Milking The Cow – Investing in The Time of The Corona Virus

Finance Add comments

Let’s face it. These are crazy times. The global economy has fallen off a cliff with the coronavirus pandemic. As I write this, official unemployment is running around 12%, while real life unemployment – counting the severely underemployed gig economy workers – is probably far higher. The airlines have lost 90% of their business, probably for at least a year. Cruise lines are decimated and retail stores countrywide are reeling. The Fed has added $3.5 Trillion in debt since January, or 25% of GDP! This has literally doubled the Fed’s debt in less than 1 year. In the process, the Fed has literally bankrolled any public corporation with a pulse, viability be damned. Before this crisis hit, the number of zombie companies was hovering right around 20%. Who knows how high that count is today?

Yet the stock market is trading close to all time highs, with the Nasdaq surpassing all time highs. Apparently, new small investors have opened brokerage accounts by the millions and have powered marketsd to unheard of price-earnings fueled by pure Fed-induced “hopium”. More and more real time hedge managers are holding their noses and investing based on Fear Of Missing Out…

If you are a conservative investor, you really don’t like the miserable returns you can find on muni-bonds, long term treasuries or investment-grade corporate bonds. Given the enormous money printing of the Fed, you’re right to think that that could eventually result in much higher inflation, which would decimate those bond investments.

There are a few paths that make sense, but the most attractive I have found I have labeled my “Milk The Cow” strategy. The analogy is to a dairy farmer who has to spend a few thousand to buy a decent milk producing cow, but then gets a secure and steady stream of income from the 3 gallons of milk it can produce a day for many years thereafter. In this strategy, my upfront investment in the “cow” is the purchase of a long term call option and a long term put option. These give me the set number of contracts at the strike price I determine, and conversely to sell the same number of contracts at the strike price I determine, for a period of at least one year.

I milk this financial investment by selling call and put options around the current market price each week, and sometimes several times during the week if the market is very volatile. When these sold options become unprofitable, because the underlying security has moved more in one direction or the other than I have collected in premiums, I roll the options towards the new market price, and if needed I roll further out in time, making sure I never become cash flow negative.

Two years have passed since I first explored this idea in my Seeking Alpha article
https://seekingalpha.com/article/1829522-leap-secured-options-writing-the-ultimate-safe-investment-strategy
. Well, back then the concept was just a little seed gnawing at the root of my brain. It made sense to me, and I thought by exposing it to the critical eyes of Seeking Alpha readers I’d quickly identify any weaknesses.

Well, the article was well received and none of the objections raised to it seemed compelling. So I plunged ahead with real money. The strategy has rewarded me well in the two years. producing around an 18 percent annual return. And that’s despite making a lot of rookie mistakes.

How did I fare during the recent roller coaster ride up and down on the Corona Virus Express? Well this strategy kept on plugging along, minting money and allowed me to face the situation with calm confidence.

So what I’ll do today is describe some of the things I’ve learned along the way, that will help an investor to maximize returns, while minimizing mistakes. I encourage you to go back and read the previous posting on this strategy, as well as the numerous comments and feedback it generated.

The reason this strategy makes money is that options cost a lot more retail than they do wholesale. By retail I mean short-term options that expire quickly. By wholesale I mean long-term (LEAP) options that expire 1 to 2 years out.

An example will help. At time of writing, the SPY (S&P 500 ETF) closed at 304.21. Let’s say you think the stock market is dropping and want to make money if that happens. Buying a JOTM (just-out-of-the-money) put of SPY at a strike price of 305, expiring in 9 days on Jun 22 costs $6.72 per share. The same strike on a put option expiring next year on Jun 20, 2021 costs $33.09. Divided by 52 weeks of validity until expiration, the yearly contract costs only $0.64 a week. So as we see the “retail” (weekly) price is around 10 times more expensive than the wholesale rate (1 year option).

Why does anybody buy weekly options then? Well it’s because the initial cost is much lower, and most investors believe they can somewhat accurately predict how long it will take for their security’s anticipated move to happen. If they are off by just one or two weeks, buying the weekly options on 2 or 3 occasions will still cost them less than a one year option. In the example of a bearish investor above, if the drop in the market does occur, but takes 9 months to happen, they’ll have spent much more money than the would have buying the yearly option. In fact, they may have spent so much that they still lose money even though they are right about the direction and strength of the move.

So as an astute investor, you want to be buying at wholesale costs and selling as frequently as possibls at retail. If volatility never changed, and the price of a security never moved, you’d make a cool 1000% return ($645 of income for a $6.72 investment). But I’ve got really bad news for you. That never happens. The strategy is profitable, but nowhere near that profitable. Because securities do move around a lot.

My strategy is simple, but requires steady maintenance. (Remember that cow needs daily milking, and you have to give her her shots…) You begin by buying a long term call and a long term put option to to ensure you are buying wholesale. This limits any potential loss and reduces margin requirements. The you start selling sell both call options and put options on a weekly basis right at the money , where the strike price equals the current price. You do this for the nice fat premiums these pay you.

An example will clarify how your potential losses are limited by the long-term calls and puts you own. I will use an extreme example – which is frankly unrealistic – but that clearly demonstrates the protection and peace of mind the long call and puts provide you.

Let’s say I buy the long-term call and put options right at the money. This is not optimal but it will make the example more easy to follow.

That will cost around $71 per share, buying a jun ’21 305 call and put. At the same time I sell a 305 call and sell a 305 put expiring in 9 days. That brings in $ 12.61 ($7.72 + $4.89) per share.

Imagine that the market were to drop by 70% in a week, to a level of $92 (I know , I know, that big a drop in 1 week is highly improbable, but humor me here).

I would have to pay $213 to buy back my short-term $305 put, before it is exercised on me. Yet I only had only originally collected $6.72 by selling it. That’s a pretty hefty loss.

But wait. The long-term put that I still own at a 305 strike price would have gained more than $213. Given the increased volatility and remaining time value in it, it would probably sell for around $290 ($213 intrinsic + delta + vega + theta). So I could sell the call, use the funds to buy back my short put, at a handsome $77 profit (per share).The sold call would expire worthless, but my long call would still have some small residual value , because it is still valid for another 51 weeks and the market could reverse sharply. Closing those positions would bring in additional funds.

Here’s the sequence of transactions (on a per share basis. multiply by 100 shares in an option):

($72) oringial cost of long options (buying the cow)
+$12.62 revenue from selling short options (milking)
+$77 – $82 closeout of all positions
+$17.62 – $22.62 profit in 1 week
$59.38 cost basis
+30% – 38% percentage return in 1 week
1982% – 1976% percentage annualized

So in such a calamitous event – a so called worse case scenario – I’d still make a fabulous return of over 30% in just one week! The same logic applies to a huge unexpected upside move. I’ll let you do the math.

So now you can understand how this strategy will allow you to sleep at night. In fact, it’s less risky than owning a mutual fund and holding it. Just a few months ago, mutual fund investors faced a roller coaster drop of 40% in many funds, before recovering 30-50%. Many are bracing for the next round of the Corona Virus Express…

Now let me demonstrate the best way to milk this financial cow. The first thing to decide is how far away from the market price you want to set your put and call strikes for your long protective wrapper.

In the two graphs below, you can compare the initial margin requirement of placing the strikes right at the money to further away. In the first graph the initial outlay is $62.74 per share or $6274 for one contract. The initial margin requirement in $0 , with a maximum lifetime margin of $6274.

SPY LEAP Straddle

SPY LEAP Straddle

spy_straddle_leap__volatility_unchanged_expiration

SPY LEAP Strangle

In the second graph the initial outlay is $3651 and the initial margin requirement in zero.

Now let us consider the effect of selling weekly options. To illustrate this, I simulated the effect of a huge drop in volatility that accompanies a doubling of the underlying indexes price in less than a week. Again this scenario is extremely unlikely, but it allows us to simulate a worse case scenario,

spy_straddle_volatility_collapse_price_surge
Compare that to the more expensive straddle:
spy_strangle_volatility_collapse_price_surge

You see that with a strangle, although the initial margin requirement may be zero, when you add in the sold options it will not remain a zero, and can actually expand a lot.

Because a strangle only becomes profitable as the outer strike points are breached, it requires more margin than a straddle would. A long straddle immediately starts gaining in value, but a strangle does not.So in the case of a strangle, you usually will require a lot less capital, but you could be subject to a margin call. Be aware of that and make sure you have sufficient funds at all times.

Other things being equal, it’s more profitable to buy a strangle (out-of-the-money-strikes) , rather than a straddle (at-the-money-strikes). Both offer you good protection to enable you to sell short term options safely. Regardless of which you buy, you’ll make the same amount of revenue selling and rolling those weekly options for income. However, the return on investment is much higher if your base outlay is lower:

$1200 (arbitrary sample weekly income) / $3651 (LEAP cost) = 32.84%
versus
$1200 (arbitrary sample weekly income) / $6274 (LEAP cost) = 19.12%

As far as choosing the strike levels at which to sell the weekly options, I prefer to place these right at the money, in order to maximize the premiums. Options close to the money have higher “vega” – the amount by which their price will increase or decrease for any percentage increase in the underlying – and thus command a higher premium.

While this brings in more money, it also means that I will have to perform more transactions of rolling the premiums. If you’ve sold options bringing in $12.00, and the underlying moves in one direction or the other by $4.00, you could choose to do nothing. You’re still $8.00 ahead and perhaps the underlying will reverse in the other direction. It would have to move in that same direction by another $8.00 before you start losing money on the weekly positions.

At that time, you could roll out the option for a later dated option, selling that one at the money to bring in more revenue, and rolling the opposite side – call or put – also to maximize revenue.

My preference is to roll frequently and every time the stock moves by an amount I consider “significant”. In the case of SPY this is $1.00. I have just one rule of thumb: never roll at a loss of premium, when taking both puts and calls into consideration. At times this will require you to move out 2, 3 or even 4 weeks in time. Try to keep the dates as close to the current date as possible. And if you have been forced to move out in time, another price swing in the opposite direction may allow you to move forward in time at the same strike price without giving up already collected premiums.

By the way, it is interesting to note that sold options that come into the money will rarely be called prior to expiration. I’ve been doing this strategy for two years on 6 different stocks and ETF’s. I’ve only once been exercised twice before the Friday 4:00 pm bell. So I always roll my options at 3:30 pm, to maximize the loss of time value, unless the stock has moved significantly.

But what happens, you ask, if you are still exercised on one of the short options?

Say the stock drops to $297 overnight, and the put options are exercised against you. You are suddenly the proud owner of 100 shares of stock at a cost of $305 per share. Yet they are selling for $297, an $8 difference. Even after subtracting your $6.72 premium you’ve still lost money on the short put. No problem.

You first sell the shares, losing $8. Then you sell another put, 1 week out, at the new lower strike price of $297. This brings in around $6.50 (option price has gained in volatility but lost in time value). Then you buy back the short call for a cost of usually no more than 1 penny, and resell a new call at the lowered $297 strike, bringing in another $5.50 or so.

Not only does your situation not worsen. It has improved. You had originally collected $12.60, but now your collected an additional $4.00. Congrats, you’ve milked your first proverbial cow. Let’s do the math:

($6.72) sale of 305 put
($4.89) sales of 305 put
$8.00 loss on sale of exercised put when stock at $297
($6.50) sale of 297 put
$0.01 buy back of 305 short call
($5.50) sale of new 297 put
($15.60) premium credit cash flow

Another important thing to consider is the general volatility at the time you are putting on the trades. The greater the uncertainty, the greater the volatility of prices and the higher the premiums on options that can serve to hedge that volatility. If volatility is at a relatively low level compared to history, it is likely to rise, and conversely if it is at a very high level it may be likely to fall. The higher the volatility remains over the entire year period, the more profitable this strategy will be.

With current volatility levels around 40% on the SPY – unusually high – the strategy is unusually profitable. It would seem to pay for all initial costs within about 6 weeks. At that point you have developed a “riskless” trading situation in which all further sold premiums over the next 46 weeks are pure profit. Unlike with a mutual fund that has risen in value, you no longer can lose money as long as you keep milking your cow.

In a more normal period, the volatility will range in the low teens. Your long calls and puts will be cheaper, but you can still expect that it will take longer – perhaps 10 to 12 weeks, to reach profitability.

I currently expect that volatility will remain at elevated levels over at least the next 6 months to a year, until such time as a vaccine for the corona virus has been developed and is in widespread use. And even then, many aftershocks to the global economies will persist.

Instead of milking the cow, you might liken this strategy to insurance underwriting. An individual investor may be richly rewarded for a one time hurricane hit, but most insurance buyers pay out more than they collect, and its the underwriting company that wins big on average. Don’t believe me. Just check the profit margins on those insurance stocks you had been meaning to buy…

*****************************
Additional disclosure: Investing in options can be a risky proposition, especially for the novice investor. Consult with a professional broker or RIA before attempting any of these strategies.

*****************************




Leave a Reply

You must be logged in to post a comment.

?>
2019 Great Investment Strategies. .