Covered Calls : Extra Income, Yes*

Zero tolerance takes on a whole new meaning 

The last time the US Federal Reserve raised rates was in Jun 2006. Some central banks around the world have even cut interest rates to negative. Not surprisingly bond yields have plummeted to record lows. Throw in the financial crisis of 2008 and the unprecedented destruction of wealth it brought about and you are looking at a picture tinged with pathos. Clearly, the last few years haven't been kind to savers, especially those in the developed world. And the bad news is - interest rates might not go up in a hurry, as less-than-moderate inflation (and signs of deflation is some economic blocs) lessens the likelihood of a rapid liftoff in interest rates in developed world markets.

The hunt, therefore, for that extra bit of income has never been as intense as it is now.

One (albeit non-traditional) strategy that investors may want to consider to generate that much needed additional income is Covered Calls.

Into the world of Covered Calls

A covered call is a financial market transaction in which you could turn into an option seller (alternatively, called an option writer) by writing a call option on stocks that you already own in your portfolio. The value of that specific option you have written is derived from various factors, like the volatility of the underlying stock for instance. This value, simply put, is the income that you, as the option writer, will earn from that transaction. This income is guaranteed. Yes, you read that right - This. Income. Is. Guaranteed. Now this is exactly where a Covered Call strategy can go awry. Very often the positioning of this strategy makes it look very innocuous (I have often heard asset managers loosely refer to this strategy as 'Renting out your stocks') and well, despite the risk-free premiums  you pocket, this strategy, as we will soon see, isn't free from risks. 

But first, lets look at this from the perspective of the option buyer as well. The buyer of a call option is always expectant of a rise in the price of the underlying stock at expiry (in this instance, let us assume that the option is European style) and if, on expiry, the stock does close above the strike price then the option buyer will exercise his right to buy the stock at the agreed strike price.

Now onto an example to understand this better, let us assume that you have a 1000 shares of Google at a average cost of $400. The current market price of the stock is $761.98 and you most definitely are looking at a sizable mark-to-market profit on your position. You should be one happy investor, right? Not really, instead you are in a quandary. Why? Three reasons (and these are true for Google and pretty much any other stock):

1. You will need to sell out your stock position to realize your capital gains. This might mean reducing your ownership in that very stock that you consider to be a powerhouse of sustained growth, to zilch.
2. You own the stock and you continue to believe in it's growth story but you are finding it difficult to monetize your ownership and generate income (since the company continues to retain earnings and invest in newer profitable avenues for growth). You are also reluctant to manufacture dividends by selling units of your ownership whenever the need for income arises.
3. And lastly, if you bought a stock after it has suspended dividend, how are you best placed to monetize your investment between the purchase date and the expected date of dividend reinstatement? 

It is in situations like these that you might want to consider a Covered Call strategy.

Recall the example I quoted earlier; You hold 1000 shares of Google @ $400 and the current market price of Google is $761.98 and your thought cloud right now contains the first two of the three reasons I mentioned earlier. You think that you would like to earn an income from your Google position and decide to write a call option on exactly 1000 shares of Google at a strike price of $ 775 expiring in a month from now. Lets assume you earn a grand premium of $ 300 for writing this option :-) We now cut to the day when the option expires.

Situation 1

If the Google scrip closes below $775 then good for you, break open that crate of beer and party all night. You made a profit of $ 300 and, more importantly, still own 1000 shares of Google at an average cost $400!

Situation 2

However, if the Google scrip closes at $777, then you are forced to sell your entire holding of 1000 Google scrips to the option buyer at $775 despite the market pricing the very same scrip at $777. You have still made a tidy profit though :  {(775-400)*1000} + $ 300.

Hang on, you might say, I have profited in both these situations then what exactly is the risk in a Covered Call strategy?

And therein lies the case of a potentially large opportunity loss ..

Look closely and you will realize that there is indeed a loss in the second situation. You were forced to sell your Google position for $ 2/share lesser than its market price. An opportunity loss of $2000! Most explanatory articles on a Covered Call strategy cite examples similar to the Google-one that I have used . And that is precisely where this strategy conceals its tail-risks. Most examples, including the one that I  quoted, simulate a very mild Situation 2. Very often gains on the long position are stated to reduce the disappointment of an opportunity lost to sell at the market price (which in these examples are usually only slightly higher than the strike price used).

You would look at a Covered Calls strategy with more suspicion if I had replaced the $777 market price at option expiry in my Google example with, for instance, $901. Your opportunity loss just for that one day (when the option you wrote expired) would be a whopping 15.95%!

Come now, I hear you say, is that even a fair assumption to make? Isn't it ridiculous to assume a 16% single day uptick in an index heavyweight like Google? 

Ridiculous? Possibly. But it did happen ......

On Jul 17, 2015, Google, in just one day, added a record $65 billion to its market capitalization (Google Adds a Record $60 Billion to Its Stock in One Day). What Google added to its market capitalization in just one single day was more than the size of Hewlett-Packard! On that day, after being locked in a narrow range for a while, Google shares rose a phenomenal 16% to a (then) record $699.62. As call option buyers cashed in their chips, one can only imagine the massive flight of assets from Pension Funds and Asset Managers, particularly those overseeing equity funds focused on Technology. A tail-risk had just ripped through the world of Covered Calls and the stocks you thought you had 'rented' out for a while had found a new owner.   

Asset Bubbles : 3 tell-tale signs that show you might be in the midst of one

Discerning readers may already have identified the image in this post as A Satire of Tulip Mania by Jan Brueghel. The Tulip Mania, said to have occurred in 1637, could well have been the first ever asset bubble in the history of mankind. At the peak of the mania, tulip bulbs reportedly sold for ten times the annual salary of a skilled craftsmen. Look closely and you will notice the artist's depiction of the subsequent collapse in tulip prices and its impact on investors - A few monkeys are shown in a debtor's court and one is being carried to its grave. The history of financial markets have been littered with numerous examples of Asset Bubbles. Japanese Equities in the 80's. The Dot Com bubble. The Latin American crisis in 2001-02. And, more recently, in 2008, the housing market crisis in the United States.

The slew of crises through time suggest that assets bubbles are inevitable. There aren't any definite indicators or predictive models in place to identify one (If there were any, then we would never have had any in the first place). I believe though there are a few tell-tale signs that might indicate that you are in the midst of one.

The Non Traditional Buyer

One of the very first signs of a possible bubble in any asset class is when a Non Traditional Buyer shows interest in an asset class that he or she had until then completely shunned. I remember speaking to a leading jeweler in September 2011 and asking him whether he thought that the bullish forecasts on Gold had substance (Spot Gold was then trading at $1920/ounce and most forecasts predicted a $2000/ounce in 2012). The jeweler considered the question carefully , shook his head slowly and said, "I don't know". He then said, "For the very first time in my thirty-three year career as a jeweler, I have seen Western Expatriates walk into my stores in large numbers and buy significant amounts of gold and that puzzles me".

Not surprisingly, Gold retreated significantly after that.

This is very similar to how the Chinese Middle Class approached Copper as an Investment Asset in 2007. Those were the hey days of Copper and while difficult to imagine, what happened was this - Chinese Middle Class households bought copper vessels overnight (even when they did not need it) and then checked if copper prices had moved up in the market the next day!

Momentum trumps Value

Bubbles also tend to be characterized by a gradual shift in the approach to Asset Valuation. Traditional Relative Value indicators like a Price-to-Earnings or a Enterprise-to-EBITDA ratio are relegated to the background. The focus intensifies on the Momentum Indicators - 52 week high-lows and the Moving Averages, for instance. Not surprisingly, this stage is also characterized by corporate statements that are best described as flippant - A simple "We are growing" statement is enough to push their stock into the orbit. Ever wondered why, during a certain phase of the financial markets, the Walmart stock in your portfolio remained staid while the Casino Stocks that the Jones' invested into quadrupled in a short span of time? You haven't got it wrong. That's just momentum at work.

The Cabbie Rule

This is a simple one. You sense you are in bubble territory when you get into a cab and at the end of your ride, your cabbie, a grizzled man well into his winter years, turns around and asks you, "Which stock do you think I need to put my money into?"

You are completely nonplussed for a couple of seconds. Its tough for you to understand how this investor (who, considering his life-stage, should have been extremely risk-averse) could have leap-frogged to the other extreme of the risk spectrum - Into a space that can best be described as the realm of speculators.

The possibility that you are in the midst of a bubble isn't because he asked you that specific question.

Its because you knew you did not have an answer.

Wardrobe essentials for India's next Prime Minister

Narendra Modi is known as a man who pays great attention to details. A lot has been written in the media about how he and his team have meticulously planned his Prime Ministerial campaign.

And yet, according to The Economist, they seem to have overlooked a rather significant aspect. His wardrobe. The Economist (India's election : Can anyone stop Modi?) says, "Mr Modi has refused to wear a Muslim skullcap and failed to condemn riots in Uttar Pradesh in 2013 when most of the victims were Muslim."

As ridiculous as it may seem, that comment gives you an insight into what Modi is really up against this month.

A very low likelihood of Muslim Votes isn't the biggest threat to Narendra Modi's election campaign this summer. Side-lining several senior leaders within his own party also was never as big a threat as it was made out to be initially. Modi's biggest threat at this stage in his campaign is Pseudo Secularism (sometimes referred to incorrectly as Hindu Chauvinism).       

I am glad he is not fighting it.

(c) All views expressed in this blog are my own

India's mission creep

Last year ended on a very dismal note for India's ruling Congress Party after its defeat in the state elections. This isn't the first time in the history of Indian Politics that the voter has exhibited decisiveness. The man on the street, perhaps, first demonstrated the power of a vote (and responded to an open palm of the hand with his fists clenched in fury) in the General Election of 1977. Public anger, at the Indira Gandhi led government's attempt in 1975 to override Democracy, catalyzed by the stirring idealism of Jayaprakash Narayan propelled the Janata Party to power in 1977 making it the first non-Congress party to form a government at the center.

Another instance of the voter's decisiveness that comes to mind is N.T.Rama Rao's meteoric rise to power in 1984, after his party, the Telegu Desam Party (TDP), formed a mere nine months earlier, won an absolute majority in state elections in the Southern Indian state of Andhra Pradesh. 

These are compelling instances of the Indian Voter not being unduly swayed by the sense of entitlement that the Indian National Congress has had over the politics of post-Independent India.

Cut to present day and we see, in Delhi, yet another instance of the voter bestowing power upon a party that has so far made earnest and insistent claims about how they are going to redefine politics in the country. In the wake of its stunning debut in the state elections at Delhi and months before the 2014 General Elections are due, the Aam Aadmi Party (AAP) has, unquestionably, fired the imagination of the entire nation.

AAP, formally launched on November 26, 2012, lists Swaraj and Anti-Corruption among its key ideologies on the party's website www.aamaadmiparty.org. The party expands the premise of Swaraj to include a government's direct accountability to people. Other actions taken by the AAP that have struck a chord among its proponents include their shunning the usual trappings associated with an elected representative of the people. Retinue. Coterie. Syndicate. Sirens. A shocking reliance on Public Transport instead of motorcades. Eschewing bungalows provided for by the state. And an absolute insistence that the party comprises of only common men.

This may well be the beginning of India's exhilarating tryst with a change that will continue to widen in its scope. What started out only as a India Against Corruption movement could soon encompass all aspects of governance. There could, for instance, be a more pronounced tilt towards Technocracy - a form of governance where key decision makers are selected based upon how knowledgeable and skillful they are in their chosen field. The party has also decried dynastic politics and is fiercely passionate about implementing the Right to Recall law - a proposed law that would allow citizens to replace elected representatives midway through their term if found corrupt or for reasons of non-performance. 

And therein lies the risk of the party getting sucked ever deeper by "mission creep". 

Mission creep is the expansion of a project or mission beyond its original goals, often after initial successes. Mission creep is usually considered undesirable due to the dangerous path of each success breeding more ambitious attempts, only stopping when a final, often catastrophic, failure occurs. The term was originally applied exclusively to military operations, but has recently been applied to many different fields (Source : www.wikipedia.com)

Some nasty examples of mission creep that immediately come to mind are the US Military's bungled operations in Vietnam during the war. Closer home, I find the UIDAI an example of a project that veered off its rails as the scope of that project started to widen beyond it initial mission statement. 

As the fledgling party now diverts its energies towards the looming national polls, AAP increasingly risks getting sidetracked from their core plank of Anti-Corruption. On the very first day of this new year, after first being introduced on the floor of the parliament in 1968, the President of India signed the the Jan Lokpal bill into a law. However, the notion of Jan Lokpal still remains exceedingly hazy and the institutions of Jan Lokpal and Lok Ayukta's remain as phantom-like as ever. It still isn't clear how the Jan Lokpal intends to fight corruption. In the early stages of the India Against Corruption movement in 2011, there were fleeting comparisons made with Hong Kong's battle with corruption. In the early seventies, Hong Kong won its long drawn battle against graft after the government created a highly empowered Anti-Corruption body to crack down on corruption, especially in their police force. Their sense of urgency was unmistakably clear. Also remarkable was the average Hong Kongers determination to never tolerate corruption again. 

You wouldn't want your favorite prizefighter walk out of the ring, due to a new found interest in tap-dancing, after having a very formidable opponent on the ropes. This still remains India's most opportune moment in time to root out corruption forever. One hopes that the AAP remains as closely aligned as possible to its primary goal of fighting corruption.

Other problems that face the nation can wait. For the time being. 

(c) Avinash Menon. Views expressed in my blog are my own and do not represent the policies or views of any political establishment or the Government of India 

Adieu Sachin!

In Greek mythology, Atlas was described as a giant who held the planet on his shoulders. The legend is that 'he stood, blood running down his chest, his knees buckling, his arms trembling but still trying to hold the world aloft with the last of his strength. The greater his effort the heavier the world bore down upon his shoulders'. Until, one day, he simply shrugged his shoulders and walked into a golden sunset.

 

After an unparalleled 24 years in international cricket during which he, unflinchingly, carried the hopes of a billion strong nation on his shoulders, India's greatest sporting icon, Sachin Tendulkar, announced his retirement from the game on Nov 16th, 2013. Adieu Sachin!


(c) Avinash Menon

Ashes to ashes ...

The little guy with the square jaw strode into the arena. He walked briskly, his body betraying no signs of the growing tempest within. A large rowdy group of spectators greeted the squat foreigner with loud jeers. A visibly large section of the crowd were up on their feet and making a really strange gesture with their arms. As one group and in perfect unison, they collectively bent low to their right, pulled their right hand back and with clenched fists, swung up hard at a phantom figure.               

They were mocking him for an earlier misdemeanor. Reflexively, the squat man grinned. As he continued his brisk trot out to the middle, in his mind's eye, he replayed the grisly scene that he was about to orchestrate. This is how he saw it panning out - He would take guard in the middle and then against the backdrop of an angry mob baying for his blood, he would slay the Home Lions. One by One. Until all eleven Home Lions lay lifeless in the arena. He would then rip off his armour, wipe the bloody entrails off his brow, hold his arms aloft and scream at the crowds - "Are you not entertained? Is that not why you are here"

David Warner did not do any of these.

Far from it. After playing an inspiring knock that raised hopes of a rare Aussie win in the fourth Ashes Test at Durham, Warner's post match press-conference was as pathetic as it can get. This is what he said. "When I first came back and I got booed walking out at Manchester I felt real nervy. I felt real small. I felt that everything was against me.". He also added, "We were talking about it just before, what goes through our minds when we walk out there and how rowdy the crowd was. It does help having the home [crowd] behind you ...."

That pretty much sums up the current state of Cricket Australia.

The whining has now reached a crescendo. The masters of sledging now no longer greet rival batsmen with imaginatively thought through barbs. The once trademark swagger has morphed into an ungainly stagger. You can now say with certainty that the Aussie rout is complete. Alas! How the mighty have fallen.

Wait a moment! Did you hear that? Did that sound like a yelp?

Is that you Pup?

(c) Avinash Menon

The Curious Case of Messrs Gross and Fink

The story so far ..

The Fed has so far purchased $ 2.5 trillion in assets since December 2008 and its balancesheet continues to rapidly balloon in size as, in the third round of bond purchases under the quantitative-easing stimulus strategy, it continues its $ 85 billion monthly purchase of Treasuries and Mortgage-backed bonds. The Fed isnt acting in isolation. Policy makers around the world (including the Fed) have pumped in more than $ 6 trillion into the global economy through asset purchases, increasing their balance sheet assets to $ 14.09 trillion as of June 2012. This is up from $ 4.99 trillion in May 2006!

These asset purchases were largely driven by the Fed’s policies. All policy moves by the Fed so far, ZIRP, QE1, QE2, Operation Twist and ‘Infinite’ QE3, were aimed at stimulating  a sluggish economy.  In the initial phases, fears were rife that the first two rounds of Quantitative Easing were nothing but the Fed trying to ‘monetize its debt’ (Central banks in most developed nations,  like UK, US and Japan for instance, are forbidden by law to buy government debt directly from the government and must instead buy it from the secondary market. Thus a two-step process, where the government sells bonds to private entities which the central bank then buys).  Bernanke has been earnest in his appeals however that the easing was to stimulate the economy and not to finance government spending (and I guess, we will have to take his word for that!).

...Operation Twist

This was followed by Operation Twist - A attempt to flatten the yield curve by selling short term debt and using the proceeds to finance the purchase of longer dated treasuries. While this may be just what the doctor ordered to keeping the balance sheet from ballooning any further, Operation Twist has a severe limitation. To finance the purchase of longer dated securities you need to have an inventory of short dated securities to sell. Unfortunately, the Fed will soon run out of short term bonds to sell. What then?  What do you do when you no longer have 0-3 year bonds to sell? Simple, you start selling the longer dated bonds from your portfolio. The Fed had until now indicated that the plan was to keep the Federal Funds rate at the zero range atleast until mid 2015. Its very likely that the ZIRP will be further extended in time.

The objective of ‘unlimited’ QE3 (While continuing its purchase of $ 40 billion per month of MBS, the Fed will also buy $ 45 billion of Treasury Debt every month; The second part of the plan replaces Operation Twist) was to put downward pressure on long-term interest rates. Much like the two phases of easing announced earlier. On September 7, 2012, the Friday before QE3 was announced, the yield on the 10-year Treasuries was 1.67%. On September 14, the day after the QE3 announcement, it had surged up to 1.88%. This was not the desired effect and it is possible that this may have been due to investors flocking to riskier assets like equities and high yield debt from treasuries.  

Bernanke may rest easy in the fact that the 10 year yield averaged 1.79 percent in 2012. The average in 2011 was 2.77 per cent!The average yield registered in 2012 is still significantly greater than the record low of 1.379 percent on July 25, 2012 at the height of Europe’s sovereign debt crisis.

By late 2012, unprecedented stimulus by the ECB had tempered the sovereign crisis in Europe and curtailed the demand for safe haven assets like Gold and Treasuries.  10 year yields seem to have plateaued at sub-2 levels, so is there really a case for purchasing treasuries at the moment?

.. and onto Messrs Gross and Fink

That brings us to the two gentlemen in the subject of this post. One of them is pugnaciously long on treasuries. Bill Gross, who runs the world’s largest bond fund, raised the percentage of Treasuries held in his flagship Total Return Fund to 26 per cent in December 2012, up from 23 per cent of assets in November. MBS still remains the flagship fund’s largest holding, though its proportion has reduced to 42 percent from 44 percent since October 2011. Gross has stated that he would steer clear from longer-dated treasuries as inflationary effects of the Fed’s massive scale of Quantitative Easing will be felt many years later. PIMCO, with $1.92 trillion in assets under management, is primarily a fixed income manager. So this is one really monstrous bet on treasuries by Gross, who co-founded the firm in 1971 (Gross incidentally is one of the rare few fixed income managers to have got in, more than thirty years ago,  on the ground floor of this spectacular bond rally). But even best laid plans can sometimes go wrong.

Gross had apologized to his investors in 2011 after, earlier in that year, he had sold all his treasury holdings.  Yep. He had reduced his holdings in treasuries to zero by March 2011! Why? It was because he believed then that the Fed would stop buying bonds at the end of June 2011 as its QE2 program wound down. Gross watched his worst nightmare come true as the Fed announced a continuation of its quantitative easing program. A few months later, an extraordinary tail risk emerged, sending shock-waves across the world. The US had lost its prized AAA rating! However, amidst the shock-and-awe, the world didnt end as we thought it would and far from triggering an exodus from Treasuries, investors piled into US Treasuries. As equity markets worldwide crumbled, the US treasuries were perceived as the ultimate safe haven by stunned investors seeking refuge from wealth destruction and increased volatility. Yields tumbled swiftly and Gross was left to rue his short treasury postion. With an approach that can best be categorized as extreme risk-averseness, will things turn out differently for him this time around?

The answer to that question may well lie in the world of extreme risk. In February 2012, Larry Fink, the CEO of BlackRock, made a statement that sounded ludicrous then. He said ‘investors should have 100 percent of investments in equities because of valuations and higher returns than bonds’.

(c) Avinash Menon