year in a range. Like from Aug ’10 to Jan ’11, Infy moved from Rs 2700 to Rs 3500. Not a bad deal.

This strategy is recommended for Long Term Investors who have shares in their demat accounts and want to earn some money on the side, without losing out on dividends or bonus.

Before entering any trade, one should have a clear idea of reward, risk and max loss and max profit.

Note: The figures at some times may be indicative or rounded off for example’s sake. The idea of this article is to try and explain the fundamental principle. True students of Option Strategies should try and grasp the basic principle. The strategy works best for stocks in which you are long-term bullish, but which may not be moving much in the near term.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

Notes from the USA (Jun 2011) – a guest post

One of the best ways to find out about the true state of financial health of a company is to scrutinise its cash flow statement. The Profit and Loss statement is based on the accrual system of accounting. The cash flow statement records the actual inflows and outflows of cash, which provides a better idea about the sustainability of a company’s business model.

What about an investor’s cash flow statement? Are you keeping track of exactly how much cash inflow is being generated by your cash outflows (i.e. investments)? Specially in a sideways or sliding stock market? In this month’s guest post, KKP shares some of his thoughts on the subject.

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Lets Get Down to Cash Flow Analysis

Q1 and Q2 2011 have shown that there might be a good size recovery, giving a feeling of hope to many people in the US, as well as corporations. The economy has slowly been recovering – no doubt. But the housing and construction market rebound has remained soft despite the big QE (quantitative easing) programs from the Fed and the low-low-mortgage rates (average 30-year fixed U.S. mortgage rate is around 4.82%). The reason is simple: Stubbornly high unemployment and underemployment, and also tight lending policies from the bankers/lenders. Bankers have swung the pendulum to the other end of the spectrum and have very stringent policies. In 2002-2008, lenders would lend money to people without any money down (by doing double mortgages), and today, even if someone is providing 25% down payment (upfront cash), they are scrutinized as if they are one of the worst borrowers.

Predictions show that home prices will fall around the 5% to 10% in 2011 compared to 2010, and they will remain flat in 2012. This median forecast was part of a poll by Reuters of 21 economists who provided price forecasts. In looking at really long term trends of US home prices, it clearly shows that home prices are close to the bottom and will hover around here for a bit, and with a ‘core-recovery’ we will see a bounce up in prices (albeit very slowly).

"It is hard to see the housing market doing better until the massive headwind of foreclosures is removed and that will likely take a couple of years," said Mark Vitner, senior economist at Well Fargo Securities in Charlotte, North Carolina. With home prices still falling, many potential buyers are sidelined and banks are more stringent with loan applications and credit scores, Wells Fargo's Vitner said. "It is not that I am pessimistic about the housing market, it is just that I am not optimistic and a gradual recovery probably will not happen until 2013 or 2014, with a full normalization not until 2015," he said.

I have noticed that there is a rise in the "distressed, foreclosed and short sale" homes due to the fact that the lower home prices have put mortgage balances (what you owe on the home) above the current price of the home. Therefore, the home either goes into a short sale (seller and lender put it on the market), or foreclosure (owner cannot or will not pay mortgage), or distress situation (seller does not pay mortgage, and lender cannot afford to keep the home on the books). The net result is that the price of the home has to be marked down significantly, for investors or home-upgraders or renters are willing to look at the properties.

I am currently sprucing up a home that I purchased as a ‘distressed home’, and will be renting it out before July 1^st, 2011. In addition, have offers out on Short Sales where the Seller and Lender are considering my offers for Downtown Condos (at 1/3^rd to 1/4^th the last sale price). Even with the above flat market situation predicted, I remind myself that I am buying real estate at the “equivalent of March 2009 Sensex prices”. Remember how undervalued we were in the stock market at that time, before we took off? Real estate will NOT take off in the same manner (of course), but my tarot-charts (figuratively speaking) is telling me that I am buying it close to the bottom and have no desire to price these out for sale since I will be renting them out in the near term (2 to 5 years).

In addition, I am buying these at really ‘distress’ prices, instead of chasing them, and have the ‘patience and privilege of dividends’ while I hold. Dividends are in the form of rent here so it is easy to convince myself to hold. So, equate it to holding a stock that may not move up immediately, but will pay you almost risk free 12% to 26% in return with minimum loss of capital (if so).

Bottom line is that a lot of books have been written about ‘cash flow’ production, and with this methodology, I have found how much of a parallel it holds to Selling Calls on individual stocks being held in a portfolio. Call Selling had been a very favourite methodology of mine when I was very active in the markets in the 1990’s, and most recently as a way of reducing my stock holdings. But, in both cases, it taught me how to ‘generate cash flow’ from the holdings, and ‘make a paycheck’ out of it.

Real estate has the power to make the same with almost the same amount of time involvement. Wow. Really? Yes, very true. In India, it is even better since you can literally buy a flat/condo and rent it out, making all responsibilities of maintaining the flat a responsibility of the tenant (minus big issues). I am able to replicate the same with a team of contractors to simplify my life and do virtual-maintenance (call someone to go and fix it at low cost).

For now, think cash flow, and figure out a way to generate a paycheck or cash flow from your investment holdings. If you hold RIL or HUL for a long time, the percentage yield to your purchase price could be significant enough to get a very net high yield, especially if the stock has provided splits/bonuses. With my net-buy-price of HUL under Re 1.00, the percentage yield on the annual dividend seems like a paycheck each time it comes. So, there are many ways to skin the cat, and as one gets more experienced, some of these techniques become part of the portfolio and life, and yet, it is each portion of the portfolio that needs to replicate the ‘cash flow’ generation methodology. Traders might be good at generating cash flow from ‘trading’, but very few can do it consistently, and hence doing it with many techniques/strategies will be good for your long term financial health.

Hope you can ‘draw’ some ideas from this to your thinking and add a twist to your investments that might change the overall short and long term return, such that it gives back some cash flow which can help with your own personal goals (buying gold or silver)…..Oh, that brings me to another favorite topic of mine (gold), but we will leave that for the future….

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

How to Short Strangle a sideways market – a guest post

In last month’s guest post, Nishit explained how options can be used to hedge your stock portfolio against potential losses. It can be a useful tool, provided you learn how to use it properly. The added advantage is that you need not sell off your holdings, if you are properly hedged.

What happens when a stock market is not going anywhere? Taking two steps forward and three steps back? Nishit presents a neat strategy that can make money in a sideways market. If you like what you read, or have a question, please leave a comment for Nishit.

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The markets are trading sideways for the past several days. How do Option Writers benefit from this?

As explained last month, Options are perishable commodities. They are a factor of price value and time value. For example, if Nifty is at 5550 and 5500 Call Option is trading at 110 rupees, 50 rupees is the intrinsic value and 60 rupees is the time value. Time value is value of time left till expiry when the Option will be squared off at the market price. The extra premium is with the expectation that the price will move up by at least 60 rupees till expiry.

Introduction on Options as below:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

Options are bought by people and those people who sell Options are known as Option Writers. Why would people write options? Option Writers always make the maximum money and they are often big institutions.

In a sideways market, one can have a Short Strangle. What does this mean? The Nifty is now near 5400 and trading in a band between 5350 and 5600. The days to expiry are 2 weeks. One can write the 5300 put at say 60 rupees and 5600 call at 50 rupees. By writing these 2 Options we can get 110 rupees as premium.

Can we make a loss?

If the Nifty goes below 5300 or above 5600 we start making losses, in the sense that we will have to pay out money at expiry. We had received 110 rupees as premium so theoretically we are safe between 5190 to 5710. At the most we will make no loss and no profit.

Also, once the direction becomes clear we can either short Nifty or buy Nifty to cover the direction whether we are making a loss. Thus one side we take in the entire amount as profit.

Writing of Options should be done keeping the technical levels in mind and not in isolation.

One more way of deploying cash balance is at the end of the month. About 4 - 5 days from expiry, write Calls about 200 points above current market price. The price of each Call would be about 10 rupees after removing the brokerage.

Now, a margin of 1 lakh will allow you to write 4 lots which will bring in about 2000 rupees. Doing it every month for 12 months, will bring you 24000 or about 24% return on capital deployed.

The Caveat Emptor here is that one should keep technicals in mind and not blindly write calls. Also, calls are much safer to write than puts as sharp rise in price is never sudden as against a sharp fall due to news events.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

How to use Options as a hedge – a guest post

In Chapter 3 of my FREE eBook, I explained why small investors should avoid Futures and Options trading. The odds for success are too low, and the chances of making a loss are too great for my liking.

I belong to the old school of buy-and-hold investors who prefer to get rich slowly. For younger (and smarter) investors, who are not as risk averse as me, Options can be a useful hedging tool. Nishit explains how in this month’s guest post.

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Options are much misunderstood and much maligned. They are best used for hedging, and not as a gambling mechanism.

To read the basics of Options one can refer to this older post of mine:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

How do we use Options?

Let us suppose we have a portfolio of stocks and feel that the market is going to take a beating. One approach is to sell our stocks and sit on the cash – which is the safer route. Another approach is to write calls and pocket the premium. E.g., when the Nifty was at 5900, we could have sold the 5900 call option at Rs 142 and pocketed the premium. One would have been at a loss only if the Nifty went above 6050, a gain of about 3%.

To buy options you need to pay a premium, and the seller gets the amount the buyer has paid. He is paid this amount in order to compensate the seller for the risk he is taking - the risk of markets rising.

If the markets rise, your portfolio would also have risen proportionately, provided it had blue chip stocks in it. One could do this month after month and earn extra money while at the same time keeping the portfolio intact. This requires a bit of effort in the sense that one needs to know a bit of technical analysis to understand the support and resistance levels.

What-if Analysis

One could come back and ask: why not buy Puts to hedge? The problem here is that Options are like mangoes, a perishable commodity. If the markets don’t fall, you lose your premium. In case of writing calls, you are getting a net inflow and you would only make less money and lose money if the markets rise more than 3%. If the markets rise more than 3%, then you have got your technicals wrong.

Is the converse true? When we feel the markets are going to rise, can we write Puts?

Writing Puts is one of the most dangerous things to do. Why? Most of the falls are sudden and unexpected. The triggers are something out of the blue. Consider the 9/11 events or some assassination or natural disaster.

Writing Puts and Calls leaves one open to unlimited liabilities. In case of writing calls, one has his or her portfolio as a hedge, but in the case of writing puts there is no hedge really. It should be left to big institutions to do.

Writing Puts can be indulged in, when one has bought another put as a cover. E.g., I know the market is at a support level and will bounce form that level. I write a 5700 put at Rs 150 and buy a 5500 put at Rs 60. My net inflow is Rs 90. The maximum loss I can suffer is if market closes on expiry at 5500, which would render the 5500 put worthless and for the 5700 put I would need to pay Rs 200. I have already got an inflow of Rs 90. So, my net loss would be Rs 110.

Options are great hedging tools but need to be handled very carefully.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)