Has anyone tried this?

[ewg]

I decided last year to take a very active role for my wealth accumulation for retirement. I figure I am 10 to 12 years away from retiring right now.

About a year ago I changed companies and received a lump sum pension. The question was, "Where do I plunk it?" I do not like the idea of investing in index funds or large company or small company funds. I do not believe the market will return greater than 6 to 8% per year over the long haul, and I believe it still could be a rally in a bear market that we are seeing now.

I am, however, not afraid of investing in certain stocks and I'm not afraid of picking them myself, so after surveying the landscape, I put the money in an IRA at a very low commssion broker. I decided to buy stocks and sell covered calls on a monthly basis. Usually I try to sell an in-the-money call that will return about 1 1/2 to 2% per month. That equates to 18 to 24% per year, with less risk than owning the stocks (or funds) outright.

After a year of doing this, I can report that it is definitely the way to go for me. I am totally comfortable with it and don't mind the little bit of work involved each month because I like investing. 18% will double my money in 4 years, so 12 years will be 8x the original amount with less risk than owning stocks or funds outright. My next step is to move two other 401ks I have into the same brokerage and do this with that money as well.

I'm just curious if anyone else is doing this to build retirement wealth?

 

[haha]

 That equates to 18 to 24% per year, with less risk than owning the stocks (or funds) outright.  
After a year of doing this, I can report that it is definitely the way to go for me.  I am totally comfortable with it and don't mind the little bit of work involved each month because I like investing.  18% will double my money in 4 years, so 12 years will be 8x the original amount with less risk than owning stocks or funds outright.  My next step is to move two other 401ks I have into the same brokerage and do this with that money as well.  

I'm just curious if anyone else is doing this to build retirement wealth?

Speaking only for myself, I say no. And not becaue I am lazy, or intimidated by making up my own mind about stocks. I just think that options are in general underpriced, not overpriced, and that you will make money in bits, until you lose everything you made and more in a big hunk. Selling covered calls is similar to selling naked puts. The return is pretty fair, but capped, until something happens and the market goes way down. Then you find yourself owning a lot of stock at much higher prices than current quotes.

Think of it this way. Your expenses to do this (even using a cheap broker) are much higher than a member firm's. Any risk adjusted profit that might exist over time will be taken by them.

Mikey

 

[wabmester]

I only sell covered calls on stocks I'm thinking of selling anyway.

If you've made 18% doing this in the last year, that basically means you lost 20% of the appreciation you would have had if you had simply held, right?

In a bear market, this strategy can reduce your downside risk, unless your stock gets called away on a pop -- then you end up buying high and selling low. Not a good long-term strategy

 

[ewg]

I think it is an incorrect assessment about losing 20%.  If I were to use an asset allocation guide, I would not have had 100% in a stock fund, so I would have only made, as you said, 38%, but only on 60% of my fund.  With this method, I am comfortable with 100% invested, so the 18% gain is on the whole amount.  I will finish the first year at around 20 to 22%, if all is willing.

The interesting thing is that many of the stocks I picked to do this with did not really participate in the rally in any big way. In other words, this could have worked just as well in a sideways market.  

I don't understand the statement about buying high and selling low.  I treat each and every transaction as a one month deal that closes at the end of that month.  I expect the stock to get called away.  I'll happily take my 2% and move on.  I don't do the same stocks every month.  Only if I still think that the stock is safe to do will I do it another month.  The key is to pick the right stocks, but if you don't like picking individual companies, there are plenty of ETFs or index shares to look at that have options.  If a stock drops below the strike price, then I have the choice of keeping it and selling another, either in the money or out, or selling and moving on.  The other key is not to do this with any stock that I would not want to own anyway, because I can get stuck with it for awhile.  It happened a couple of times this year, but I ended up selling out of the money calls when they dropped and did very well with them overall.  If I think a stock is already overpriced and ready for a fall - I simply stay away.  I was doing this with QQQ until it got to these lofty levels.
 

As far as commissions go, they only amount to about 5% of the profit.  It costs me a penny a share to trade the stock and 1$ per option contract.  I don't even give it a second thought.  My expense ratio, if you will, is about .007%.  The rate is a flat rate and there is no lump sum charge, which lets me do one contract of stock A, one of stock B, and so on.  I don't have to put all the eggs in one basket.  In fact, I do many companies each month in many sectors to limit exposure.  Commissions are not an issue whatsoever.

 

[TheFIREman]

 In fact, I do many companies each month in many sectors to limit exposure.

Sounds like "work" to me.  

 

[John Galt]

Hey FIREman! That was my first thought, i.e
"sounds like work" It's the work that we avoid............
we love to work at nothin' all day! (BTO)

John Galt

 

[ewg]

John,

Are you the same John Galt that is on the MIR board?

 

[John Galt]

Nope! This is the only site I visit regularly.

The reason you run into other "John Galts" is that
John Galt is the main character in Ayn Rand's magnum
opus 'Atlas Shrugged'. Don't be confused though.
I am the real life version of my fictional doppelganger.



John Galt

 

[Cut-Throat]

ewg,

Play with fire and you'll eventually get burned!

 

[Ted]

Regardless of whether or not a person owns stock, the nature of options is this, as recognized by financial academics.

If you own options, the "expected return" is essentially the current short-term interest rate. Conversely, if you sell options, the expected rate of return is the negative of the short term interest rate. Of course, options are so highly leveraged that the standard deviation in the return is enormous. For most practical purposes, trading options is a lot like playing roulette, where only the house (the broker) has a very high probability of gaining.

Options trading can be done "conservatively" to reduce the volatility of a portfolio. But the more a person does it, the more they are likely to experience "reversion to the mean" and end up losing what the "house" will gain.

 

[unclemick]

From 1966-1992, I tryed to beat the 'house' - nowadays they might call it 'benchmarking'.

DCA into broad diversified stock funds and later index funds.

The other portion - individual stocks, raw land, rental property, gold coins, timberland, patented gold mine, some interest arbitrage, etc. Had some 1-3 yr periods of living 'large'.

AT ER, the DCA - index provided 90% and my - 'beat the house stuff'-10%.

I did pass on futures and otions though.

 

[ewg]

It is work, FIREman, but I like the pay.

Compared with owning stocks or stock funds, there is much less "playing with fire" doing this. Some of you see this as higher risk than owning stocks or stock funds outright? I sense a general attitude about options trading in general - that it is high risk - without careful consideration for what I am doing in particular. It is high risk for the option buyer, not me.

 

[wzd]

Really!? Well, can you elaborate on the upside and downside expected return/loss as well as maximum upside and downside? If so, then fine, but if not, I recommend some research.

Wayne

 

[ewg]

Here is a hypothetical trade that I would do, using prices from earlier this morning. Currently I would not really choose to do much QQQ at its current level, though.

Buy 100 sh QQQ @ 37.08 and at the same time,
Sell 1 FEB QQQ 36 Call for 1.55

Cash outlay: $3710.00 - $155 = $3555 ($2 commission)

Profit on Feb 20 if QQQ stays above 36: (.45/37) = approx. 1.2%
Breakeven price for QQQ on Feb 20: $35.55

That breakeven point is about 4% safety margin, and would put the Nasdaq at about 1965

Having a full month til expiration would bring slightly higher option premium than what I quoted- I try to get at least 1.5% to 2% for each combination I do. Like I said, 18 to 24% per year with safety.

Where is the option-related risk?

Over the long haul, who will be ahead, someone doing this, or someone that leaves money in a stock fund? What are your realistic expectations for annual rate of return on those funds? And if you try to time them, we all know what happens then.

 

[wzd]

Over the long haul, who will be ahead, someone doing this, or someone that leaves money in a stock fund? What are your realistic expectations for annual rate of return on those funds? And if you try to time them, we all know what happens then.

I think the stock fund will be ahead. To actually calculate the odds however, you need to run simulations on historical prices for stocks and options. Using an ETF for your stock helps with the risk to some extent, as the ETF is less volitile than individual stocks.

The 'risk' in the covered call strategy is that you have fixed your upside gain at 1.2%. In the months where the gain is higher you do not get part of it, so you lose by giving up some of the gain. In the months where the gain is lower you win by getting more.

Your downside loss is not limited however, as you have limited the upside but not the downside. This will work in a flat or bull market, but you can lose in a bear market.

I haven't seen MPT type analysis of this strategy, but I expect it does exist. If I were to try this, I would certainly look for it first to be sure I understood the risk/reward characteristics compared to holding index funds. Using ETF's for this sounds good in that I think it would reduce the downside risk.

In regard to the option buyer vs. option seller risk: The option seller gives up potential gain for a fixed gain, and retains the downside risk. The option buyer limits their downside risk to the option premium, and has unlimited potential gain. Both sides have risk, albeit of different types.

Wayne

 

[eridanus]

ETFs are the way to go if you're using this strategy. Think of trying to do this with Enron or some of the high-techs (JDSU).

You still could get caught out if there's a tumble. In your example, a decline of 4% means you're not assigned and you keep the equity. Fine, you say, you can write another one maybe at ATM. But look at the action on QQQ in the summer of 2002 when we were still in the bear market. It declined almost 7% from June to July. Any safety margin was blown through and to get even you'd be selling calls OTM. Low premium. Then, from July to August, it went down over 10%! You'd be forced to sell at a loss or sell nickel and dime premiums until things turned around.

Ok, so what? All of the total market/S&P index holders are also doing poorly. But, if you hold a bond fund, that part of your portfolio actually increased in value during the summer of 2002.

There's also the tax problem. You're selling premium at a short-term rate. Index funders don't sell and only have to worry about small distributions. That in and of itself would mean an index funder would be ahead last year if you're above the 15% bracket (even with a 60/40 portfolio).

I'd also be careful of doing this with all of your retirement assets. I'm no lawyer, nor a tax attorney, but there is some concern that actively trading with retirement assets might invalidate the tax-advantaged status of IRAs/401ks. It's not clear, and you're not daytrading, but it's something to be aware of.

In the end, I think if you're careful it could work but, as others have written, it's only good for a bull or sideways market. You could always do spreads but the volatility is so low that the risk:reward may not be worth it.

 

[eridanus2]

Ok, I repeated much of what wzd wrote. Oh well, good to emphasize those points.

 

[ewg]

You still could get caught out if there's a tumble. In your example, a decline of 4% means you're not assigned and you keep the equity. Fine, you say, you can write another one maybe at ATM. But look at the action on QQQ in the summer of 2002 when we were still in the bear market. It declined almost 7% from June to July. Any safety margin was blown through and to get even you'd be selling calls OTM. Low premium. Then, from July to August, it went down over 10%! You'd be forced to sell at a loss or sell nickel and dime premiums until things turned around.

Ok, so what? All of the total market/S&P index holders are also doing poorly. But, if you hold a bond fund, that part of your portfolio actually increased in value during the summer of 2002.

There's also the tax problem. You're selling premium at a short-term rate. Index funders don't sell and only have to worry about small distributions. That in and of itself would mean an index funder would be ahead last year if you're above the 15% bracket (even with a 60/40 portfolio).

I'd also be careful of doing this with all of your retirement assets. I'm no lawyer, nor a tax attorney, but there is some concern that actively trading with retirement assets might invalidate the tax-advantaged status of IRAs/401ks. It's not clear, and you're not daytrading, but it's something to be aware of.

In the end, I think if you're careful it could work but, as others have written, it's only good for a bull or sideways market. You could always do spreads but the volatility is so low that the risk:reward may not be worth it.

You have picked an almost worst case scenario to say that this process can lose money. Obviously it can, but I'm still better off than I would have been in a stock fund with no margin of safety. Not to mention I can also pull myself out instantly during a trading day if there is a specific reason for a decline without having to wait until damage is done at the end of the day as many 401ks do.

Asset allocation is always a valid argument. This investment method can be done with whatever percentage of funds one chooses to use.

In an IRA there are no tax implications. Nothing has to be claimed until withdrawn, when it is taxed as normal income. Trading in the IRA is okay.

It works in a bear market in that it lessens loss compared to holding a fund. It could actually still produce all anticipated gains in a declining market. QQQ for instance, could lose ground every month for the whole year and you could still make all premiums and the anticipated rate of return.

Theoretically, of course.

 

[eridanus2]

Well, it was a worst case scenario for all of 2002. The cubes dropped about 38%. It could be better than an all stock fund portfolio, true, and the only real risk is you'd be stuck holding QQQ/DIA for a while...just like everyone else.


Re: trading in an IRA:
----------------------------------
Q: Robert Green wrote in his February 2003 Active Trader article, "A Special K", that if you trade more than 25% of your retirement account assets, the IRS may deny the tax-deferral benefits of the account.

A: Our current research shows that SEP IRAs and Mini 401 plans set up on the individual-level (with no employees) are not covered by ERISA; whereas Mini 401K plans set up on the company-level are ERISA covered plans. ERISA plans include all company-level plans including but not limited to 401k plans, traditional retirement plans and other qualified retirement plans.

Our attorney specializing in retirement plan tax and ERISA issues has suggested in the past that traders only actively trade (with risk) 25% of their ERISA plan assets and should diversify the remaining 75% outside of the active stock trading arena; to conform to the DOL 25% plan diversification rule. For the other 75%, she recommended interest-rate and other types of non-stock investments. She cited some DOL cases which raised this argument in litigation.
------------------------------------

http://www.greencompany.com/gttforu...page=0&view=collapsed&sb=5&o=&fpart=1#Post127


Now, he could just be pimping for his firm, and there are a lot of caveats but be aware of it. It doesn't sound like it's applicable to IRAs but it may be applicable to 401ks. It looks like you're rolling so that may not be an issue.

I'd backtest this strategy to cover the boom and bust years. Wade Cook was a popular adherent for this strategy and he's now bankrupt and vilified. In conclusion, it can work, but it ain't the Holy Grail.

 

[Ted]

The "bottom line" fact about options is that they are strictly a zero-sum game (actually, a negative sum game when transaction costs are considered). This necessarily means that for every dollar that someone gains at it, someone else loses a little more than a dollar. So suggesting that any group of investors can profit from it is downright irresponsble, and the sort of "advice" that frequently appeared on Internet chat rooms during the boom in stocks in the late 90s.

The only assured benefit that an investor can get is to buy put options as a form of "insurance" against a decline in the value of the covered security, but this "insurance" has a cost in that it will reduce the expected return of the portfolio.

I have suggested that people consider making long-term transactions in futures for oil, natural gas, and other commodities as a hedge against inflation. Since making this suggestion more than a year ago, I have done so myself and done very well. But I'm not suggesting that investors in general can profit from it because, like options, it is a zero-sum game before transaction costs and a negative sum game after those.

 

[haha]

I have suggested that people consider making long-term transactions in futures for oil, natural gas, and other commodities as a hedge against inflation.  Since making this suggestion more than a year ago, I have done so myself and done very well.  But I'm not suggesting that investors in general can profit from it because, like options, it is a zero-sum game before transaction costs and a negative sum game after those.

Ted, would you be willing to talk a bit about commodities? In particular, how far out do you go? Are you willing to invest when the outmonths are quoted higher than the near contract, or only as it has been recently in crude where the mere passage of time and a crude quote that stays stable will give a profit? Over the years I have invested in commodities from time to time, and I always keep an account. But it can get expensive when you are repeatedly rolling to a higher priced contract even though the spot is stable.

Any comments?

Mikey

 

[Ted]

Ted, would you be willing to talk a bit about commodities?

Sort of.  Since commodity trading is basically a zero sum game, I'd be pretty stupid to broadcast my strategy over the Internet.  Likewise, any advice that you see given away, or even sold, should be highly suspect.  And there are a bunch of "professional traders" out there trying to sell people on their schemes for allegedly "beating the market" (which necessarily requires them to beat each other).

What I will say is that I regard the most "conservative" approach to commodities trading to be one of going long on long-term futures on economically vital raw materials.  Of these, the most vital, with the longest term contracts available, is crude oil.  And the astounding thing about oil futures is that the distant futures trade at a big discount to the spot price.  The only reason that I can think of for this is that oil producers must go short on long-term contracts when the price exceeds their costs of production, thereby locking-in a profit on future production.

The one disadvantage to trading long-term futures contracts is that they have a large spread between the bid and asked price.  All securities that are traded in secondary markets have this bid/asked spread, and I must admit that I wasn't aware of the cost that it adds to trading until I did some transactions on thinly traded futures contracts.  For example, a December 2007 contract on crude oil might go for days without there being a trade, and might have a standing asked price of $27.30 per barrel and a standing bid price of $26.80 per barrel.  So, at 1,000 barrels per contract, you could "buy" (go long) a contract at $27.30 per barrel, soon afterwards decide to "sell" (liquidate) it at $26.80 per barrel, and immediately lose $500 ($1,000 barrels @ $.50 per barrel) plus the brokerage commission on two trades.

What you need to do is to "get your feet wet" by acquiring one or a very few long-term contracts that you can afford to hold onto even if the price drops (which will require you to put up money on margin to cover your loss on paper).  The commodities that I find attractive are crude oil, copper, natural gas, and lumber (although for practical purposes the contracts on it only extend for about 6 months.)  As the contracts approach expiration, they become a lot more liquid and can be liquidated at a reasonable cost and "rolled over" into long-term contracts.  If you believe that inflation will cause commodity prices to continue to increase in the future, then going long on commodity futures contracts is a way to cash in on that prospect.  But if anyone chooses not to trust my advice on this, that's OK with me  

 

[haha]

And the astounding thing about oil futures is that the distant futures trade at a big discount to the spot price.  The only reason that I can think of for this is that oil producers must go short on long-term contracts when the price exceeds their costs of production, thereby locking-in a profit on future production.

Ted, thanks for your comments. I am not a virgin with commodities. I have traded corn, wheat, cotton, cocoa, coffee, world sugar and the "TED SPREAD". I made money overall, but I didn't think it was an appropriate amount, given the risk exposure.

Not to argue with you- after all you volunteered to give me some information- but I think there is an alternate explanation to the out months trading at a discount in storable commodities. While some smaller E&P companies probably "must go short on long term contracts" presumably their bankers would insist on it- many better financed producers probably go short or not depending on their reading of the market. It had been assumed that producers were obligatory shorts in many markets, but  a lot of research has shown that it is more nuanced than that. So, if the out months are at a discount, it could say that producers while experiencing strong markets in the spot, do not expect that strength to continue into the future.

Comments?

 

[Ted]

For most commodities, the longer term futures tend to trade at a modest premium to the spot price. (Exceptions are heating oil and certain agricultural commodities where the price tends to vary seasonally, but I don't trade those.)  

There are arguments for and against the theory that the futures price is an "unbiased estimate" of the price that will actually occur.  (My suspicion that far-out oil futures prices are depressed by oil producers hedging would be an argument that the futures price is biased downwards.) In any case, the price of the futures contract is a very poor estimate of the future spot price, and that is what permits people to make or lose a lot of money trading futures contracts.  

So it might be that somebody out there trading oil futures has knowledge superior to mine to the effect that oil prices over the next 5 years will drop substantially below the current spot price.  But their assessment of that over the past two years has been wrong and my assessment that prices would rise has been right.  That doesn't prove that I am right to think that prices will continue rising, but I just can't conceive of a set of events that would cause oil prices to undergo a long term sustained decline.  There will always be temporary fluctuations, but the advantage of long-term investing is being able to profit from anticipating long term trends.