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Monday, September 25, 2017

Established Covered Calls in Alibaba Group Holding Ltd.

Today, the Covered Calls Advisor established a new Covered Calls position in Alibaba Group Holding Ltd. (ticker symbol BABA) with 26 days remaining until the October 20th, 2017 options expiration date.  This position is a relatively conservative one since it was established today when the price of Alibaba was $169.05 (5.4% downside protection to the $160.00 strike price).  This strike price is -0.68 standard deviations from the current stock price.  Note: A recent research paper "Which Index Options Should You Sell?" by Israelov and Tummla determined that in the range of -0.5 to -0.7 standard deviations on average yielded the best alpha returns for us options sellers.  

For Alibaba, the chart below (click on the chart to view a larger and more legible version) shows that the potential annualized return of +18.4% for this Covered Calls position is preferable to the +16.8% to establish a comparable 100% Cash-Secured Puts position. 

The implied volatility of the Call options was 30.3 when this position was established and the open interest was 20,811 contracts  

The downside 'breakeven price' at expiration is at $157.90 ($169.05 - $11.15), which is 6.6% below the current market price of $169.05.  

Using the Black-Scholes Options Pricing Model, the probability of making a profit (if held until the October 20th, 2017 options expiration) for this position is 76.1%. This compares with a probability of profit of 50.2% for a buy-and-hold of this Alibaba stock over the same time period. Using this probability of profit of 76.1%, the expected value for the annualized return-on-investment (if held until expiration) is +14.0% (+18.4% maximum potential annualized return on investment * 76.1%), an attractive risk/reward profile for this conservative investment.  

Finally, the 'crossover price' at expiration is $180.20 ($169.05 + $11.15).  This is the price above which it would have been more profitable to simply buy-and-hold Alibaba stock until the Oct. 20th options expiration date rather than establishing this Covered Calls position.


  1. Jeff,

    It's always interesting to see your trades. I have been doing much the same for over a year now, adding in the occasional cash secured puts. I started out with 2-3 month expirations, but have shortened up to the next monthly because the annualized return is theoretically higher. The strategy has resulted in greater than 30% annualized return. I attribute this to the upward movement of the market more than any genius on my part. The problem that worries me is what happens when the market reverses? Do you just walk away at that point after taking your losses or do you hang on to all of your positions that are possibly way out of the money?

    1. Hi Mark,
      Good questions. I would normally just increase my downside protection by lowering the strike prices on my Covered Calls (i.e. go deeper in-the-money). This requires us to be willing to accept lower annualized returns on our positions, but even a small annualized return is better than losing money when the stock market is declining.

      Another good alternative is explained in a prior post on my blog:
      This approach uses similar logic for obtaining added downside protection by going deeper in-the-money during bearish markets.

      Hope these thoughts are helpful to you.

      Best wishes,

  2. Jeff,

    I find your style very interesting!

    I do wonder though, what the difference in your strategy is from selling a naked OTM put in place of an ITM buy/write.

    Bearing any Vol skew, they are synthetically very similar however the naked put typically uses much less buying power (more left over to hedge).

    I appreciate everything you do here and I am not challenging your strategy, rather just trying to understand!

    1. Good question.

      I do not recommend investing using margin, which your comment regarding selling "naked" Puts implies. So, whenever I sell Puts, they are 100% cash-secured which (as you stated) would make them synthetically equivalent to Covered Calls.

      Here is a comment I made in a blog post in 2009 on this topic:
      "From my experience, margin investing imposes unnecessary additional stress on the investor. This tends to distort the calm, dispassionate temperament needed for our investment decision-making process. For this advisor, the potential for returns deterioration associated with this disadvantage more than offsets the potential incremental returns advantage that might otherwise accrue from leveraging Naked Puts."

    2. Understood! My question then would still stand with a cash-secured put instead. It would use the same buying power but cost less in fees than it would to buy a security and also write a contract.

      I definitely see writing ITM calls if one were to already OWN shares from a previous purchase and the market starts to get scary or choppy... However, why would he buy/write in that same environment over a synthetically identical position that might save $5-$10 (bearing vol skew)?

      You are the first person to ever talk any sense about the ITM covered call and to be honest... I am planning to put it into action next week with some of my shares simply due to the scary valuation of the market as a whole. Thank you for that!!

      Your style makes me wonder though if my put writing is not an error? Should I be buy/writing or am I okay to just keep writing cash-secured puts?

    3. In this Alibaba position, you can see from the chart that the potential annualized ROIs when established were 18.4% for a Covered Calls position and 16.8% for a comparable 100% cash-secured Puts position. Both of these calculations included my broker's (Schwab's) commissions, so the Covered Calls provided a slightly higher potential result than the Cash-Secured Puts in this instance. Normally, because of Put/Call parity, equivalent CCs and CSPs provide AROIs that are very, very similar so if your personal preference is to begin with CSPs, that's fine. I prefer to compare them (as in my chart) before investing -- and then transact whichever one (CCs or CSPs) is likely to provide a slightly better return result.