## 34 posts in this topic

Selling covered calls limits my upside gain and, while it mitigates my downside loss, it does not limit it. The value of the strategy lies in the fact that the odds are against the option buyer and in favor of the option writer.

Betsy, would you please explain how and why those odds are so?

By the mathematics of statistical distributions and option-pricing, an at-the-money option has a roughly 50% chance of being exercised, an out-of-the money option, less than 50% (i.e. there is a less than 50% chance the market moves sufficiently to make the option exercisable). And the deeper out-of-the-money, the less likely to be exercised.

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By the mathematics of statistical distributions and option-pricing, an at-the-money option has a roughly 50% chance of being exercised, an out-of-the money option, less than 50% (i.e. there is a less than 50% chance the market moves sufficiently to make the option exercisable). And the deeper out-of-the-money, the less likely to be exercised.

Actually, an out-of-the-money option will not be exercised at all since that means it is cheaper to get the security at the market price than by exercising the option at the striking price.

An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the current trading price of the underlying security.

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By the mathematics of statistical distributions and option-pricing, an at-the-money option has a roughly 50% chance of being exercised, an out-of-the money option, less than 50% (i.e. there is a less than 50% chance the market moves sufficiently to make the option exercisable). And the deeper out-of-the-money, the less likely to be exercised.
Actually, an out-of-the-money option will not be exercised at all since that means it is cheaper to get the security at the market price than by exercising the option at the striking price.
An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the current trading price of the underlying security.

Entire article

Betsy, I took TruthSeeker to be referring to the probability of an at-the-money or out-of-the-money option ever being exercised over the whole period it exists--that is, the market value of the underlying stock changing to make the option in-the-money before it expires.

TruthSeeker, is that what you meant?

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By the mathematics of statistical distributions and option-pricing, an at-the-money option has a roughly 50% chance of being exercised, an out-of-the money option, less than 50% (i.e. there is a less than 50% chance the market moves sufficiently to make the option exercisable). And the deeper out-of-the-money, the less likely to be exercised.
Actually, an out-of-the-money option will not be exercised at all since that means it is cheaper to get the security at the market price than by exercising the option at the striking price.
An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the current trading price of the underlying security.

Entire article

Betsy, I took TruthSeeker to be referring to the probability of an at-the-money or out-of-the-money option ever being exercised over the whole period it exists--that is, the market value of the underlying stock changing to make the option in-the-money before it expires.

TruthSeeker, is that what you meant?

Almost... I was referring to the probability that an option ends up in-the-money by expiry. (It never pays to exercise a call option early, and only in unusual circumstances does it pay to exercise a put early; meaning, you're leaving money on the table if you exercise early.) At any given instant, if an option is out-of-the-money, there is a less than 50% chance that the market will move sufficiently by expiry to make it in the money and hence exercisable (at least for short-term options; LEAPS are a different matter). If you're familiar with the concept of 'delta' with respect to options, the delta of an option can be taken as an approximate proxy for the probability that that option will be in-the-money at expiry. Since most options trading takes place in out-of-the-money options, outstanding options expire worthless most of the time. But there's no free lunch shorting out-of-the-money options -- yes, they'll expire worthless and you'll make money more often than not, but the times that they don't, your loss is typically much bigger. So you have frequent small gains, and a few large losses, averaging out to zero if the options are fairly priced (i.e. accurately reflecting the volatility of the underlying stock).

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Investor Jim Rogers is interviewed here. He calls most big banks in the U.S. bankrupt.
“What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent,” he said. “What’s happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people. It is horrible economics…

Governments are making mistakes. They’re saying to all the banks, you don’t have to tell us your situation. You can continue to use your balance sheet that is phony…. All these guys are bankrupt, they’re still worrying about their bonuses, they’re still trying to pay their dividends, and the whole system is weakened.”

He's another guy like Peter Schiff whose articles and interviews are worth reading.

Very well said (both of you).

I took a large portion of the investments in my 401K that didn't bomb in the recent decline and moved them to a self-managed portal with Schwab and put a majority of those funds in The Merk Hard Currency Fund. I learned of this fund in Peter Schiff's "Crashproof" - a terrific read. I commented to the broker at Schwab, "I will be calling you about every quarter to make a transfer like this at least until Obama is out of office and quite possibly beyond that." He seemed to appreciate that comment.

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I had a quick look through the other threads and the following wasn't mentioned. Caveat emptor (as ever with these things): I haven't hit a professional trading desk yet, unlike many members here (have participated in two funds, profitably, but that's another story). This is purely the product of my part time hobby and preparation for a career in the field, as well as insights from friends working in the industry.

What do you think of having a bit of fun with extremely conservative distressed/deep value investing? Targeting small/mid cap stocks that are less likely to be followed by Wall Street/City banks. Value + supply/demand imbalance as a catalyst. Keeping your positions very concentrated, because you've done the work and you're pretty sure of the fundamental value (although risk management is vital as ever). Spending a fair chunk on hedging, and keeping a lot of your money in cash equivalents (i.e. being very patient to only get into the best opportunities). Now is the time for value.

2 caveats:

1. this is very hard work, as with any active, fundamentals-based strategy. For example, Baupost had an analyst focus on Enron alone for years in order to determine the value of its senior debt (and discovered it was underpriced at 10-20c/\$, should have been 40-50c/\$).

2. markets are not really behaving in a logical manner these days (unless you can predict and time the next steps of Socialism, US style; general direction is clearer ) and a lot of bears got burned over the past year thinking they could handle the wait. (3. it is becoming popular with hedge funds, Klarman's book being, from what I hear, the "buzz" of 2008-2009 in the HF world; this may limit opportunities.)

Also note this goes against "buy and hold" in that once your target value is reached or approached, you sell.

The resources: aforementioned Graham/Graham & Dodd (both the Intelligent Investor and Security Analysis) for the philosophy, but they are outdated and everybody has read them (or pretended to); Buffett's letters to shareholders for some more modern thinking (early letters and other value goodies here: http://valuehuntr.com/resources/); Klarman's fantastic book on just that strategy "Margin of Safety", as well as his articles and any shareholders' letters you can get your hands on; the Value Investor's Club is great to see how the professionals go about making the decision (although as a Guest you won't be able to view opportunities real time); finally, since options are mentioned, Sheldon Natenberg's book is worth a read to think through what the other side will be using for risk management. This blog is also worth a read: http://www.distressed-debt-investing.com/ - there's even a post describing the search and purchase process in helicopter view.

I like this strategy because it fits with rational, Objectivist values - stuff is mispriced, and you as an investor profit by looking at the facts, by assuming reality will prevail in the medium to long term.

However, you could always make money from Socialism - I met a fairly senior exec of a bank recently who had gone long AIG and Citi, because "they'll always be around" (thanks to leftist US administrations), and valuations were very low. Personally, this feels dirty. Thoughts?

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It seems like a barbell strategy: Keep much (most) of the money in a very safe, low return vehicle (hard currency, gold, etc), and put the rest on a few bets with high volatility. Do I characterize this properly? It's what Taleb recommends in the "Black Swan". (Note that one way to do that is to invest in launching your own company.)

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From my limited knowledge, I believe the barbell analogy (and indeed, calling deep value strategies "risky" or "volatile") is philosophically flawed (much like Taleb and his various attempts at making money), although you are right that from a technical trader point of view it could be seen as that. Basically, I disagree with the barbell strategy's measure of risk.

Klarman's philosophy is of capital preservation, not seeking returns, in that by aiming to preserve the value of your capital you de-risk your portfolio and hence achieve higher returns in the long term, as a beneficial side effect (reminds me of the Objectivist/Libertarian philosophical clash! "better for the common good" as a side effect vs. the target). Taleb aims to achieve a couple of very high return years whilst most of the time his portfolio is slowly wasting away, effectively betting on a crisis to happen before he runs out of money (which he has in the past). Graham aimed at achieving medium return years with no significant down years, which he argued over time resulted in higher returns since you never got wiped out. Sure, high sigma moves in the price. But only in one direction. Klarman says "stop calculating your future return to 5 significant figures; just grab high margins of safety, hedge properly".

Thus, the investments aren't "bets" like Taleb's deep OTM, super-cheap options; you wait for circumstances such that there is an inherent factor, that you have spotted, that forces the mispricing (e.g. if a stock is delisted from an index, the index trackers offload the stock; get on the demand side, especially if you are small, and you get good deals). This is not a "bet", it's arbitrage over time instead of space. Or, the situation is so complex (such as with Enron debt) that few manage to or are willing to do the due diligence to value the stuff fairly and the market errs on the side of caution. Again, once you are certain, much like the asset strippers of the 80s, that the assets are underpriced, and you are certain of the reason for which they are underpriced, you buy, and wait for the market to correct as the debt matures. You can even add a behavioural flavour, but personally I find behavioural investing a lot more difficult (since this borders on technical analysis).

Klarman focuses on less researched companies because he feels he can get an edge on them; to me, this suggests the investment grade, liquid big stocks are actually more volatile, since the market is more efficient and the price more likely to follow the semi-strong EMH (for example, as detailed by Clayton Christensen, the market tends to price in future growth accurately on large cap stocks). This view was shared by a small cap manager of £10bn+ in one of the big UK firms.

The key lies in the market's perception of the risk/return relationship; I've seen a fair amount of smart people recently write more articles on how risk (or at least, beta) and return aren't correlated anywhere near as much, if at all, as is described in portfolio theory, especially in terms of long term returns.

One of the reasons for which I wonder whether this method could be applicable to a (for example) retired professional managing their savings, rather than one of the most talented managers in the world with an army of very smart and driven analysts, is that a friend of mine actually won the University's trading competition by using similar strategies (special situations with supply/demand imbalances) with just £100k of (virtual) capital.

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Larry, 10 months late but better late than never! I know you're sitting there thinking you couldn't live without my advice, so here it is ;-)

I am very worried about inflation but I don't think there's much you can do about it .I think gold is a risky investment, because it's a volatile commodity market, and governments still hold extremely large reserves and frequently manipulate the gold market to prop up their currencies. I like the idea of gold the same as you but the idea is not reality.

My investment strategy, should I ever choose to execute it, is the Warren Buffet approach. Purchase companies with mature, established businesses, which are profitable and pay dividends, and have strong owner-managers. Expect your profit to come from dividends, not from appreciating stock price. This is a fundamentally sound business logic. Anything else is speculation and carries a lot of risk.

I guess to sum it up, "long-term sustainable free cash flow" is the goal of any sound business and these are the ones you want to be a part of.

Warren Buffet actually dispenses great investing advice in his annual shareholder reports for Berkshire Hathaway. It's good stuff, I definitely recommend it.

If you have risk capital, find an entrepreneur with some experience whom you know and trust.

Oh and since real estate has gotten about as low as it can get, 10 months after your post, now is a good time to buy

Jawaid

I'm a buy-and-hold investor (still 20+ years from retirement), so I'll sit tight with the index stock funds in my IRA.

However, when governments start firing up the money-printing presses to "save" us from disaster, I worry about my cash positions due to inflation. Is anyone here seriously worried about inflation? Is moving cash to precious metals or other currencies a prudent move? I have to say I'm surprised gold hasn't shot up during this whole mess.

What about real-estate? Do you think things are going to get much worse before they get better?

Also, pointers to any articles or reactions from Objectivist-admired economists would be appreciated!

--Larry