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Covered Call

How Did Madoff Claim He Was Investing People’s Money?

by Evan May 22, 2017

Not unlike a large amount of people in this country I find the Madoff scandal fascinating, so when I saw HBO was doing a movie with Robert DeNiro I was pretty excited. I find the story so intriguing for a few reasons, but the main two are that I know a few people personally affected, and to a much larger extent, it builds into my obsession with wonder just how many people are completely faking and full of shit. While watching, Wizard of Lies, with The Wife I started to wonder what the hell was Madoff’s claimed strategy? I am completely familiar with the psychological part of pushing people away, until they are begging to get in, but at some point he had to explain what his investment style was, even if it was purely fake.

Before I even hit the google machine to start looking, I knew it was an options based strategy, but I didn’t know it was going to be one I had never heard of before.

What Was Madoff’s Investment Style?

Madoff claimed that he was using a Split-Strike Conversion options trade. I know it is easy to throw out the baby with the bath water in this type of situation, but you have to separate the two. Remember, this is the strategy that Madoff claimed he was using, but in actuality he was running the world’s largest illegal ponzi scheme. Interestingly one of the individuals who tried to warn the world about Madoff, Harry Markopolos, stated he couldn’t actually be using the strategy,

Over time and with some simple math calculations, Markopolos concluded that for Madoff to execute the trading strategy he said he was using he would have had to buy more options on the Chicago Board Options Exchange than actually existed, yet he says no one he spoke to there remembered making a single trade with Bernard Madoff’s fund. (emphasis added)

So, the first step someone has to take is understanding that the split strike conversion options strategy is not inherently fraudulent. The investment strategy is no different then some of the other options strategies I looked at like the naked put, bull put spread, straddle and strangle. Now that we are past that we can learn about the strategy together (much like my other posts, I am going to learn while preparing the post).

What is a Split Strike? What is a Collar?

A split strike seems to be the same thing as a collar which is,

…a protective options strategy that is implemented after a long position in a stock has experienced substantial gains. An investor can create a collar position by purchasing an out-of-the-money put option while he simultaneously writes an out-of-the-money call option. A collar is also known as hedge wrapper.

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A collar may also describe a general restriction on market activities. An example of a collar in market activities is a circuit breaker that is meant to prevent extreme losses (or gains) once an index reaches a certain level. However, the term “collar” is more often used in options trading to describe the position of being long put options, short call options and long shares of the underlying stock.

Let’s break it down piece by piece:

We own an underlying long position. Obviously this would have to be at least 100 shares since we are talking about options.
We sell covered calls. When you sell a call you are guaranteeing that you’ll provide 100 shares (1 contract) of an underlying stock or index at a price previously determined. In this particular strategy the calls sold would be out of the money (i.e. above the current price of the stock) and covered (we own the stock; this is the opposite of selling a naked call). If the stock does not hit that predetermined price then there would be no reason for the buyer to “call” the stock from you at a higher price than they can get it on the open market. The covered calls are out of the money and generate return/income.
We purchase a protective put. When you buy a put you are buying the opportunity to put a stock or index to someone at a predetermined price (no matter how low the stock may go). It is called a protective put because we are protecting our long position from a sudden drop in the stock. This protection costs money and is offset by the income generated by the covered call.

An Example of a Collar or Split Strike Options Strategy

I find that when I am learning new strategies it is best to use an example:

I own 100 Shares of ABC at $50/share
I sell a covered call with a strike price of $55 that expires in one month – this generations $50 (.50 * 100 shares = $50 for one contract)
I buy a protective put at $45 that expires in one month – this costs $40 (.40 *100 shares = $40 for one contract)

My possible outcomes in one month’s time:

The stock finishes between $45.01 and $54.99 – I keep my $10 and any dividends that were paid on ABC
The stock finishes above $55 – my shares get “called away” at $55 and I receive a 10% capped profit. If the stock finishes that month at $65 I left a lot of gain on the table.
The stock finishes below $45 – I get to put my 100 shares to someone at $45. If the stock takes a real nose dive I will have lost the $5/share between my $50 basis and the $45 strike price, but I may not have lost what I could have lost if the stock is actively trading at $30 on the open market.

Would I Ever Enter into a Collar or Split Strike Options Contract?

Absolutely. I think this is a fantastic strategy to implement once I get to 100 shares on my long term holds from way back in my dividend growth days (feels like a lifetime a go since I stopped because of some naked puts that went south on me). When/if I get around to implementing this strategy I think I’ll be going way out of the money and just generating some cash to further my investing.

May 22, 2017 1 comment

Investments

Waving the White Flag on Actively Trading my Traditional IRA

by Evan June 24, 2013

About a year ago I decided to put some money towards an investment idea I had been thinking about for years. I was going to buy stocks for the sole purpose of selling covered calls on them. My thought process was simple enough:

Buy equities that were near option call levels
Sell a covered call at a price that was predetermined to be an acceptable gain for me
Use premium to buy different equities

If the stock got called then I received my premium plus the gain that I already accepted as my maximum profit. If the stock didn’t get called away then I would just do it again (and again and again) with the same equity position. During that time I also bet against my first stock using a put strategy.

As far as the covered call strategy I still believe in it 1000%, but I think I implemented it incorrectly. My focus was to,

find companies with a market cap of at least $200 Million, a positive P/E, a stock price of below $5.00 per share and are traded on the options exchange. From the remaining companies I will research them one by one to determine whether to move on any of the options available. The covered calls will be out of the money options that will expire within 0 to 6 months of purchase. The strike price will be an amount that I am very okay profit-wise

Not once do I discuss the underlying business because it didn’t matter to me…and that was/is a mistake. The reason the stock price had to be low was because I needed enough cash to buy the underlying stocks to sell the calls against. At this point I would call this speculation at best, and at worst, gambling.

When I finally roll out of the outstanding contracts I will provide an accountability report as I always do. My plan is that once the contracts come due I will sell the underlying stock at market value and look into picking up passive index investing.

Why passive index? Because I have active funds in my hated 401(k) and a non-qualified dividend portfolio (my favorite asset), so I feel like just taking this account off the table for a very long time.

Again, I want to revisit this investment strategy one day, but when I do I will do it correctly.

June 24, 2013 2 comments

Investments

Covered Call Strategy in my Traditional IRA Update

by Evan October 5, 2012

Earlier this year I decided to finally man up and put some money into an idea I have had for a while. The basic idea is to purchase short term covered calls on near the money stocks that are inexpensive in terms of whole dollars so I can buy multiple contracts (an option contract is based on 100 shares). The stocks I have been and would continue to buy first had to survive a pretty rigorous stock screener which is outlined below. I am not providing financial or legal advise so please use this post only as a voyeur looking into some of my moves.

What is a Covered Call?

To understand what I am doing first you need to understand what a covered call is. According to Investopedia a covered call is,

An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium

A covered call has no additional risk than just owning the stock in a normal manner. I actually think it wouldn’t be a hard argument to make that it is less risky as you have actually received some of the money you invested back in cash.

Put a different way:

I own (at least) 100 shares of a company
I then sell a contract (1 contract = 100 shares) that says if the company reaches $X price (the strike price) by a certain time the purchaser gets the option to purchase the shares at that price.
When they are buying the contract they believe that the share is going to be worth more than that amount.
For creating/selling this contract I get a sales price.

Screening Stocks for Covered Calls in my Traditional IRA

I use the following screen options:

Market Capitalization is Greater than or Equal to $200mil
P/E is in the range of 1 to 20 – I want only profitable but not highly valued companies
Options are offered – Some stocks are not on the options exchange
Security Price is less than or equal to $5 – As you will see below I need the stock price low since I have to buy 100 shares per contract and I am usually doing multiple contracts.
Security Deposit is not a Depository receipt

I have provided updates a couple times this year it seems that this screen usually provides me with about 30 (sometimes its 28 and sometimes it is 34) stocks. I then look up every single stock and determine whether:

Is the underlying equity near an in the money strike? Depending on the exchange the stock is on there might only be strikes at certain intervals ($2.50, $5, $7.50) or there may be strikes at every single dollar. If you have a $3/share stock and the next strike is $5 I don’t believe I am picking the next winner that is going up 70% within 6 months. If I could do that I wouldn’t have to work lol
Does the underlying equity have a healthy option exchange. There are situations where we could meet the above screen, and even be near the money, but no one is trading the option so who am I going to sell a contract to?
Is the stock a Chinese Company? The above stock screener provided 5 or 6 companies that were wholly owned and operated Chinese companies but trading on our exchange. For some reason I just feel like this is not the area I should get my foreign exposure. We will leave that to my 401(K) and through my dividend paying stocks that operate over there.

Looking at each stock doesn’t take that long.

How I have Done with this Investment Strategy Since my Last Update

I had an excellent conversation with W at Off Road Finance about what is “Done” meaning am I calculating losses and gains on the actual option contracts, and to be truthful, it may be a terrible way to look at it, but I am solely looking at account value and trade profit.

If you would like details starting from the beginning please check out my Tracking Traditional IRA Page which I constantly update or any of the individual post updates, but below are the moves made since my August Update:

NSU

Bought 500 Shares of NSU at $4.54 plus commissions for a total of $2,280.30
Sold 5 December $5 contracts for $.50 minus commissions I received net $238.14
As of the post date the equity jumped .30 cents to $4.88
If it closes at $5 my gain will be just shy of 20% inside a few months ($2,492.05 + $238.14 – $2,280.30)

RDN

I had successfully navigated this equity with multiple contracts being opened and closed but I was left with 300 shares of RDN left over from my August Update.
I had thought about selling more contracts, but from the time between my update and when I actually paid attention to the account the value SPIKED from just under $3.50 since that was my last option contract that didn’t get called to $4.87!
Decided against it since the options market for this equity didn’t seem that interested in selling $5 calls (volume was low). I could have waited but after that type of gain I walked.
Closed out on $1,453.01

EXM

September $2 strike was no where near met as the stock was/is measured in dimes lol
I am sitting a thousand shares with a basis at $1.88 a share
I sold 2 expired contracts worth about $378.
Once there is a market for the stock I will sell a $1.00 call – that will bring me back to even…maybe

I haven’t made a move in a bit because I was waiting to write this post, but the cash to equities ratio in this account is just unacceptable and not discipline.

Stocks I am Looking at For the Covered Call Strategy

I am not comfortable saying I am buying X stock. I don’t do it anywhere on the site, but here are the stocks I have whittled that list of 30 down to for a final judgment tomorrow:

MGIC
EXEL
NSU – I bought in at $4.54 and it is currently (as of this post) trading at $4.88 so that $5 call has a lot less upside
MTOR

Any opinions on my strategy or on the stocks chosen for the next few months to watch?

October 5, 2012 3 comments

Qualified/Retirement

Updating my Covered Call Traditional IRA

by Evan May 23, 2012

It has been almost two months since I have provided an update to my Traditional IRA which is used to primarily purchase Covered Calls. I am not sure if I should be quoting myself but as a brief reminder about the account:

My goal is to find companies with a market cap of at least $200 Million, a positive P/E, a stock price of below $5.00 per share and are traded on the options exchange. From the remaining companies I will research them one by one to determine whether to move on any of the options available. The covered calls will be out of the money options that will expire within 0 to 6 months of purchase. The strike price will be an amount that I am very okay profit-wise.

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In a covered call I own (at least) 100 shares of a company I then sell a contract (1 contract = 100 shares) that says if the company reaches $X price (the strike price) by a certain time the purchaser gets the option to purchase the shares at that price. When they are buying the contract they believe that the share is going to be worth more than that amount. For creating/selling this contract I get a sales price.

My Covered Call Moves

Two of the Symbols that are still open (S and EXM) were done before I nailed down my positive P/E requirement as such they don’t exactly fit the model but they are there and thus should be shared.

For organizational purposes I will provide the update in regards to the symbol. I think this will provide an easier understanding as to what I have done and the money I have made or lost going forward in the years to come.

S – Sprint

Bought 575 Shares of Sprint at $2.25 on 2/22/2012 (I had a a few in the account to round me up already)
Sold 6 Sprint Covered Call Option Contracts on 2/27/2012 for a Strike Price of $3.00 in August

Since buying the stock in the $2.30s the stock shot up and dropped back down, but since I am locked up till August it doesn’t really matter. As I explained in the first post in the series even if it closes me out at $3 I will have made a very health gain. If not I will just sell more covered calls.

RDN – Radian

I purchased three lots of RDN:

With those lots I have sold 4 Covered Calls:

So I have purchased $2,432.49 worth of RDN Stock.
I have collected (and kept) $111.97 on an expired Contract
I still have outstanding Covered Calls that have brought in $228.89
I have taken 10% off the table on my risk between the covered calls and if any of the contracts are called I will have collected a very healthy return.
Currently, the investment is underwater as I bought 500 of the 800 shares at a price higher then we are at currently.

EXM – Excel Maritime

I purchased one lot of EXM:

I sold one contract on it which expired already:

I then sold another contract:

So I paid $1,877 for EXM
Sold a Covered Call with a net of $189.74 – it expired
Then brought in another $187.74 – Still open
I took $375 off the table in risk which I am happy about – almost exactly 20% of this trade is on the houses money.
This stock is embarrassingly low right now ($1.06 as I write this Post) but it doesn’t matter since I am not looking to sell until the contract expires.

State of the Covered-Call Traditional IRA

While I am not particularly happy that two of the three holdings are underwater, I don’t see it as the biggest of deals as the shares of those companies are pretty locked up until August which is when most of my contracts expire. At that time I will revisit the account to determine the future of this experiment.

May 23, 2012 5 comments

Investments

Screening Covered Call Options for my Traditional IRA

by Evan March 5, 2012

For the past couple years I have have mostly ignored my Traditional IRA. I would put money into it every once in a while but it would mostly just purchase the only mutual fund that was in it The Fidelity Freedom 2050 (FFFHX). I know that sunk costs shouldn’t matter but I promised myself if I ever got to even I would sell the whole thing and use the couple grand in there to try a trading idea I have had for a while. I WANT CRITICISM PLEASE!

What is a Covered Call?

To understand what I am doing first you need to understand what a covered call is. According to Investopedia a covered call is,

An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium

A covered call has no additional risk then just owning the stock in a normal manner. I actually think it wouldn’t be a hard argument to make that it is less risky as you have actually received some of the money you invested back in cash. This fits in perfectly with my income oriented sense of investing (and my risk tolerance of an 82 year widow).

In a covered call I own (at least) 100 shares of a company I then sell a contract (1 contract = 100 shares) that says if the company reaches $X price (the strike price) by a certain time the purchaser gets the option to purchase the shares at that price. When they are buying the contract they believe that the share is going to be worth more than that amount. For creating/selling this contract I get a sales price.

How I am Going to Invest my Traditional IRA

My goal is to find companies with a market cap of at least $200 Million, a positive P/E, a stock price of below $5.00 per share and are traded on the options exchange. From the remaining companies I will research them one by one to determine whether to move on any of the options available. The covered calls will be out of the money options that will expire within 0 to 6 months of purchase. The strike price will be an amount that I am very okay profit-wise.

My first purchase is a fantastic example of what I am looking to do:

My First Purchase Using Out of the Money Short Term Covered Calls

I have utilized this technique in the past, but never involved my blog which keeps me accountable and has a built in feature of being able to record my moves. Also since this purchase is one that I was involved in before I came up with the screening options it is falls a bit outside of the strict guidelines needed to figure out which stocks/options to even look at. Even though I have done this before this is going to be my first “recorded” move:

Bought 575 Shares of Sprint at $2.25 on 2/22/2012 (I had a a few in the account to round me up already)
Sold 6 Sprint Covered Call Option Contracts on 2/27/2012 for a Strike Price of $3.00 in August

I am not an investment or option guru by any means but here is my thought process on the available options:

Sprint Increases to $3.00+ in August – my shares are acquired at $3.00 for a very healthy 30% gain inside 6 months or so months! Plus my $111.89.
Sprint stays the same – I keep my $111.89 (which I will reinvest in another stock pick) and the shares remain mine. The $111.89 is about 8.5% of my initial investment! So at risk is really only 92.5% of my initial investment.
Sprint goes down – I believe in the longevity of the company so this really isn’t a huge deal as I am willing to keep selling covered call until the 3rd largest national wireless provider gets their act together or is acquired.

Screening For my Next Purchase

Using the Criteria above my Stock Screener came up with 25 possibilities. Right on the list, was Vonage (VG) which I am shocked to learn that it is trading at just 1.35 price to earnings and earned 1.72 per share. There isn’t a lot of option activity so not sure I’ll be able to actually sell a covered call so I will watch it in the upcoming months. But for his next purchase I am going with Radian Group (RDN).

Shares are trading at $3.50 per share
P/E Ratio of 1.57!
Activity on the option front

Thinking I can sell the May $4.00 Strike for .30 – .40 per contract so if I can get .30 I will get 7.5% off my purchase price back with an upside of 15%+. Not bad for 2 months! If it doesn’t get called then I just re-sell it for 2 months later again.

Some Final Thoughts

Why Use Stocks Below $5?

I don’t have a lot of money in the account, maybe a couple grand and so I need to be able to purchase enough multiples of 100 so that I can sell a few covered call option contracts to make the $8 fee not seem huge in comparison.

Why in my Traditional IRA?

I don’t have to keep records! The whole thing will be eventually taxable so I don’t have to keep tax records which I believe would be a PAIN in this type of strategy.

What am I missing with this strategy?

March 5, 2012 17 comments