Copyright © 2016 by Rich MacDuff · All Rights reserved · E-Mail: email@example.com
Systematic Covered Writing
... more than just covered calls
It is hard to imagine a discussion about investing without understanding that one must be able to measure his or her success. Before discussing stock market investing, let's discuss something a little more familiar to the average person, namely ... real estate investing. Covered writing is often compared to the housing market. Please realize that when I talk about a covered call position, the verbiage also applies to a cash secured put position. In one case we own the stock and sell call options, in the other we sell Put options with the obligation to potentially own the stock. With this in mind, consider two ways of investing in the housing market.
One approach for the real estate investor is to purchase homes with the intent on selling them relatively soon for a profit. The homes can be anything from a fixer upper to a newly built home. Once the desired profit level is at hand, the home is liquidated. This is a very common methodology. One measures their success by the amount of profit generated when the home is sold. One could also look at his or her potential for profit based on the current value of the home as compared to the amount invested. This should not be anything new.
Another type of investor is the person that purchases homes for the soul purpose of renting them as a source of income. Needless to say, the 'rent' needs to be greater than the mortgage payment in order to have positive cash flow. Again, this should not be a foreign concept. Do realize, the landlord is in the game for the rental income, not for selling homes at a profit. This does not mean they won't sell one if the right deal comes along, but in general, that is not their goal. This person does not measure their success in the same way as the flipper. The landlord's measurement is based on the difference between the expenses and the rent or more likely the lease payments that are received. The expenses include loan payments as well as the cost of maintenance and upkeep.
With this in mind, it should be fair to say that even though both methods of investing deal with real estate, the method or process used to measure success are significantly different. The difference in the way success is measure is not hard to understand as both methods of investing have been in play for decades. It is easy for someone that is just getting started to realize that while the both methods involve real estate, the approach to evaluating success are not the same.
STOCK MARKET INVESTING
When it comes to investing in the stock market. The basic principal is to Buy Low and Sell High. This has been the methodology for investing for decades. It is the way it is done, and the only way that is taught by most brokerage firms and the establishment. As simplistic as it may sound, the investor in the market can always just look at their monthly statement to see how they are doing. By comparing the liquidation value today with the liquidation value at some point in the past, the investor can easily 'see' their investments are working. This is the way we have been conditioned to look at success. Please realize, there is nothing wrong with this method. At the same time, one needs to understand this investor's objective or goal. In a nutshell, they are looking for capital appreciation. They want their money to grow. That is their goal. This method of stock market investing is akin to the real estate flipper in that they buy at one price in hope of selling for a higher price. That's what they do.
The vast majority of investors have been conditioned to use this method of measurement. Again, I am not saying this is bad, but rather I am pointing out the way we have been taught to think about our investments. It's almost always a matter of 'what's it worth'.
SYSTEMATIC COVERED WRITING
There are many pundits who compare covered call positions to renting houses in the real estate market. This is not something that I thought up, though I have been using the analogy for over a decade. Rather than buying stock with the intent of selling it for a profit, the stock is purchased with the intent of sellng option contracts against the investment. This is the covered writer's income stream. In other words, it's the rent. If the right deal comes along, a stock may be sold and a new one purchased with the proceeds, but until that happens, the idea is to continue to collect the 'rent'.
Even for an individual who is just beginning to explore SysCW, it is important to understand not only how we measure our success, but also why we do it the way we do. Know that there is a mindset behind the SysCW thought process. Statements about what we do are either verifiably true, or they are probably false. One has to have an open mind in order to ‘see’ the difference in our investment method. Many investors get hung up on the liquidation value of their portfolio. This, in my opinion, is based on a conditioned perception of how one is to measure success. It’s what we have all been taught to believe by the establishment. We measure our success by an ever increasing account balance. That is what we are supposed to do. Unfortunately, this is what creates the ‘fear of loss’ that keeps money out of the market. It’s the ‘if the value is not going up, then I must be losing money’ … right?
Here is an analogy, to illustrate the point. Simply … an individual would not measure the amount of liquid in a container with a tape measure. They would use a measuring cup instead. Likewise, one should not try to measure the value of an SysCW Portfolio using the traditional liquidation or 'account' value approach. There is a reason why I say this. It is either true … or it is not. The following example should illustrate the point.
There is one assumption to this discussion that we need to accept as true. Please know that it is based on a significant amount of historical data. This assumption states that in the vast majority of instances where an investor replaces one option contract with another, he or she will take in more cash than is spent. In other words, closing out an option contract, almost always results in positive cash flow. One would just have to look at the monthly cash generation reports that I send out to verify this is true. We are talking around 99% of the time, the replacement option will bring in more cash than it cost to close the existing option. This is either a fact, or it isn’t. It’s not an opinion … it is a reality within the SysCW process.
Below you can review the initial data from a longer term position that was established in May 2016. It really doesn’t matter which position we look at, the thinking is always the same. This happens to be a cash secured put position with the Put being sold against PANW. When the option was sold, $1,669.28 in cash was added to the account. If it had been a call option, cash would also have been added to the account. This is real money … it is the writer's (seller's) to keep no matter what happens. There are three normal possibilities going forward:
The price of PANW will be above $135 on January 20, 2017. If that happens, this Put will expire worthless, which means it will have a value of ZERO and our obligation to purchase shares of PANW will end.
The price of PANW will be below $135 on January 20, 2017. If that is the case, we will Buy Back this option and replace it with a new one that has an expiration further into the future. As mentioned above, when we do this, we will generate additional cash in the vast majority of instances. The cash flow for the two transacitons will be positive.
If this were an IRA account, the writer may elect to allow the Put to be exercised which would mean 100 shares of stock would be purchased at $135 a share. Once that happens, a call option would be sold to continue the cash generation process.
Regardless of what we do in January, we are going to be keeping the $1,669.28 in cash that we received on May 20th. The reader needs to accept one of these outcomes as an inevitability, barring the demise of the underlying stock. Again, the image above provides the details of this position when it was established. Next we have an image of how this position looks online on June 24, 2016. You do need to accept that this is a real image of current data. I assure you, it is.
Now to the point of this discussion. Above we have a snapshot of how this position looks online in this portfolio. Now you need to pretend with me for a moment. Pretend this is the only position held in this portfolio. Let’s also pretend that the cash that was generated in May was withdrawn to supplement the investor's retirement. So, the only position held in this portfolio would be this active Put. In reality, there would also be cash in the money market, but that cash balance was there before this position was established. To make the thinking easy, this cash balance is still the same as it was, and we are not going to include it in the discussion.
Notice the current Market Value (Mkt value) of this position. It has a value of -$2,190.00 … right? The image is also showing the proceeds of $1,670.00, which we removed from the account. As of this moment in time, the liquidation value of this position would be minus $520.00. In other words, the account balance would show that we had lost money, but have we really? We know two things. First, we know we removed $1,670.00 from the account. Second, we also know that one of three things is going to happen with this Put. In a non-IRA account, it is either going to expire worthless in January, or it is going to be rolled before it is exercised. In either case, the cash flow will be positive.
Multiply this idea times the number of positions one has in an active SysCW Portfolio. Even though we are generating capital, the account balance is not showing it. This is because the online data is always showing where one would be if they closed every position. This means they would Buy Back every short option contract, and they would sell every long stock position. That is what is reported online BECAUSE the system is not setup to evaluate the extrinsic value of the option contracts.
As soon as a writer sells a call or a Put, there is an entry added to the online information showing what it would cost to buy it back. This 'cost' is included in the current account value or liquidaiton value. With a traditional account, the investor typically only has their long positions. If on average these positions have increased in value, the account value would increase. There are no option values subtracted from the total.
Think about this ... Let’s freeze the prices of the stocks held or potentially held in a portfolio. Using traditional investments, the liquidation value would remain constant over time. If the prices of stocks are the same in January of next year as they are today, the liquidation value of the account would be exactly the same (ignoring dividends and account fees). This is either a true statement, or it is not. With traditional investments, the only way the value of one’s account can increase is if the average price of the stocks held in the account increases. Am I right ... or am I right?
Now, let’s look at a SysCW portfolio using the same assumption. If the price of PANW is the same on January 20th as it was on the day this Put was sold, I guarantee you, the value of the account would be higher. This is because the cost to close the short Put would erode to zero. As long as PANW is above $135, the option will cease to exist as will the obligation to purchase the stock. Nothing will happen. The stock did not appreciate, but the value of the account did because the cost to close the existing option went to zero. It has to. Now, if we factor in that if the stock is not above $135, we are going to roll the Put, and when we do that, we are going to take in more cash than we spend. Either way, we are going to keep the cash that was generated when the option was sold. Did we make money or didn't we?
Once again … take this same thought process and compound it by the number of positions held in a portfolio. So here is another statement of fact … a SysCW Portfolio has an intrinsic value that cannot be seen by looking at the online liquidation value. Trying to use traditional investment thinking to evaluate an SysCW portfolio does not work anymore than a tape measure can tell you how many cups of liquid are in a container. I express this in the following manner.
With an SysCW Portfolio, we measure our success by the new cash that is generated every month, NOT by any potential increase in the online liquidation value. This is because the online balance is always subtracting what it would cost to close all of the option contracts. We are never going to do that, which is one of the rules of engagement. We do not need to sell our stock in order to withdraw cash. We just need to be paid for owning it.
The cash that is generated is measured against the account funding. Once we start withdrawing cash, we will eventually be using the 'house’s' money, and we will continue to do so until the cows come home.
I know this is hard to grasp, but either the statements above are true … or they are not. This does not mean the system is perfect. We will have times when stuff happens which causes us to incur a loss on a given position. That’s just something that we know can, does, and will happen. We offset this possibility by establishing many small positions. Each one is a source of income, Think of it this way, the landlord owning rental homes in Detroit is not concerned with the liquidation value of the homes he or she owns. What they focus their success on is the rent checks they receive each month. You cannot measure their success by the current value of the homes. This is the same mindset that covered writers have. We are landlords, not flippers.