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Saturday, March 15, 2008

The Black-Scholes Formula is Wrong! - Part 10/12 - Only Fools and Hedge Funds Write Covered Calls

Table of Contents

Part 1 - Overview and Background
Part 2 - Axioms
Part 3 - Formula Derivation
Part 4 - The Put/Call Parity Formula
Part 5 - The Volatility Smile
Part 6 - The Contradiction
Part 7 - Resolving the Contradiction
Part 8 - The Kelly Criterion
Part 9 - How FSK Trades Options
Part 10 - Only Fools and Hedge Funds Write Covered Calls
Part 11 - Other Options
Part 12 - Summary

There's an odd tax loophole for retail investors who write covered calls. If you write a covered call against stock you own, that isn't considered taxable income. Instead, your cost basis in the stock is reduced by the premium received when you wrote the call. This deludes some retail investors into thinking that writing a call is a good deal. It's actually an incredible ripoff.

Remember that EVERY LISTED EQUITY OPTION IS MISPRICED. Calls are usually underpriced and puts are usually overpriced. If you write a covered call against stock you own, you are giving up the most lucrative part of your payoff distribution, the tail. Inflation is 15% or more. Owning stock gives you the possibility of a huge payoff in absolute dollar terms, even though it's a smaller return in inflation-adjusted terms. When you write a covered call, you're reimbursed as if inflation were only 4%, which is a raw deal.

Similarly, buying a put is a ripoff. Due to inflation, the stock is much more likely to go up than is priced into the put.

If you have specific information that a stock is likely to go down, you may buy a put. You are making a huge anti-percentage bet. Even companies that are horribly mismanaged can manage a stable or increasing stock price, due to the benefits of inflation and the massive government subsidies that large corporations receive.

If you own stock and are considering writing a covered call or buying a put, there is a more attractive alternative. Suppose you own shares in a stock that has gone up in value, and you want to hedge against loss. In that case, you would be better off selling half your shares (paying capital gains taxes) and then buying some call options. Take the surplus cash and invest it elsewhere. This way, you would still benefit if the stock continues to rise. You would be protected against loss. Selling shares of stock and buying a call is logically equivalent to buying a put. However, calls are underpriced and puts are overpriced, so buying the call is a better deal.

Even after the effect of capital gains taxes, selling stock and buying a call is *MUCH* more preferable than selling a covered call or buying a put.

If you do sell stock and buy calls to replace them, make sure you wait 30 days in between each leg of the trade, so it doesn't count as a "wash sale". I read the IRS capital gains tax rules, and it was ambiguous if a stock sale followed by a call purchase is considered to be a "wash sale". I wait the 30 days just to be sure.

From the point of view of a hedge fund manager, it DOES make sense to buy puts and sell calls. When you are a hedge fund manager, you are investing other people's money. If you lose money, you risk losing your job as investors pull out their money. If you make a 20% return while the market is up 30%, then people probably won't pull their money out of your hedge fund. There's a psychological barrier for negative returns.

If you're a hedge fund manager, your goal is to maximize your PERSONAL income, not the expected return of your fund. You're willing to trade away expected return for less variance, because of the risk of losing your job if you have bad returns.

Further, hedge funds use leverage ratios of up to 7x when buying stock. They may not get the same preferential treatment when they trade options, or the hedge fund manager may not be very knowledgeable about options. The hedge fund manager is borrowing at 5% while inflation is 10%-15% with a leverage ratio of 7x, yielding a return of 35%-70%. In that case, the hedge fund manager can afford to give up some of his expected return by writing covered calls and buying puts. This guarantees that the hedge fund manager gets to keep his job no matter what.

This position where you own stock, wrote a covered call, and bought a put is called a "synthetic call spread". You can achieve the same return by buying a lower strike call and short selling a higher strike call. However, only professional options trader gets preferential margin treatment when making this trade. The hedge fund manager probably only gets preferential margin treatment when he uses a 7x leverage ratio on his stock position. Further, if you own the stock, you get to vote on management. A hedge fund could buy 5%-10% of the shares in a corporation, buy puts to protect themselves from loss, and still pressure management to make certain changes.

It doesn't pay for the average person to write covered calls or buy puts, because the odds are statistically against you. When you write calls or buy puts, you're betting AGAINST inflation. Unless you have specific information a stock is going to tank soon, don't buy a put. If you own a stock and want to reduce your risk, you're better off selling some shares, buying some calls, and investing the extra money elsewhere. Don't write covered calls against stock you own, and don't buy puts to hedge against loss.

1 comment:

Anonymous said...

Very, very stupid comment about inflation and the movement of stock prices. Options trading can be about timing (not just hedging), as a result, many stocks move down in the short-term (which can continue over a longer period of time). I can't believe someone would post something like this. I personally know people making tons of money by buying puts and selling calls.

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