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Game Theory

Overall concepts needed to achieve your freedom.

Covered Calls: How Do They Work?

Last time we talked about what kind of strategies we can take in a sideways market, and here’s one good option, the covered call.

WHAT IS A COVERED CALL?

One of your rights as a stock owner is the right to sell your stock at any time for the current market price. The selling of this right to someone else in exchange for cash paid today is called “covered call writing”. What this means is that you give the option buyer the right to purchase your shares prior to the expiration date of the option at a predetermined price, known as the “strike price”.

The “call option” is a contract agreement giving the buyer of that option a legal right, without obligation, to buy a set number of shares of the underlying stock at the “strike price” at any time prior to the expiration date. When the seller of the call option is the owner of the underlying shares then the option is deemed “covered” because the owner is able to deliver these shares without having to purchase them on the open market at as yet to be determined – often higher – future prices.

 

HOW TO PROFIT FROM COVERED CALLS

To secure the right to purchase shares in the future at a predetermined price, the seller is paid a “premium” to the seller of the call option. A “premium”is the fee paid in cash by the buyer on the date he purchases the option. The seller keeps this money regardless, whether the option is exercised or not.

 

WHEN TO SELL

Selling a covered call allows you to exchange some of your stock’s future upside for money in your pocket today.

To illustrate, you purchase your stock at $50 per share with the idea that it will go up to $60 within a one-year period. Plus, you’d consider selling at $55 in six months time, aware that you are sacrificing any further upside but satisfied with this profit for the short term. This is a situation where you might find it advantageous to sell a covered call on your stock position.

Upon examining the stock’s option chain, you locate a six month call option at $55 selling for $4 a share. This $55 call option could be sold against your shares, purchased at $50, which you hoped to be able to sell at $60 within 12 months. By doing this you would be obligating yourself to sell these shares within the designated six-month period if the stock reaches the $55 price. This would leave you with the $4 per share premium and the $55 per share from the sale, a total of $59 (a return of %18) for the six-month period.

Conversely, should the stock fall to $40, for example, you will have a $10 loss based on your original position. However, the $4 option premium from your sale of the call option, which you keep, offsets the total loss, making it only $6 per share instead of $10.

 

 

Scenario One

Shares go up to $60, and the option is exercised

January 1

You buy XYZ shares at $50 January1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $60; option is exercised because it is above $55. You receive $55 for your shares. July 1

Total Profit: $5 (capital gain in the stock) + $4 (premium collected by you from sale of the option) = $9 per share, or 18%

 

Scenario Two

Shares drop to $40, and the option is not exercised

January 1

You buy XYZ shares at $50 January 1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $40; the option is not exercised and expires, worthless, because the stock has finished below the strike price. ( Why would the option buyer still want to pay $55/share when he or she can purchase it in the market at the current price of $40?) July 1 Total Loss: -$10 + $4.00 = -$6.00, or -12%. You may sell your shares for $40 today, but you keep the $4 option premium.

ADVANTAGES OF A COVERED CALL

Selling a covered call option is a good way to offset downside risk or to increase upside return. However, it also means that you trade the cash you get from the option premium today for any upside profit beyond the $59 price per share, including the $4 premium. That is to say, if your stock finishes above $59, you end up worse than if you had merely held the stock for the six months, But if your stock ends the six month period at any point below $59, you end up ahead of where you would have been without selling the covered call.

RISKS OF A COVERED CALL

For as long as you maintain the short option position, you must hold onto the shares, or else you’ll be holding what is known as a “naked call”, which, theroetically, could have unlimited loss potential should the stock go up. Because of this, if you choose to sell your shares before the option expires, you will have to buy back the option position, costing you extra money plus some of your profit.

Q3 Earnings Are Coming In… Head for the Exits??

The new earnings season has started, and already several big names have revealed their earnings to the awaiting financial masses.   Microsoft, Google, McDonald’s have all weighed in.  More than half of the Dow Jones index has issued guidance for the 4th quarter, and none of it is looking good.  (edit: well, surprisingly Facebook turned in a positive surprise… good for them!)

So the question remains, should we be heading for the exits?

Personally, I think you can make a case either way.

When you buy a stock, you are buying a piece of a company’s earnings.  If you buy a share of Google, you are buying into the $32ish that the company made per share over the last 12 months, hoping that earnings per share will grow, or that Google will start to pay out a dividend.

But a share of Google costs a lot more than $32.  In fact it costs around $675 per share.  That difference is called the Price to Earnings (PE) multiplier.  At present, people wanting to invest in Google are willing to pay $21.20 for each dollar that Google earns.  Both parts of the equation carries equal weight.   Share price = Earnings per Share    X   PE 

And while the earnings per share of the overall market look to be anywhere from flat to a small decline overall, due to the Federal Reserve flooding the asset markets with easy money, the amount of money that an investor (or much more likely, an institution) is willing to pay for a dollar of those earnings is still destined to increase, because each month there are way more dollars having to compete for a share of any single asset.

Now does that result in overall stock prices going up or going down?  That’s the part that’s hard to say.  One side of the equation is pulling down, and the other is pulling up.    Whether the market increases or decreases depends on which pull is stronger.   But whatever the result, we are likely to see a lot of generally sideways action until earnings pick up again.

So how does make money when the market is going nowhere, or close to it?

Stay tuned, kids.

The Printing Press Race Is On

An interesting side effect of Quantitative Easing is that while the Federal Reserve is trying to stimulate spending and risk taking inside America, it has effects far outside of America.

Because when America suddenly finds that it has a lot more USD in circulation while other countries are still printing at the same rate, the value of the US dollar would tend to decline. We saw it through pretty much the entire Bush administration, as USGov was forced to issue debt at a much faster rate than other governments, causing the USD to lose roughly 40% of its value vs other currencies.

But here’s the issue for other countries. America is still the largest consumer of, well, pretty much anything. And when America’s currency goes down, everyone else’s currency goes up. Since a factory in China is paying its expenses in Yuan but collecting its profits in USD, it’s not in that factory’s best interest for its local currency to be gaining strength vs its profit currency. Simply put, when the USD goes down, everyone that exports to the US loses money.

Obviously, the central banks of these factories are aware of this plight. When factories lose profits, some of them close down, which increases unemployment. So what do you do when the world’s biggest economy has shifted the printing press into higher gear, and that threatens to make your currency so strong that you become uncompetitive?

The most obvious solution will most likely become the most popular. Exchange rates are all about ratios, (or at least perceptions of those ratios). So if the other guy has kicked the press into high gear, and you need to keep the same ratio… Expect China, Canada, Australia and pretty much everyone else to follow suit. (Europe was already printing up like crazy because of their own financial crisis.)

And because currency levels are now being actively managed by every central bank out there? We can probably expect to see a lot less volitility in exchange rates from now on.

“Hold on a minute,” I hear you asking “every major country in the world is going to start printing up currency even faster than before? That can’t possibly be good.”

Well, it certainly will have side effects. All that money has to go somewhere, all that money just sitting in a current account somewhere is not in a bank’s DNA. So it has to pile into an asset. Which means that despite corporate profits having gone flat, the amount of dollars competing for each dollar of corporate profits increase. And corporate debt. And pretty much any other big asset class. Inflation of assests, essentially.

However, that does not turn into inflation for the hot dog cart on the street.  Yet.

When we talk about inflation, we talk about the overall general level of inflation.  But that glosses over the reality that there is not just one level of inflation.  There are literally thousands.  The price of energy may go up over time, but the price of technology moves completely independently (and usually in the opposite direction).  The price of hot dogs moves independently as well.  And money spilling into junk bonds, for example, doesn’t effect the price of that hot dog on the street.

Until large amounts of people start spending more money on hot dogs (and other basic necessities) overall.   But if asset prices keep going up, people’s portfolios will increase right along with it.  And just like the housing boom, people will start treating their retirement portfolio’s like piggy banks, withdrawing (as opposed to borrowing against their house) whenever they get a whim for a faster car, a bigger TV, or hardwood floors.

At THAT point, all that money that’s being pushed into the system will result in big time inflation.  But that’s years down the road.  Maybe 10.  Maybe 20.  No one knows for sure.

Hopefully by that time, the brains at the Fed will have worked out a solution around that situation.

At this point, we can only hope.

 

 

The Fed Will Not Be Outdone

So now the US Federal Reserve has followed the ECB’s lead and pushed forward their own third stimulus program, and this time it is a multi-pronged, indefinite time frame approach.

This time, the Fed is going to be buying mortgage backed securities (hear that? a cookie for the first person that figures out what the next safe asset class is…) to the tune of $40 billion a month. That’s a hell of a tailwind.

They also plan to continue to extend their Operation Twist program, where the Fed exchanges their short-term bonds for longer term bonds at the same rate of interest.

And wait kids! There’s more! This time they put no upper limit on the amount that could be spent on this program

However, this is not a cure-all panacea. The US dollar is quite likely to experience even more weakness in the short term due to the fact that this requires the printing of a pile ($40 billion a month minimum) of new money, and as such will work to push down the USD versus other currencies. So look for a lot of strength in currencies other than the USD and EUR (and currencies linked to them)

And gold. Don’t forget the gold. When the US Fed and ECB have committed themselves to turning on the printing presses indefinitely, and the Chinese Yuan pegged to the dollar (meaning they have to start printing, too), well there’s going to be a hell of a lot of inflation fear out there for the next little while, and that is exactly what gold prices thrive upon. Of course there is more to inflation than simply the expansion of the money supply (which isn’t actually expanding that much, we are still in a deleveraging phase), but it’s the fear that counts.

ECB Announces “Unlimited” Bond Buying Program… So What?

http://www.denverpost.com/business/ci_21485809/stock-market-soars-after-mario-draghi-announces-bond

So the European Central Bank has decided that they are officially going to backstop Spain and Italy (and probably anyone else), provided they submit to the ECB’s version of responsible spending.  I won’t get into the details here, there’s plenty of other coverage for that.

Question is, who stands to benefit?  What asset classes stand to profit from such a move?

One word can cover that, and that word is “risk”.   Part of the reason that Euro zone has been such a risky investment is the huge amount of uncertainty surrounding the region.  The ECB formally stepping in and buying Spanish debt severely reduces the risk (I don’t think we can every really say “eliminates”) that Spain will slide into a debt crisis.  Which makes investing safer.  Which means money that was previously sitting on the sidelines waiting for a chance to jump in is now either jumping in, or about to.  Especially in the european banking sector.

However, by the same logic, expect traditional safe havens for money to take a hit as more and more money starts to get brave.  The US dollar and US government bonds for a start.

Also look for this to play out the same way in foreign currecies as well, where the US dollar is the haven of safety and stability, foreign currencies react in the opposite fashion, dropping as uncertainty increases, and gaining as stability grows.  Look for most currencies to gain vs the dollar as investors balls start to drop.

One more play that I would look to would be gold.  Gold, as we’ve covered before, does not increase due to inflation, but to the preceived risk of inflation.  With the ECB printing up more euros to buy bonds, the Euro money supply will begin to accelerate.  Whether this results in on-the-ground inflation or not depends on whether that money filters down to the people that spend it, or simply remains in the financial world, where it will cause asset inflation instead.  Either way, that threat is likely to push gold higher, at least over the short-term, until the effects of this bailout start to have an impact.  Don’t expect the gold rush to continue once it becomes apparent what’s going to happen with EU inflation rates.