Recommended Reading -- #4

I.  Over the years, whenever I need to learn more about any investing-related topic, I invariably do a search in Investopedia.com (here).  It is an excellent resource, so I would encourage you to do likewise whenever you encounter an investing-related term or concept where you would benefit by obtaining some additional insights.
I recommend reading this article: link (from Investopedia.com) titled "The Ins and Outs of Selling Options".   This article explains why options tend to favor the options seller over the options buyer, how to get a sense of the probability of success in selling an option, and the risks associated with selling options.  In short, it provides some useful insight on why we sellers of options (both Calls when we establish Covered Calls positions and and also Puts when establish 100% Cash-Secured Puts positions) have a financial advantage over buyers of options. 

II.  Over a decade ago on this blog, I wrote an article titled "Exploiting Our Covered Calls Investing Edges" -- read here.   In it, the following twelve primary "edges" (i.e. advantages) of Covered Calls investing when compared to a stocks buy-and-hold strategy were identified as:
1. Specialize in Covered Calls Investing
2. Active Management
3. Value-Oriented Stock Selection
4. Adjust Moneyness of Strike Prices
5. Sell Higher-Than-Average Volatility
6. Exploiting the Volatility Risk Premium
7. Increase Frequency of Trading
8. Adjust Our Position Sizing
9. Seek to Minimize Losses
10. Invest in Non-Correlated Assets
11. Use a Tax-Advantaged IRA Account
12. Use a Dividend Capture Strategy When Appropriate

In last week's Recommended Reading, an article was included where we thought about whether Peter Lynch, Warren Buffett, or John Templeton might have been the greatest investor of all time.  But their performance was much lower than that of the Medallion Fund (run by Jim Simons' company, Renaissance Technologies), that achieved an astounding 66%+ annualized return-on-investment over a 30-year period.  I was reminded of this while reading about their investing methods in this excellent book "The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution" (see here).  

Even if you don't read the book, I do strongly recommend you read the related information in this fascinating article (please read it carefully here).  As I was reading it this week, I focused on whether the Medallion Fund's super-successful approach could also be applied to our Covered Calls investing strategy as additional (i.e. secondary) Covered Calls investing "edges".  Fortunately, I identified four of their concepts that could be beneficial in our approach to Covered Calls investing, namely: 
1. Regarding Medallion's increased frequency of trades -- we can establish some weekly and/or bi-weekly CC trades instead of only monthlies.  The advantages to us is that shorter duration positions provide us (a) higher potential annualized return-on-investment results; and (b) more frequent opportunities to adjust the strike prices of subsequent positions based on up-to-the-moment stock prices and current market trends.
2. Regarding their position sizing decisions (using the Kelly Criterion) -- we can calculate our expected value return-on-investment for all Covered Call positions we are considering prior to entering the trade.  Therefore, we can also apply the Kelly Criterion when deciding our position size for each Covered Call investment we make.
3. Regarding improving long-term returns -- Please answer this question: If you lose 20.0% on your investments in Year 1, what percent increase will you need in Year 2 to get back to breakeven?  If your quick answer is 20.0%, you are incorrect.  The correct answer is 25.0%.  Compounded returns over time are not arithmetic averages.  Compounded returns are geometric averages, so as this simple example demonstrates, it takes a higher return-on-investment to fully recover (back to breakeven) from a negative return-on-investment period. 

So, we want to work hard to avoid losses since we have to achieve higher returns to bounce back to breakeven.  Therefore, good compounded returns are achieved by minimizing losses in comparison to that of the overall stock market.  Warren Buffett understood this principle very well (see image)

Achieving this will result in a reduction in the standard deviation of our investment returns over a period of time, and we know this is true because it is well-documented that Covered Calls are 30% less volatile than their comparable buy-and-hold stocks.  As Covered Calls investors, by selling Call options against our long stock positions we are hedging our long stock positions which reduces volatility by providing (a) downside breakeven price protection; and (b) decreased portfolio drawdowns during neutral and especially in bearish market periods.  The end result is an improvement for our overall geometric compounded returns.
4. Regarding Claude Shannon's contributions to the Medallion Fund's investing philosophy -- It is directly related to his work on rebalancing and correlations.  Like Medallion, we can also enhance geometric returns in our Covered Calls portfolio by both regularly rebalancing our portfolios and also by including non-correlated assets in our portfolios.  For example, related to non-correlated assets, we can establish Covered Calls portfolios with a group of stocks that are diversified by most of the eleven U.S. stock sectors as well as by including some positions with significant exposure to non-U.S. (i.e. international) markets.

I hope I didn't lose you in #3 above, but if I did and you want to understand it further, a careful reading (and perhaps a re-reading) of this article (read this link) will aid your understanding.  Other posts in this "Breaking the Market" blog (here) are also helpful in learning more about the four concepts listed above.  Finally, related to #3 above, I am often asked "How do I pick a strike price?".  I plan to address this question further in the near future, hopefully in my next Recommended Reading article on this blog.
  

III.  Is the Stock Market currently "Overvalued"?  According Buffett's favorite indicator, the answer is definitely "YES".

 

 

 

 

 

 

 

 

 

IV.  This video is a short master class in stock selection: Buffett/Munger Video.  Here, the legendary investing team of Warren Buffett and Charlie Munger describe the 4 key filters they use when evaluating whether a particular company is a worthwhile potential investment.  These 4 factors are an important part of the Checklist I now use (see blog post here) when doing my own detailed research on each company I consider as a potential candidate for my Covered Calls Advisor Portfolio. 

Hope you have found worthwhile/useful information in this post.

Regards and Godspeed,

Jeff Partlow
The Covered Calls Advisor
partlow@cox.net