The Silent Killer

08/11/05 "I’ll happily accept a lower return in exchange for much
lower volatility," a seasoned stockbroker declared
yesterday. "That’s why I’ve been selling call options
against most of the Valero Energy stock that my clients
hold."

"Seems like a reasonable approach," your New York editor
replied. "I love the idea of selling a depreciating asset,
which is what most options become."

"Right," the broker agreed, "especially when the
depreciating asset is richly priced. I don’t sell options
all the time, just on the stocks that make me nervous…The
question I’m constantly asking myself is, ‘How do I
position myself so that I’m able to hold onto my hand and
not to fold too early?’"

"And the answer is?"

"Well there’s not just one answer, of course," the broker
explained. "But selling call options is SOMETIMES the
answer…Everyone knows you’re supposed to buy low and sell
high, but in the heat of the moment, most investors want to
do the exact opposite. They just can’t make themselves do
the right thing. If a stock starts to act badly, they’ll
want to puke it out, even if the stock’s fundamental story
is so good that they should be buying the thing with both
hands. They’ll puke it out to create the bottom – the same
bottom that the smart investors are buying into. So if you
sell calls against volatile positions, it makes it much
easier to hang in there."

"Agreed," we replied, "Volatility is a silent killer. It
destroys the confidence required to hold onto well-reasoned
investments…So how do you decide when to sell calls
against a position and when to do nothing?"

"Any time I’ve got a fundamentally strong company with an
unbearably volatile stock," he explained, "I’ll be looking
around for ways to hedge the volatility. The way I see it,
there are two kinds of stocks – the ones that you buy
outright and the ones that you hedge. Valero is a perfect
case in point. I have wanted to be long this name all year,
but it has been too volatile for most clients. So I
structured an option-write on Valero that allowed us to
hold some kind of position, without subjecting ourselves to
100% of the volatility. I knew going in that I would be
sacrificing some of the upside, maybe even a lot of the
upside. But I also knew going in that my day-to-day
volatility would be much lower. More importantly, I knew
going in that SOME upside would be better than NO upside."

"How’s the trade treating you, so far?"

"I have to say that I’m pretty happy with the results…and
none of my clients are complaining about picking up a 14%
return in 5 months. That’s a 35% annualized return after
all."

"What option did you write against VLO?"

"Well, I took the most conservative possible position by
selling a long-dated, at-the-money option. Back in early
March, we bought the stock around $69 and simultaneously
sold short the January 70 call option for about $11. So as
things stand right now, we’ve got a $22 gain on the stock
and a $12 loss on the short option, for a net gain of $10.
"Obviously, the unhedged buyers of VLO would have a much
bigger gain to show for themselves," the broker explained.

"But I know from my many years in the business that very
few clients would have tolerated the stock’s volatility
over the last five months. Most of them would have called
me in mid-May and begged me to sell them out of the stock
as it was tumbling through $60…and looking like it was on
it was to $50. But we hung in there and made a few bucks."
"Sounds good," I said. "Making a few bucks is better than
losing a few, if I recall my Econ. 101 coursework
correctly."

It is always true, dear investor, that some investor
somewhere will be making more money on something than you
will. Such is the natural order of the universe…someone
is smarter, someone is prettier, someone is luckier and
someone is making more money in the stock market. But we
accept these realities without complaint. We do not care to
join the "thin tails" of life’s bell curve, merely to avoid
the losing side of the probability distribution. We don’t
care about winning the lottery, for example, we just don’t
want to lose our shirt.

To further this ambition, selling options can be a helpful
ally.

The nearby chart tracks the historical performance of two
VLO investments: 1) An unhedged 500-share purchase in early
March and; 2) A 500-share purchase hedged by the
simultaneous short-sale of 5 VLO January 70 call options.
As our stock-broker friend readily admits, the unhedged
purchase of VLO would have produced twice the return of the
covered call position that he established in early March,
but it also would have subjected investors to much higher
volatility.

As of May 16, for example, the naked VLO buyer would have
been nursing a paper loss of more than $4,000. By contrast,
the covered-call investor never saw a loss of more than
$1,800. That’s because the drop in value on the "short"
call option offset some of the losses on the "long" VLO
stock. Such is the beauty of covered-calls.

And let’s not forget that VLO might not have recovered as
promptly as it did. It could have languished at lower
levels for many months. In which case, the covered-call
writer would be sitting on small profits or very small
losses, while the naked stock buyer would be suffering
large losses.

We would also point out that our broker-friend initiated
one of the most conservative of all possible option
strategies. Had he wished to be a little more aggressive,
for example, he could have sold short options with a higher
strike price, instead of the January 70s. If he had sold
short the VLO January 80 call options, for example, his
covered call position would be up about 20% right now,
instead of 14%.

Option-selling is not appropriate for every stock. But as
our friend observes, it’s not a bad strategy for the
"stocks that make you nervous."

The GolDollar Index was invented buy Tom McClellan
(www.mcoscillator.com), and is calculated by multiplying
the price of gold by the U.S. Dollar Index. (We divide the
result by 10 to keep the numbers from getting too big.) Its
purpose is to cancel the effects of currency fluctuations
on the price of gold. By comparing it with the spot gold
index we can determine if there is inherent
strength/weakness in the price of gold.

The first panel on our chart shows that the GolDollar Index
has been rallying since the beginning of the year and has
exceeded its 2004 high. This means that the demand for gold
has been strong enough to overcome the negative effects of
the dollar’s strength. This is also evident from the fact
that, rather than declining, gold has been consolidating in
a triangle formation, even though the dollar has been
rallying.

Now the dollar has begun a correction (see bottom panel of
chart), so it is likely that gold will be breaking out of
the triangle and challenging the 2004 high around 450.
Assuming that (1) gold’s intrinsic strength persists, and
(2) the dollar continues to correct to its support around
85, gold could rally above the 450 level by 10 or 20
dollars.

Unfortunately, such a move will likely prove to be a gold
bull trap. The weight of the technical evidence indicates
that the dollar has begin a long-term rising trend, which
is long-term bearish for gold. But for now, the dollar is
showing short-term weakness, and gold has intrinsic
strength – a combination that should make gold bugs very
happy…for a while.

Eric Fry

Eric J. Fry,  the Publisher of The Daily Reckoning, has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling. Mr. Fry launched the sometimes abrasive, mostly entertaining and always insightful Rude Awakening. His views and investment insights have appeared in numerous publications including Time, Barron’s, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times, San Francisco Chronicle and Money.  He appears regularly on business news stations like CNBC and Fox. Special Report- “Why Oil will Hit $200 a Barrel! What to Do to Protect Yourself Financially“

View articles by Eric Fry

Other Daily Reckoning Articles:

• September 12, 2007 -- A New Record!
• May 12, 2009 -- Inflation and the Mass Confusion to Follow
• November 26, 2008 -- Billions in Bank Rescue Funds are Fueling Buyouts, Instead of Lending
• February 16, 2006 -- Between The Devil And The Deep Blue Sea
• June 3, 2005 -- Imperial Conceits

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