Three key tips for option traders

Most new option traders start by selling covered calls. It is an income producing strategy where you sell a call option on a stock that you own to collect the option premium. However, the premium comes with an obligation, if the call option you sold is exercised by the buyer, you may be obligated to sell your shares of the underlying stock.

1.  Consider the ex-dividend date

A common mistake to avoid is selling a covered call near the ex-dividend date of a stock that you own. Sometimes investors will come in to buy a stock a few days before the dividend date causing the stock value to briefly go up. This could make it very profitable for the buyer of the call option to force you to sell and collect the dividend payment. Not only do you lose the dividend but your broker’s fee to sell your shares will be much higher than normal.

For example; Royal Dutch Shell (RDS.b) has an ex–dividend of May 17th and pays $0.94 per share every quarter. So if you sold a May 19th call option, your shares could be called away early if the call option is in the money.

2.  Open interest or liquidity

Sometimes there is a wide spread between the bid and ask price of an option based on trading volume or the amount of open interest. The open interest will tell you the total number of option contracts that haven’t been exercised or assigned. Many options on Canadian stocks are illiquid and the bid-ask spread can be really extensive.

For example; Shopify (shop) trades on the Canadian exchange at $128. 14 and $93.58 on the U.S. stock exchange. If you wanted to sell a cash secured put option June 125 strike price the bid is $4.50 and ask is $5.75 but the open interest is zero contracts. However, the June 90 put option on the U.S. exchange has an open interest of 873 contracts and the bid is $3.10 and ask is 3.30 making it much easier to trade.

3. Implied volatility can increase when earnings are released

Implied volatility represents the expected price action of the stock over the life of the option. As expectations change, or as the demand for the option increases, implied volatility will also rise. Earnings expectations can influence the option premiums that expire when companies release their earnings.

For example; Ulta Beauty (ulta) is currently trading around $297.55 and is reporting their earnings on May 25th. See the weekly at the money call and put options below:

Calls Bid Ask Open Interest
May 19 $297.50 $2.45 $2.85 141
May 26 $297.50 $8.90 $10.60 87
June 2  $297.50 $10.30 $11.80 0
June 9  $297.50 $10.80 $12.30 2

 

Puts Bid Ask Open Interest
May 19 $297.50 $2.45 $2.80 99
May 26 $297.50 $8.90 $10.50 13
June 2  $297.50 $10.40 $11.90 1
June 9  $297.50 $10.70 $12.00 0

Without the change in implied volatility  the May 26 calls and puts options bid-ask price would have been in the $4.90 to $5.60 range but earnings expectations have increased the value of these options. Take note of the wider bid-ask spread on the June 9 and 16 call and put options which have little or no open interest contracts.

Before you buy or sell options you should always check for the ex-dividend date and earnings release date. Keep a close eye on the number of open interest contracts, a large bid-ask spread could turn a profitable trade into a loser.

 

Disclaimer: The stocks mentioned in this post are for educational proposes only and not recommendations.

Baby Buffett loses 4 Billion on Valeant shares

Hedge fund manager Bill Ackman first came to my attention when he invested in Canadian Pacific railroad. As an activist investor, Ackman started a lengthy proxy battle with the board of directors to remove Fred Green as CEO and appoint Hunter Harrison in his place. Not only was Ackman successful but it was very profitable for his hedge fund since the value of CP shares more than doubled under Harrison’s leadership.

In early 2015, Bill Ackman invested in Valeant, another Canadian company. His hedge fund purchase shares around $196 and recently sold all of them at $11 a share. He accelerated his losses by buying call options and selling put options.

Hindsight is of course 20-20, are there any investment lessons that we can use?

 Lesson: Intelligent people are capable of doing very dumb things.

Bill Ackman is clearly a smart man otherwise his Pershing Square hedge fund wouldn’t manage pension fund money. But if you asked the average investment professional /your grandmother whether it is a good idea to stick over a quarter of your assets into a highly levered pharma roll up the answer would tend to be a firm “no”.

Lesson: Position sizing is very, very important.

Always be aware of your risk of ruin, no matter how much you are convinced the odds are in your favor. Regardless of how amazingly smart and brilliant you are and how many hundreds of hours of research you have done, it is perfectly possible that you will lose money on any given investment. Pershing Square had too large a position to simply sell its stake and walk away when things started to go wrong.

Lesson: Highly incentivized management teams can still blow themselves up, and take you down with them.

Part of the original appeal of Valeant to the hedge funds that backed it was how the CEO’s stock options had been structured to make him highly incentivized to get the share price as high as possible. Having management teams with “skin in the game” is clearly important but this does not mean they will not do something very stupid.

Lesson: Auctions are not usually very good places to find bargains.

Ackman admits that he now believes Valeant “substantially overpaid” for Salix, its last big acquisition before things fell apart. A big problem with a role up strategy is paying high prices for third rate assets that no one else in the world is willing to buy.

Lesson: Beware of political risk.

Valeant used aggressive drug pricing to help pay for their acquisitions which got the attention of American lawmakers. Bill Ackman had to testify at a hearing held by the U.S. Senate aging committee which was reviewing escalating drug prices. It also became a big issue during the U.S. 2016 presidential election.

Lesson: Take a loss, don’t let your Ego get in your way.

There is no doubt that billionaires tend to have large egos. Being labeled “Baby Buffett” on the cover of Forbes is quite the ego booster. But there is an old saying, “the bigger they are, the harder they fall”. Ackman’s buying call options and selling put options on a losing position is a clear sign that his ego wouldn’t accept taking a loss on Valeant shares.

Postscript: The share price of CSX railroad jumped up 35% on rumors that Hunter Harrison would be the new CEO. Harrison got the job but can he deliver another turnaround? It may be too early to tell. However, I bought some shares of CSX for my investment club. 

 

20 Seconds of fame on the National News from a blog post

rico-dilello

One of my blog posts that I wrote back in September of 2015, caught the attention of a T.V. producer at CBC News which is a division of the Canadian Broadcasting Corporation. On Feb 24th I received the following email:

Rico,
I`m a National TV News producer at the CBC and I just read your article “Why I quit being a financial Advisor” we are working on story about the trend away from “active investing” to more “passive investing” and think you might be a unique and interesting voice in our item. Can you give me a quick ring so we can have a chat?

I immediately gave him a call and answered some questions about my views on both active and passive investing. He asked if I was willing to be interviewed at my home which I agreed to but I wasn’t given a confirmed date.

To my surprise, I received a phone call while I was at an indoor golf driving range to do an interview. Not actually camera ready, but they were willing to send out a senior writer and cameraman to the driving range. They couldn’t wait because it was going to air the next day before the RRSP contribution deadline of March first. The producer was kind enough to send me a copy of the story. Click on the link below to view my 20 seconds of T.V. fame:

https://drive.google.com/file/d/0B62hJdYjW6psU3Iwam5JTzRKN0k/view?usp=sharing_eil&ts=58b6e6d5

 

Please reframe from making any comments on my golf swing! It has been three months since I swung a golf club.

 

Bull call spread strategy update

call-spread

Back on December 13th,  I suggested that a bull call spread can be used as an alternative to a covered call strategy. I was hoping that out of the three examples, there would be one good, one bad and one ugly. All three examples were just paper trades for discussion purposes. It turns out that all three paper trades were profitable if they were closed as of today at 11:00 a.m.

Bull Call Spread: An Alternative to the Covered Call

Quotes as of 11:00 a.m. on Jan 5, 2017

Example #1 Apple @ $116.08

Original buy was 100 shares of Apple at $114.90 sell one call option Jan 20 at $115.00 for $2.60

Action: Buy back call for $2.02 sell stock $116.08

Profit: ($116.08 – $114.90 + $2.60 – $2.02) = $1.76 divided by $114.90 = 1.53%

Original Call spread: Buy 1 Jan 20 $105 call for $10.45 – sell one call Jan 20 at 115.00 for 2.60

Action: Buy back call for $2.02 sell 105 call for 11.10

Profit: ($11.10 – $10.45 + $2.60 – $2.02) = $1.23 divide by $10.45 = 11.79%

Example #2 Netflix @ $131.36

Original buy was 100 shares of Netflix for 123.75 – sell Jan 20 call at $130 for $4.50

Action: Buy back the call for $7.95 sell stock for $131.36

Profit: ($131.36 – $123.75 + 4.40 – 7.95) = $4.06 divided by 123.75 = 3.28%

Original Call spread: Buy one Jan $120 for $9.15 – sell Jan 20 call at $130 for $4.50

Action: Buy back the call for $7.95 sell call for 14.10

Profit: ($14.10 – $9.15 + 4.50 – $7.95) = $1.50 divided by $9.15 = 16.39%

Example #3 Facebook @ $119.65

Original buy was  100 shares of Facebook for$119.40 – sell Jan 20 call at $120 for $3.10

Action: Buy back call for $1.68 sell stock for $119.65

Profit: ($119.65 – $119.40 + $3.10 – $1.68) = $1.67 divided by $119.40 = 1.4%

Original Call spread: Buy one Jan 20 $110 for $10.45 – sell Jan 20 call at $120 for $3.10

Action: Buy back call for $1.68 sell call $9.75

Profit: ($9.75 – $10.45 + $3.10 – 1.68) = $ 0.72 divided by $10.45 = 6.89%

The capital required to purchase 100 shares of each of these three stocks is $35,805 minus $1020.00 from selling the covered call options equals $34,785. Total profit of closing these positions today would have been $749.00 dividend by $34,785 equals 2.15% (not including trading fees)

The bull call spreads requires a total outlay of $3,005 minus $1020.00 from selling the exact same covered calls equals $1985. Total profit would have been $345 dividend by $1985 equals 17.38%. (not including trading fees)

A bull call spread allows for a higher percentage return with less capital. Plus it allows you to trade higher priced stocks. In case you don’t remember, both Apple and Netflix were trading over $700 before they did a 7 for 1 split. Many small investors didn’t have enough capital to invest in these two stocks. In hind sight, I could have pick higher priced stocks like Amazon ($778.00), Google ($790.00) or Priceline($1501.00) but I didn’t currently feel very bullish on these stocks.

There are many stocks trading in the $200 to $300 range like Goldman Sachs, Biogen, Tesla and Chipotle where a bull call spread could be an alternative to a covered call strategy. To reduce trading costs, I would recommend call spreads that contain a minimum of buying 3 calls and selling 3 calls on the underlying stock.

If you are bullish, earnings season is just around the corner, a call spread strategy could boost your returns. Please note that call spread trading requires having a margin account and approval from your discount broker.

Disclaimer: This post is for discussion purposes only!

 

Bull Call Spread: An Alternative to the Covered Call

call-spread

Most new option traders start with a covered call strategy. You buy 100 shares of company xyz and you sell one option that has a near month expiry date. One objective of this strategy is to earn extra income from the option premiums which hopefully expires worthless. Short term options decline in value very quickly if the stock price remains fairly flat or falls a little in value.

The covered call strategy is limited by the amount of capital you have to invest. Many popular stocks are trading over $100 like Apple ($114.90), Netflix ($123.75) and Facebook ($119.40) so buying 100 shares of these three companies would require about $35,805 of your capital.

An alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. Instead of buying the underlying stock in the covered call strategy, the bull call spread strategy requires the investor to buy deep-in-the-money call options instead.

To illustrate the difference, I am going to select 3 bull call spreads for the above three popular stocks. Disclaimer: These trades are for educational purposes only and are not recommendations.

Quotes as of 10:00 a.m. on Dec 13, 2016

Example #1

Buy 100 shares of Apple at $114.90 sell one call option Jan 20 at $115.00 for $2.60

Call spread: Buy 1 Jan 20 $105 call for $10.45 – sell one call Jan 20 at 115.00 for 2.60

Example #2

Buy 100 shares of Netflix for 123.75 – sell Jan 20 call at $130 for $4.50

Call spread: Buy one Jan $120 for $9.15 – sell Jan 20 call at $130 for $4.50

Example #3

Buy 100 shares of Facebook for$119.40 – sell Jan 20 call at $120 for $3.10

Call spread: Buy one Jan 20 $110 for $10.45 – sell Jan 20 call at $120 for $3.10

Now, the capital required to purchase 100 shares of each of these three stocks is $35,805 minus $1020.00 from selling the covered call options equals $34, 785. The bull call spreads requires a total outlay of $3,005 minus $1020.00 from selling the exact same covered calls equals $ $1985.00

Only time will time if these bull call spreads are good, bad or ugly. Stay tune for a follow-up post in the new year.

Another suckers rally in oil stocks?

opec

Over the past year there has been a lot of talk regarding the possibility of OPEC either freezing or cutting production. The Organization of the Petroleum Exporting Countries (OPEC) on Wednesday agreed to its first oil production limits in eight years, triggering an oil rally. The new norm for crude prices could be between $50 and $60 going forward.

OPEC has said it is seeking to secure 600,000 barrels per day of cuts from non-OPEC producers, and that Russia has committed to temporarily cut production by about 300,000 barrels per day in the first half of 2017. Russia and other non-OPEC producers are set to meet with OPEC on Dec. 9.

The key to all of this is whether these cuts will be implemented. Plus market watchers are also questioning whether the oil group will cheat. The sharp oil-price rally may well be short-lived, as oil production has been turning the corner in the U.S., with the rig count up 50 percent from lows in May.

Extracting oil from the Permian Basin, which spans west Texas and southeast New Mexico, is less expensive than it is in many major fields.

“Basically, $50 is good for Permian Basin stocks,” said Paul Sankey, senior oil and gas analyst at Wolfe Research. Pioneer Natural Resources and EOG Resources expanded their presence in the region in the last few months, and Sankey said the two companies would also benefit from $50 oil.”

In Conoco Phillips’ third-quarter conference call, management said the company was adding three rigs to its operations in the North Dakota Bakken oil fields for a total of four rigs in the region.

“The Trump Wild Card”

Cutting corporate income taxes will make U.S. shale producers more profitable and they could have extra cash to produce more oil. Less banking regulations could also allow more bank loans to the energy industry. Could Trump impose tariffs on imported oil? He is after all unpredictable!

The oil futures market has quotes for monthly contracts that are being offered at $53.00 for the first quarter of 2017 and $55 for the rest of the year. The trading volumes of contracts changing hands is very low which could be a bullish sign that oil producers believe that higher prices are coming.

Now over the last two years, I have avoided investing in oil stocks and posted many articles regarding the oversupply problem. I am currently doing research on some U.S. shale oil producers. Unfortunately, the fundamentals haven’t changed and most companies are still losing money at current oil prices.

What do you think?

Is this another suckers rally because hedge funds are rushing in to cover their short positions or is this the start of a bull market in the oil patch?

 

 

 

 

 

Rolling options can turn a profitable option trade into a loss

call-put

One of the hardest things to do as an investor is to control your emotions when making investment decisions. It is even more difficult for option traders because all options have an expiry date. Plus option prices are very volatile which can be difficult to ignore.

My dollar cost average using an option strategy for buying 200 shares of Royal Caribbean has been an emotional roller coaster ride. I took a position on Oct 11 with the intention of either making 11.2% return in 38 days or owning 200 shares at an average price of $68.84 per share. The chart below illustrates the price movement over the past 16 days.

rcl

I get nervous when a stock price falls 3.5 % two days before earnings are released. I seriously thought about buying back the call & put options and selling my shares for a loss. However, the whole point of this strategy was to own 200 shares of Royal Caribbean. Nothing really has changed, under normal conditions I would have bought 100 shares at $72.22 on Oct 11 and bought another 100 shares at $68.00 for an average price of $70.11 per share.

My option strategy, up until Oct 27 has reduced my paper loss to $68.84 – $68.00 = $0.84 divided by $68.84 or 1.2% compared to $70.11 – $68.00 = $2.11 divide by $70.11 or 3%. The next day, RCL released their earnings that surprised on the upside. See the chart below: 

rcl1

Now I am faced with more challenging set of opportunities.

  1. Do I buy back the Nov 18 call & put options which brings my cost base down to $69.92 and I hopefully sell my 100 shares on Monday for $74.40 ( 6.4% return)
  2. Do nothing for the next 22 days and hope that the shares don’t fall back below $72.50 and make 11.2%
  3. Do I roll my options forward by buying back the Nov 18 options and sell the Dec 16 $72.50 call for $4.10 and Dec 16 $72.50 put for $2.20?
  4. Do I get greedy? Buy back the Nov 18 options and sell the Dec 16 $75 calls for $2.64 and the puts for $3.30?

Analysing the risk / reward of rolling my options to Dec.

Scenario (1): What happens if the shares of Royal Caribbean are trading below $72.50 on Dec 16?

Under choice # 3, call option expires and I buy 100 shares at $72.50 bring down my purchase price per share to $66.20 for the 100 addition shares plus 69.92

Under choice # 4, I still buy 100 shares at $72.50 bring down the purchase price per share to $66.56

Scenario (2): What happens if the shares of Royal Caribbean are trading above $72.50 but below $75.00 on Dec 16?

Under choice # 3, I sell my 200 shares for $$14,500 – $6,620.00 – $6,992.00 = profit of $888.00 or 6.72%

Under choice # 4, I will own 100 shares at $69.06 plus my 100 shares at $69.92

Scenario (3): What happens if the shares of Royal Caribbean are trading above $75.00 on Dec 16?

Under choice # 3, nothing changes, I still make $888.00 or 6.72%

Under choice # 4,  buying back the Nov 18 options, I reduced my cost base on the 100 shares to $69.92 – the Dec 16 put option of $3.30 – call option for $2.64 = $63.98 per share. I will be force to sell at $75.00 for a profit of $11.02 or 17.2% 

Two factors that I am weighting are the Fed is considering raising interest rates in December combine with tax loss selling could spark a market correction. Now, Choice # 3 is out of the question, less change of being profitable than choice # 2, 6.72% in 48 days compared to 11.2% in 20 days.

Now, I still have until Nov 18 to decide if I want to change the perimeters of my original trade. However, I do run the risk that the purchaser of the Nov 72.50 call option will force me to sell my 100 shares before Nov 18th if the stock price continues to the upside.

What choice would you make if you were in my shoes?

Remember this old saying “Bulls & Bears make money and Pigs get slaughtered.”