19 February, 2009

Anatomy of a Trade: Selling Calls in a Bear Market

Risk is without a doubt the de-facto component of any investment. There's certainly no free-lunches out here, especially in the Bearish climate traders are finding themselves in. With the majors touching November 2008 lows, the already fragile marketplace finds itself hanging by mere strings from a profound loss of confidence.

Anatomy of a Trade, as this article is titled, is thought of as the first in a series of pieces attempting to give some insight into a Traders mindset, which seems more prevalent now given the climate. A consistently volatile and bearish mood of the marketplace, can often cloud sound reason decision making by forcing a Trader to maneuver more swiftly and determinately than typical.

First, a brief introduction to the concept of selling options. Wikinvest (Link) has a brief primer on the concept of "covered calls", which in laymen speak is the process by which an Investor holding a stock position sells a call option to the marketplace giving another Investor the opportunity to buy said stock position at a pre-determined price on a pre-determined date. Several good and more detailed resources exist on the topic both online and off .

How this trade started! WC Power Tech Fund holds in its portfolio long positions in both Google (GOOG) and Goldman Sachs (GS) and as January was coming to a close, Covered Call Option positions were opened on both securities.

Jan 22: Covered Call Option position sold for Goldman Sachs with a strike price of $85 for February netting a premium of $2.23 per share.
Price for GS: $71

Jan 23: Covered Call Option position sold for Google with a strike price of $350 for February netting a premium of $5.70 per share
Price for GOOG: $324

Selling Covered Calls doesn't exactly tickle anyone's risk bone in the slightest because in the best case the options expire worthless and the seller keeps the premium received and their stock, and in the worst case the seller keeps the option premium but has to also sell the stock at the strike price despite the fact that in the market the stock is trading at a higher value. Either way there's technically no "loss" if an Investor chooses a comfortable Strike Price for their position.

How the Selling Covered Call strategy works against an Investor is the "potential lost profit" on a stock that continues to surge. And this is exactly what happened during a two-week run for both Google and Goldman Sachs stock prices as the Market experienced a Bullish bounce. The value of the sold options went increasingly higher and to buy the options back at market prices would have led to losses of 4 to 5 times the initial premium received.

Within a week the prices of the option positions were as follows:
Google Feb $350: $14.20
Goldman Sachs Feb $85: $8.35

This is where that seductive element of Risk steps through the door. The Naked, or Uncovered Call Option. Staring at unrealized losses on a short position of 400-500%, the Trader has the Option (pun intended) to sell more options. These are different from the original sales as the Investor doesn't currently have the stock to offer if the prices remain this high.

But in a Bear Market, the Anatomy of this trade had 2 main parts: Sell Uncovered options at the same strike prices to drive up the average selling price of the position. The thinking was that Bearish tones will overtake the general markets and bring prices back down prior to expiration of the options. This would present the ideal opportunity to close out this trade, by buying back the uncovered and covered options for less than a now increased average selling price! In simple terms, turn this heavily negative current position into a profitable one. That was the goal.

On paper, its a very risky trade, as the losses are potentially limitless if Markets kept proceeding higher. But by sticking with the prevailing notion that the Markets are Bearish, a small spike in prices presents an opportunity to sell into if not at the peak.

Initially the small spike, wasn't so small at all and both Google and Goldman Sachs kept being bid up and bought ever higher. By February 9th: Google's stock stood just shy of $380 (nearly $60 higher) and Goldman Sachs shares fetched $98 (nearly $30 higher). Nothing short of a complete disaster for a short-term trade.

Option prices on February 9th:
Google Feb $350: around $30
Goldman Sachs Feb $85: around $14

Some simple math based on the first covered call sells shows that the Google position had increased over 5 times! and the Goldman Sachs position had increased over 6 times!.

However with continued Uncovered Option selling mathematically the potential loss didn't look so daunting and the continued collection of premiums had built a cash position for the fund. The risks associated with the accumulation of short call positions in both Google and Goldman Sachs was that as expiration dates loomed ever closer the fund was on the hook for an increasing amount of stock, should there not be a sell-off.

So, what is the thinking at this point. The trade has gone against the Trader, and perhaps the smartest thing isn't to continue selling into the wind. When purchasing stock you're told to buy a position in pieces in an effort to average down if the stock moves the opposite way. Same thing applies to selling short, both stock and options. Whether this practice is smart for uncovered option positions in clearly debatable, it is however absolutely possible. By continuing to sell more Uncovered Call Options the average prices of each position had increased 3 and 4 fold by the infamous February 9th date.

Infamous because that day proved to be the peak for both Goldman Sachs and Google stock. The initial theory was beginning to prove correct, albeit after many days of market-watching worries and frantic paper loss calculations. By using Uncovered Calls the positions had grown but so had average selling prices.

January 23 & February 9th Position Average Selling Prices:
Google Feb $350: $5.70 on Jan 23 --> $17.10 on Feb 9
Goldman Sachs Feb $85: $2.23 on Jan 23 --> $9.10 on Feb 9

Now that initial convictions had been proven correct and the Market began making its way to November 2008 lows the current prices of both Option positions fell dramatically. As expiration approached, the Trade should look to be closed, and with that the Uncovered Call contracts bought back.

With each passing day in the third week of February the markets slipped and along with them, were the share prices of Goldman Sachs and Google, closing Thursday at $86.01 and $342.64 respectively. The WC Power Tech Fund closed all outstanding Google and Goldman Sachs option positions on Thursday. So although the bullish market spike in late Jan/early Feb as a threat proved formidable it was not, in the end, insurmountable.

February 19 Position Buy Back Prices:
Google Feb $350: position bought back for $1.54 --> net percentage gain
(kept 91% of option premiums received based on $17.10 average selling price)

Goldman Sachs Feb $85: position bought back for $2.54 --> net percentage gain
(kept 72% of option premiums received based on $9.10 average selling price)

In a market that hasn't been Investor friendly for a long time, there are Trades that can be very profitable. The Uncovered Call brings with it enormous and limitless risks, which don't translate well to the average Investor. There are easier ways to exploit Bullish Market spikes in a Bearish market, and options are one of the most cost-effective ways to do that. They are also amongst the riskiest. The WC Power Tech Fund uses and has since inception used Covered Call selling as a monthly income generator, to supplement dividends and supplement or offset capital gains and losses that positions incur.

So for all those nail-biting moments earlier in this month with these option positions, the end proved to justify the means, this time, and what was a very risk-intensive trade turned profitable in this inaugural Anatomy of a Trade.

Disclosure: Author owns GOOG, GS

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