selling put options

Buying back and rolling over near but in-the-money puts just before expiration

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Option contracts have two kinds of value, time value and intrinsic value.  On the last day before expiration, a put seller has a few possibilities for dealing with near but in the money puts.  By afternoon, the put contract has only intrinsic value and time value has fallen to nothing.

A person can do the following:  (1) do nothing and accept assignment; (2) buy back and take a new position with more time value.  I had the following two experiences:

The PWE (Pennwest Energy) June $23 was near the money, but as long as it was within a few cents, the price to buy to close remained 10-15 cents.  But when the price of the underlying dropped to $22.75, I was able to buy back the put at 25 cents plus commission 2.7 cents; and then sold the October 23 at 2.273 after commission.  So I cleared roughly $2.00 per share by rolling over and I never received assignment.  The assignment would have been 6.1 cents per share, so that the two commissions of 2.7 cents were less than the commission at assignment.  So that was a consideration.  But then, if I waited until after assignment for the shares to go above $23, I figured that the PWE October $23 would lose also a little time value and little intrinsic value–though this could depend on other factors such as implied volatility.

The PGH (Pengrowth Energy) July $13 put was about to expired in near money.  Last week I was a volunteer our church’s Vacation Bible Camp, and I came home on Friday morning to deal with it.  First, I wanted to sell an January $13 put to replace it, then buy back the expiring put.  But when I used the Questrade platform I made the mistake of buying a put instead of selling.  It is a new platform for me, and I was being a little careless.  But all of these DIY platforms default to a certain option, and so you must physically change it if you do not want “to buy open”.  I think that there should be no default option, but the programmers never talk to traders, I guess.  Immediate panic set in and it took me two tries to sell these back (as I didn’t put in the correct number of shares the first time) but finally at a loss of only 6 cents per share (including three commissions!) I was able to exit a position that I never intended to hold.  At that point I had no more time and I had to return to the camp.  In the afternoon, before market close, I went to buy back my July $13 put, but the underlying (PGH) was at $12.75 and had therefore 25 cents intrinsic value, but the ask price was 40 cents.  Unwilling to pay 15 cents above intrinsic value, I let it expire and took assignment.  Then, two trading days later I sold my shares at $13.05, which provided me a small profit after all commissions (2.35 cents).  I then sold a PGH January $13 put $1.185.  Now on Friday, I probably could have sold the same put at $1.335, so that the difference between what I got on Tuesday and what I would have gotten on Friday was 15 cents (including all commissions).  This seems the same as my loss on Friday had I rolled it over then, but it has to be remember that (1) I would have paid 3.5 cents commissions to roll it over that day, and I made 2.35 cents profit on selling the assigned shares.  So I saved 5.85 cents which almost pays for the 6 cent blunder that I made.  So the net profit was 1.185+.0235-.06 (blunder)=$1.149.  On Friday, I figured that I could have only cleared as much as $1.15 before commissions so I was happy with how it finally played out.  So it was a wash in the end, despite my careless trading on Friday.

So I guess the lesson in these two scenarios is that it is good to buy back an option on expiry if you can get it for intrinsic value.  The commission cost on assignment would easily offset the commission costs of buying back and selling the new position.  But if market will not sell at intrinsic value, it is probably just as well to take your chances with assignment, particularly if you are still bullish on the underlying security.  The advantage of PGH is that it’s 7% monthly dividend would have more than paid margin interest charges–so even if it takes months for it to return to the strike price, you are able to cover all the carry charges.

“I never recommend a trade”, Mark D. Wolfinger

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Mark D. Wolfinger is an experienced options trader who kindly offers his expertise to others.  His blog, Options for Rookies, has excellent advice about buying and selling options, including information on doing spreads like condors and collars–strategies I don’t use because I am a seller of put options.

Recently, he has made the following comment on his blog about recommending trades, which applies not just to options but also to all trading:

As you know, I NEVER recommend a trade. That violates one of my core beliefs:

When someone sells a trade recommendation, the advice seller probably believes the trade will be profitable. However, ultimate profitability is not only dependent on the trade chose, but also depends on how it is managed. That salesman may be able to turn a profit, but that does not mean that you would. Your pain threshold is lower and there would be many instances in which you exit with a loss and he holds and earns a profit.

He claims a profit for his followers and all you see is a loss. Do you understand why that happens?

Each trader has his/her own comfort zone, trading goals and the ability to withstand a loss. Each would exit the trade at a different time. Each is at a specific point in life – perhaps raising a young family or retired. Perhaps wealthy or struggling. No one who understands trading would suggest the same trade to every person. Yet, that’s what these gurus do.

The post in which these lines are found is called, “Risk Management for the Small Trader” in which he recommends that options trader have a minimum of $10,000 trading cash and preferably twice that amount because the newbie with $5000 or less will have just enough cash to enter positions but insufficient cash to manage them well.

His advice about the management of trades applies also to stocks.  If new traders, who enter a stock with the hope that it goes up quickly, sell  it when it goes down 15%, they will likely lose that cash forever.  If they average down, and I believe in such a strategy, then they will be much less likely to lose money as a trader–even the black swan event of the market drop of 2008-2009 could have been overcome with a strategy of averaging down on losing positions.  But alas, if you have only a limited amount of cash, then that strategy won’t work, because you shoot your wad in the first instance, and there’s nothing left with which to average down.

Petrobank spinoff II: What happens to an option contract?

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In a previous post, I wondered what happens to an options contract after a spinoff. Petrobank spun off Petrominerales–its Columbian holdings.  I figured, based on the rules, that if my puts were assigned I would receive 100 shares of Petrobank and 61.5 shares of Petrominerales, and then learned that the Montreal Stock Exchange confirmed my analysis.

Saturday the January contract expired.  PBG closed at $23.38 and PMG at $37.27; thus the closing price for the underlying  = 23.38 +37.27*0.615=$46.30.  Well, a newbie in the backroom of the options desk at my brokerage decided my January $42 was in the money and exercised my contracts, charging me the $42 per share of Petrobank plus a $43 commission.   Obviously, Petrobank at $23.38 was deep in the money, right?  $23.38 is a lot less than $42.00.   This is the note in my activity (with amounts whited out):

Apparently, not everyone in the backroom knows what she’s doing and somebody a little smarter decided that this assignment better be canceled.  I never did get my 61.5 shares of Petrominerales (per contract). But hey, guys, if you want to assign me 100 shares of PBG and 61.5 shares of PMG, I’d happily receive them for the price of 100 shares at $42.  That would be a net gain of $4.30 per share.  I’ve heard that once in a blue moon a novice options buyer will exercise an out of the money option–for the seller, this is a gift.

My final thoughts on this is that after a bit of experience, it is very possible that the DIY trader will know more about options than some of the people working the options desk at the brokerage.  When I first started out, I asked about the commission rates upon assignment/exercise–not just once but several times.  Each representative gave me a different answer: one said standard commission, others said they didn’t have any idea, others said $43–but what about multiple contracts?  No idea.  etc. etc. etc.  I finally stopped trying to get a definitive answer and just waited.  My contracts that did expire in the money were charged $43 (the DIY rate) upon assignment and this was for multiple (5) contracts in the same order.  So the actual event helped me to formulate a better cost analysis.

Aggresivity or Gold: what is needed in the current investment climate

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These are difficult times for investors. They are wonderful times for speculators. Speculators will make (and lose) a lot of money over the next couple of years. In my opinion, investors are likely to lose. Prudent investors might better avoid financial assets for awhile. Traditional wisdom is apt not to apply to what is coming.  Monty Pelerin, “Speculators Only”

There is the saying, “Those who remain calm while others panic, don’t know what the hell is going on.” It is a troubled time and I genuinely feel bad for what central banks are doing to people’s savings. But as Pelerin says, speculators will make and lose a lot of money. The biggest winners today are those upon whom Bernanke shines his favor, such as the big banks that borrow money from the Fed and lend it back to the US federal government, which is perhaps the biggest Sopranos-type racket going: but it’s not some kind of under the table payoffs, but it’s being done right in front of all of us and with impunity.

The 2008 market crash has been particularly devastating on people’s savings. They were forced by inflation to buy so-called “risky” instruments, esp. stocks. Then that bubble burst twice in less than a decade. Stung by this double whammy to their savings, many are still too scared to bet on the market again, and so Bernanke, and the other sovereign banks around the world are robbing them blind through their loose monetary policies; the euphemism for excess money creation is “Quantitative Easing”–it used to be called just simply “inflation”.

Loose money is also created by low interest rates.  In Canada, for example, there has been something like a 20% increase in the cost of houses since the summer of 2008, due to the Bank of Canada keeping the rates at ridiculously low rates. So you can’t sit on cash–because the riskiest investment in an inflationary environment is cash in a savings account that pays 1%. Here in Canada since the nadir of the stock market crash, such cash has lost about 19% against real estate and much more against stocks and gold.  Commodity prices on world markets are rising rapidly too.  Or rather, fiat currencies are losing their symbolic value quickly.  A interest bearing GIC, savings account or bond is recipe for a portfolio with a rapidly declining buying power.

I’ve devised an aggressive and flexible investment style to beat the coming inflation, if possible.  The stock portfolio I manage is now almost all commodities (oil and gas, gold mining), 100% Canadian-based (as I live in Canada), and I am shorting the US dollar to buy these companies. I am selling cash or margin covered puts on oil and gas, gold-mining companies (etc.) for income (which gives from 5-10% downside protection) and, because I can’t trust my margin to stay high in market downturn, I am accumulating unused lines of credit (notably my HELOC) as my hedge against deflation,with the view of seizing the day if there is a market crash. I believe the investor must be aggressive and engaged–you can’t have a “lazy” portfolio today (John Mauldin said the same in his most recent interview with Steve Forbes). The goal must be to beat inflation, and the higher that goes, the more aggresivity is necessary. Or if I had to sit out as you suggest, then I would put most of my funds into silver, gold, non-perishable foods, or other commodities–things with durative and intrinsic value (gold and silver are liquid and so are excellent choices, but you have to have a safe place to put it).

Most people’s best hedge against inflation is still their mortgage, as Bernanke’s devaluation of the dollar will also reduce everyone’s debts. It’s the Year of Jubilee, when everyone’s debts will be canceled, especially the Federal government’s. Or as Dickens says, “It was the best of times, it was the worst of times … ”

This post is a revised comment that was featured today at Monty Pelerin’s blog, “One man’s approach to investing in dangerous times“.  Thanks Monty!!

Please read my financial disclaimer, if you haven’t already.

Rolling over puts: when to buy to close a put option

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I use the following spread sheet to determine when and whether to buy back a put option (please note that commissions are calculated into the costs and original premium):

expiry symbol market strike # Current
premium		 comm cost original
premium		 gain/
loss		 % gain/
loss		 days at
start		 days
remaing		 time
remaining		 composite
Jan 2012 abx $47.02 $45.00 3 $5.95 $13.74 $1,798.74 $2,656.21 $8.85 $857.47 32.28% 620 446 71.94% 104.22%

The number in red is the price to buy back the option, and $857.47 is the difference between the original premium and the cost to close.  The composite number in the last column is the percent gain or loss plus the percent of time remaining.  When that number is at 100% the buy back is neutral.  You neither win nor lose on the contract.  If the number is negative, I would normally not buy back the option for I would sooner take possession of the underlying upon expiry–I should be comfortable owning the position in the underlying or I wouldn’t be selling the put option in the first place.  If the final number is above 100% then buying back the put can be done without disadvantage, because the time decay and percent of gain still add up to 100% as on the day the put was sold.  Here are the circumstances I use to buy to close:

(1) Buy to close a put if the composite number adds up to over about 135%.  This means that the premium has plummeted because the underlying has increased rapidly in market price.  At this point it becomes interesting to buy back and realize fast gains and then use the margin value to sell another put.  Gains can be multiplied by doing this.  So for example, I sold 2 puts on RY and bought it back 8 days later as such:

apr 2011 ry $45.00 2 $2.55 $12.49 $522.49 $827.49 $4.14 $305.00 36.86% 233 225 96.57% 133.42%

Less than four percent of the time had passedt, and yet there was 36.9% gain on the position.  The composite was at a very nice 133% and I didn’t have to wait another 225 days to re-risk the capital, which I used in turn to sell a put on PWE:

Mar 2011 pwe $21.43 $19.00 5 $0.70 $16.24 $366.24 983.74 $1.97 $617.50 62.77% 197 161 81.73% 144.50%

The composite number was an astounding 144.5% after only 36 days.  I repurchased the put.  Thus, the total realized gain over $305 + 617.50 = $922.50/$9500 (captial at risk)= 9.7% gain in a period of 44 days, which represents a 80% annualized gain.  This shows how it can be lucrative to buy back a put option.

(2) Buy to close a put when it only costs about $50 and there is more than about 60 days remaining.  Since most of the original premiums for me are in the $700 – $1000 range, it makes sense to buy back something that has so much time left on it but costs so little to buy back–less than $1 per day.  When its more than $1 per day, it’s probably better to let it expire worthless.

(3) Buy to close a put after losing confidence in the underlying.  TA was downgraded at TD Waterhouse and Scotia Capital.  I bought back the position as follows:

dec 2010 ta $21.00 $20.00 5 $0.26 $16.24 $146.24 $508.76 $1.02 $362.52 71.26% 232 88 37.93% 109.19%

The composite number was still at an advantage to me, but I had lost confidence in the underlying and did not want to take the position if the put expired in the money.  I still came out ahead on this one by $362.52.

So far these are the guidelines that I use to buy to close put options and would appreciate any pointers or questions that people might have to make in the comments.