The Silent Killer

“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

“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

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.”

Did You Notice…?
By Carl Swenlin

Generally speaking, gold and the dollar have an inverse relationship – a rising dollar causes the price of gold to decline and vice versa; however, supply and demand pressures also influence the price of gold, but it is often difficult to see them. For this we use the GolDollar Index.

The GolDollar Index was invented buy Tom McClellan (, 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.

And the Markets…

WednesdayTuesdayThis weekYear-to-Date
DOW 10,594 10,616 -47-1.7%
S&P1,229 1,231 -51.4%
NASDAQ2,158 2,174 -27-0.8%
10-year Treasury4.40%4.39%0.120.18
30-year Treasury4.58%4.57%0.10-0.24
Russell 2000660 660 -201.3%
Gold$437.60 $434.70 $8.100.0%
Silver$7.09 $7.03 -$0.144.1%
CRB319.94 314.67 7.9412.7%
WTI NYMEX CRUDE$64.90 $63.07 $4.3349.4%
Yen (YEN/USD)JPY 110.72 JPY 111.98 1.73-7.9%
Dollar (USD/EUR)$1.2371 $1.2367 -2448.7%
Dollar (USD/GBP)$1.7935 $1.7867 -3606.5%
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