How options can make you look dumb and smart at the same time

As I wrote, the HSI had an incredible week, and the Tracker went up 4% by itself. 

There were many outsized, single-day gains, particularly the ones that were long suppressed (tech comes into mind), and real estate. Heck, even China Vanke went up 20%.

The Dumb

Most of you would know that I have a income strategy with selling options-- through the virtue of a bull market, most of the calls I sold are exercised. A few good examples of missed gains:

Link REIT: wrote calls at 35. Today's price: 38.9
Commentary: I don't regret this being called away as Link REIT is a dividend payer. Dividend payers have very low volatility and hence very little premium yield. I didn't make any money with this one as I have to sell calls below my cost price. The dividend of 1.x HKD distributed was my saving grace, else I would be staring at capital losses.

Tracker Funds: wrote calls at 18. Today's price: 20.66
My cost price was 17... and I wrote calls for the same reason: Volatility on the tracker fund is way too low, and premiums are insignificant.

The Very Dumb

The only stock left in my portfolio as Anta Sports ("Anta") and Southwest Airlines. I regard Anta as a good company-- and selling puts on them have been more comfortable than most. Through the selldown last month, I have acquired a sizable amount of Anta, approximately 50% of the NAV of my income portfolio. 

The problem is, because Anta is already substantial, I did not sell a huge amount of puts this month, but I did sell calls on them, and unfortunately I sold calls on ALL of them.

So when Anta was priced at 69.4 HKD on 16 Sep, with my cost price of Anta at 77.3 HKD, I sold calls at strike price of 77.5, collecting a premium of only 0.417. The premium would be very low if the expiry is on 27-Sep (note: Hong Kong Exchange's options are only available monthly), so I sold the ones expiring on 30-Oct.

So what happen yesterday, 25-Sep?

I was in two minds on 23-Sep and 24-Sep if I should roll my options. Anta was priced at 75 (recall that my strike is at 77.5, expiring 30-Oct). So on 25-Sep, the stock open at 81.45 (practically busting my calls) and I was resigned to it being called away. What happen? the day ended back at 76 HKD. I felt like a genius for not covering/rolling my sold call options.

Charting can make you look like a fool sometimes. Notice the near term resistance at 80 HKD. The price action on 25- Sep would have hint that the market, as a whole, is not ready to go beyond that price point.

So I was reading this and thinking: this is great. Maybe I don't have to cover my calls.

Then today happened.

My call premium was 0.417. FML.

It would cost me MORE than the unrealized profits to cover this "short."

Note that Anta is now priced at 86.85. The strike of this option is 77.50. So there is a intrinsic value of 9.35 HKD. The additional 2 HKD is time value of the option, as well as the spike in implied volatility due to movement of the underlying.

So, what should I do now? Nothing. There is still time remaining in the option, and realistically, no option buyer (the other party in this contract) would exercise the option now (hence forgoing the 2 HKD worth of time value). The only time this happens is if there is a dividend of more than 2 HKD coming up.

The blog post is titled "How options can make you look dumb and smart...".... so where is the smart part?

The Smart
As my income portfolio is looking thin at the moment, I was looking for candidates to sell options for, and ran my screener for good companies. Good companies are basically compounders. They have decent ROE/ROICs, and usually are not priced cheap. A 52-week low of this list reveals an outstanding candidate for investment.... Nongfu Springs ("Nongfu")

There are two sides of the coin with Nongfu Springs. The pro side is: Nongfu has problems that are not economical in nature. Overly nationalistic rumours swirled after Wahaha Holdings' owner passed on, and certain Nongfu products have Japanese-looking design on them.

And then, there was this report of too much bromate.

This result in revenue falling for this natural water segment, but the other segments still displayed growth. I believe this problem is temporary.

However, Nongfu is priced to perfection, despite it falling to as low as 23 HKD a share. This is substantially lower than its IPO price, but by no means it present itself as a silly bargain.

There are two ways you could use options to acquire a position "for free." Notice the quotations-- they are NOT free and comes with their risks.

1) You sell ATM puts and use that premium to buy ATM calls. On normal days, the price should not be too different... if the premium for a put is 0.5 HKD, the call should be close. Today, however, isn't a normal day-- markets are way too bullish and demand for calls went sky high.

So what is the risk? If the stock goes down, the put you sold get exercised, and you have to buy the stock. But hey, you were ready to buy the stock anyway, right? So this isn't too bad.

2) You could use a call ratio backspread. 

A call ratio backspread involves selling a ATM call and using that premium to buy twice as many OTM calls.

E.g.: So assuming you liked Nongfu Springs at 28 HKD, but you are mindful that it still has problems and could go way down.

Selling a call, expiring at the end of the year,  at 28 HKD gives you 2.4 HKD. You would need to buy 2 contracts that cost you 2.4 HKD-- looking up the option chain, it happen to be priced at 31 HKD

So if the price goes down, you lost nothing as the sold call becomes out of the money.

If the price climbs gradually, you start to incur loss on the sold call. The moment the price goes beyond 31 HKD, those two call contracts that you bought becomes in-the-money, and the value of these options increases as the price increases. Eventually, if the stock does "moon," you close both positions.

You should only use a call ratio backspread if there is substantial downside and a substantial upside.

Well... hopefully this bull market have legs.