Current subscribers are not left out. There is a separate random drawing for them.

First issue goes live March 22.

Expiring Monthly is the brainchild of five of the top options bloggers on the Internet:

• Adam Warner of the Daily Option Report

• Bill Luby of VIX and More

• Jared Woodard of Condor Options

• Mark Wolfinger of Options for Rookies

• Mark Sebastian of Option 911.

Their goal is to provide a monthly magazine in digital format that’s informative to new option traders, yet interesting to the most experienced traders. Those bloggers, who are now contributing editors to Expiring Monthly, have varied backgrounds.  Three have on-floor market making experience; three have authored at least one book on options.  Summing their trading experience, they have been trading options for 77 years.

You can view the Table of Contents for the first journal here. Double click the image for a better view.

Subscribe to Expiring Monthly risk free.

If not completely satisfied with their initial offering, request a refund within 30 days of subscribing, or prior to receiving your 2nd issue: Whichever is later. No questions asked.

I love this sort of deal. All you have to do is set yourself a reminder in your calendar to consider cancelling. In this case you get to try the first issue for free and if you don’t like it then cancel and get your money refunded. I’m expecting a high quality publication from Adam, Bill and Mark Wolfinger, the three guys I’m familiar with and I’m looking forward to seeing how the other two guys approach options.

Disclosure: I have been given a free subscription to Expiring Monthly. Though I turned down an affiliate offer, i.e. I don’t want to be paid for recommending or mentioning their service. Anything I recommend I want to be 100% sure I’m recommending it on its own merits and not because I get a cut of any subscription fees. To make that 100% clear I will not receive any financial reward for this post or you clicking through to Expiring Monthly from any of the links here.

In day seven Mark Wolfinger penned a warning for option buyers. I thought it appropriate to provide the yang to Mark’s ying.

I don’t recall where I read that options sellers eat like chickens and shit like elephants, but I sure laughed hard and the phrase still brings a smile to my dial. I’m predominately an option seller and can testify to having been covered by a few large steaming piles in my time.

Experienced traders will extol the virtues of buying protection for written options. That is insuring you’re not naked. Unfortunately those new to the trading options seldom listen to that advice for a number of reasons.

1. Buying protection reduces the attractiveness of a position.
2. Buying protection forces an acknowledgement and assessment of the risk and requires more involved calculations.
3. It won’t happen to me.
4. I’m happy to buy or sell at that strike price.
5. I’ll close the position if it moves against me.

Two words sum up the danger, surprise volatility. In Bleed or Blowup, Nasim Taleb has the following to say

In some strategies and life situations, it is  said, one gambles dollars to win a succession of pennies. In others one risks a succession of pennies to win dollars. While one would think that the second category would be more appealing to investors and economic agents, we have an overwhelming evidence of the popularity of the first. A popular illustration of such asymmetry in returns is evident in the story of the Long  Term Capital Management hedge fund. The fund derived steady returns over a dozen quarters then lost all of them in addition to almost all its capital in a single observation (see Lowenstein, 2000) –only for the main principals to restart a new, albeit milder, version of the strategy. Is there a systematic bias in favor of such return profiles?

That’s right LTCM were options sellers. So if the most intelligent (note I didn’t say smartest) collection of people to ever form a hedge fund blew up selling options, why do newbie option traders think they can better?

How to Overcome the Dangers of Selling Options

Slip, slop, slap. Slip on some protection, slop on some protection, slap on some protection. Buy a lower priced put or higher priced call to protect yourself from surprise volatility.

Invert your thinking. In day five, believing writing covered calls is conservative, I highlighted how covered calls are not as risk free as many investors think. The easiest way to overcome the danger of writing covered calls is to invert your thinking by considering whether you would write a put on the stock at the same strike price. As a put is equivalent a covered call that simple mental gymnastics helps me decide whether I should be writing the covered call or simply selling the stock.

While that takes care of downside risk, which to me is the real risk, many experienced investors have argue that missing out on the upside is an even greater risk. While I disagree, I certainly concede that forfeiting upside is a risk that many investors ignore. Is it worth selling that $50 call for $1 when the at expiration the share could be $60?

When you sell options you are in general forfeiting upside while taking on the downside risk. You’re behaving like an insurance company and as such it pays to re-insure against catastrophic risk.

More:

• Day Eight in this series of options trading mistakes.
• The series so far, ten biggest mistakes in option trading.

Option Buyers Beware

Most option rookies begin their careers by buying an out of the money put or call, hoping – more likely expecting – that the stock will magically soar or dive, earning that rookie trader a good-sized reward.

When a few weeks pass and the option expires worthless, the rookie is not only disappointed, but often perplexed.  The stock underwent a very nice rally in just 4 weeks – moving from 40 to 48.  He/she owned call options.  How could the trade not make money?

The bottom line is that it’s difficult, at best, to prosper when buying options.  Many beginner books suggest buying options as the ideal learning strategy, but I find that to be very poor advice.  We all know that the majority of professional money managers cannot beat the stock market, yet they are handed hundreds of billions of dollars to try to do just that.  And, they charge their customers a fee for under-performance.  The fallibility of money managers is well known, yet the majority of individual investors are confident that they are different, and can beat the market.  There’s plenty of evidence to show that individuals perform no better than the market averages, and many accept that as true and buy index funds.  But not all investors accept the facts.

Bucking those odds is bad enough.  But to make matters even worse, investors with market-beating stars is their eyes love the idea of buying options.  After all, the prospect of spending a few hundred dollars to control several hundred shares of stock (that’s leverage) allows them to the chance to make as much money as investors with larger bankrolls.

To win the option-buying game, they must not only pick the correct direction for the stock – and as already mentioned, that’s already too difficult for most – but the timing must be right.  That makes the probability of earning a profit even lower.  Options have a limited lifetime and if the trader is not sufficiently accurate in timing the market move, there’s no payoff.  Just more losses.

If that combination is not bad enough, there’s also the requirement to make a good guess as to the size of the market move.  I’ll agree that if the trader buys in-the-money options, this becomes less of a factor.  However, option-buying, leverage-seeking traders – especially newcomers to the options world – prefer those low-delta out-of-the-money calls and puts.  And that makes guessing the size of the move imperative.  True, options should not be held until expiration day, but if the underlying stock doesn’t move far enough, fast enough, then the option’s value can quickly fade away.

Looking at the example I used earlier, the trader sees the stock zoom 20% in one month and all the investor has to show for making a good stock prediction is the equivalent of a torn-up pari-mutuel ticket.  The ‘horse’ just did not have enough to finish the race.  Out of the money options are useless once expiration arrives.  The trader bought calls with a strike of 50 when the stock was 40.  The price was low, but it was still too high.

It’s a difficult task to make money buying options.  The incentive to try is the chance for big score.  It’s possible to turn $1,000 into $10,000 in only a few weeks.  And that possibility is what keeps hope alive.  I’m not telling you it cannot be done.  Traders who have proven they have a good track record when it comes to picking direction or timing the market may be able to earn a very good living when buying options.  Those with exceptional technical analysis skills may also prosper.  But for the average individual trader, buying options as a primary strategy is a big mistake.

I am not suggesting these traders should be selling options.  Especially not naked options.  But there’s a world of option strategies between buying and selling naked options.

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More:

• Day Seven in this series of options trading mistakes. Under and over valued options.
• The series so far, ten biggest mistakes in option trading.

I invited Mark to contribute to this series and was delighted that he accepted, especially when he has his own very busy publishing schedule. Mark along with four other excellent bloggers are about to launch Expiring Monthly a journal for option traders. There is currently a a charter member offer for $79 (regular price $99) and you could even win a free subscription. I plan on subscribing.

AEO, MIDD and NUAN averaged a 4.6% cash gain for the six weeks and ended lower. If you’re both happy to hold and to sell a stock then calls are excellent dividend producing options. However, if you want to sell a company then sell it, don’t use calls to stretch for another dollar, as that leaves you holding the downside which is why you probably want to sell in the first place.

I was once again reminded that I should I close my positions when I have captured most of the profit and yet substantial time remains.
Get out of the hot seat.

Telstra Corporation Limited (TLS) is the dominate telco in Australia. It owns the network that most voice and data travels down and half the main cable TV provider, plus directory listings and some other small businesses.

I see little point in over thinking an investment in Telstra, so will try to keep this simple.

Telecommunications is a large and growing necessity in our lives. The only way is up for data movement and Telstra are the biggest toll collector on the digital communication and entertainment highway. More bits will travel down Telstra’s pipes and as they complete their transformation from wires to wireless and ubiquitous broadband they will grow their slice of consumer’s dollars. Telstra business is highly capital intensive so it will take excellent management to control costs and produce excellent returns, fortunately Sol set Telstra on the right  path there and team Thodey and Stanhope are well equipped to manage the business.

The current price of $3.21 is low. Telstra are a slow growing utility and thus it’s appropriate I back that low price call up with the dividend discount model as a valuation approach. I’ll get to that in a moment, but first let’s keep it really simple. The current 28 cent dividend provides a net annual return 32.2 cents to SMSFs, with Telstra trading at $3.21 yesterday that’s a 10% annual net return before even looking for upside. The holy grail for many dividend investors is a potential 10% dividend yield at some future point, with Telstra it’s not potential, it’s right here right now.

Back in June I worked through an example of using the Dividend Discount Model. In summary, Price = dividends one year from now/(discount rate-growth).

As with all models the danger is garbage in garbage out, so I’ll do my best to limit the garbage in.

Current Dividend is 28 cents annually, the same as it’s been for four years if we exclude special dividends. Payout ratio is 85% or 80% on a free cash flow basis.

Growth Rate.The dividend has doubled over the last 10 years. While it has not moved over the last four years, there were three special six cent dividends in 2005 and 1H 2006. Plus the massive restructuring and investment for the move from fixed line to wireless and broadband consumed a lot of cash, which stymied any dividend increases. I’ll use a range of growth rates, all below the past decades.

Discount Rate: I’m going to stick to 10%. Though, I am left concerned that the discount rate has such a large impact on the DDM output, see the chart below for an example. I could use CAPM to determine the rate as Aswath Damodaran does in this dividend discount method spreadsheet. In CAPM the discount rate is the risk-free rate plus the risk premium (difference between market and risk-free returns) multiplied by the stock’s beta. My bias is there has to be something better than beta to measure risk. I view Telstra as less risky than the overall market.

The Results

If you’ve skipped ahead you may have noticed Roger Montgomery came up with the very exact valuation of $4.01.

I prefer to work with ranges or ball-park figures. The chart to the right shows Telstra valuations with differing growth rates using 10% and 11% discount rates. My range within this chart is $3.60 – $4.90, but like Roger I view Telstra as fairly valued right now in the low $4 range.

The next chart shows what the dividends would be out til 2016 at those growth rates.

I see 3% – 4% growth rates as achievable, but as Roger points out below Telstra haven’t grown their earnings in a decade so perhaps it is ambitious to see them growing over the next decade. I’ll look at growth in the forward looking section, but in summary, Telstra have been repositioning their business model over the last decade and low growth will now be delivered.

Telstra’s Dividend

Is the dividend sustainable? The current 85% earnings and 80% free cash payout ratio is sustainable. However, Telstra will need to grow earnings to enable increases in the dividend.

As the Telstra Dividend Payout chart below shows Telstra now comfortably cover the dividend. Telstra earnt 32.9 cps this year, up 9.8% on 2008, continuing the recent pattern of 2008 up 13.3% and 2007 up 2.9%. There was only one year, 2007, when Telstra were guilty of paying out more in dividends than their free cash flow.

Looking Forward

Up to now I’ve been looking in the rear view mirror, so let’s take a few minutes to consider the future.

Telstra is transitioning from a heavy reliance on their fixed wire, PSTN, network to the future drivers of wireless and broadband for ubiquitous communications and data. Mobiles are now Telstra’s largest contributor in sales and while some commentators are stuck in 2007 and can only see the decline in PSTN, the reality is that mobile revenue grew 10% in 2009 while PSTN declined half that amount. Telstra now have 10.2M mobile customers and those subscribers are a large part of the future of this business.

Telstra are targeting a massive $6B in free cash flow this year, 35% year on year growth.  While that is mainly due to cost and capital control they still predict low single digit growth in revenue and earnings. With those cash flows it would be no surprise to see a dividend increase this year.

In the words of Sol, Telstra have rewired and unwired. Telstra is not the company they were a decade ago, their future is more assured and their price is only 40% of what it was then trading for. Its financial ratios have compressed while earnings and cash flow in particular are growing. Show me a safer investment with a shot at 30%+ returns and I’ll be all ears. Seriously if you know one, leave a comment, as I’m very interested.

The thrust of this post is Telstra’s long term story and dividend stream. However, there is also a capital gain story. If, or I should say when investors re-rate Telstra and it trades at its usual dividend yield of 7% the shares will be worth north of $4.00. The sooner that happens the greater the annual capital capital. Buying Telstra at current prices gives SMSF investors a relatively safe 10% yield while they wait for a respectable capital gain. The total return within a year could be 37% or higher with exretemly low chance of a permanent risk of capital.

A Bearish View

Here’s a bearish perspecitve by By Roger Montgomery from the excellent Eureka report.

“Telstra shares do look cheap and I have a valuation of $4.01 but this is a business that is currently earning the same profit that is was earning at the turn of the century, whose return on equity is still not back to where it was a decade ago and whose rising return on equity is due to equity falling rather than profit growth. This latter fact stems from the policy of paying dividends far in excess of profits. Moreover, the company is a capital-intensive one – just look at the $24 billion of property, plant and equipment on the balance sheet. Further, borrowings of $17 billion are well in excess of the $12 billion in equity, which in turn is boosted by $8.4 billion of intangibles, a combination I simply prefer to avoid. ”

Buying Telstra at $3.21

It’s Monday afternoon now and Telstra has fallen back to $3.26. I wouldn’t be surprised to see Telstra change hands for $3.21 or lower over the coming weeks, heck maybe even tomorrow. So buying Telstra at $3.21 may be as simple as waiting patiently. For those not willing to wait, there are other options. Here’s two that spring to mind.

1. Buy Stock and Short Straddle. I saw this strategy referred to the other day as The Money Tree, which is a lot more catchy than what I call it, but money does not grow on trees, so I’ll stick to Covered Straddle. In summary you buy half the stock you want and then sell at the money calls and puts. Here’s an example with Telstra.
   Imagine you want to own 10,000 shares of Telstra. Here’s what to do:
   - Buy 5,000 shares at $3.26
   - Sell 5 $3.36 October Calls and 5 Puts. (To keep the maths simple, I’ll ignore that these Telstra options are for 1040 shares,  and round to the standard 1,000 shares for Australian options)
   - At current prices that will give a cost basis on the shares of $3.01, ($3.26-.17-.08).

   Come October if Telstra is:
   - above $3.36, shares will be called away and you’ll net (ignoring transaction costs) 11.6% or 35 cents, an annualised return of 94%. Annualised costs generally glorify reality so it’s best to cut that figure in half. Rinse and repeat the process.
   - below $3.36. You’ll be put the 5,000 at $3.36 and will now have the full 10,000 shares with a cost basis of $3.19, ($3.01+$3.36)/2.
   - exactly $3.36, get a grip the chances of that happening are slim, but for completeness you’ll be left with half your shares at $3.01 and you repeat the straddle the following month.

2. While the above may sound a little tricky to those not familiar with options, it is easy to do. Though I understand you may want something even easier. Selling puts are like placing buy limit orders, except you get paid to do so. While that may sound great the downside is that you’re taking all the downside risk without the potential of upside gain. The October $3.36 is currently trading at 17 cents, if you sell that then the following can happen if Telstra is:
   - above $3.36 you’ll walk away with your $0.17
   - below $3.36  you’ll be put and will have to buy the shares at $3.36 no matter what they are currently trading for, you cost basis will be $3.19

One of the slight tricks with options is comparing apples to apples. As I often say you can’t buy a latte with percentages (yeah I know I really must work on my saying), so let’s concentrate on the cash. In general there is no such thing as a better option strategy, as it all depends on what you’re trying to achieve. However, if you want to profit from taking ownership risk on Telstra which of the above strategies would you choose?

Picked one? Did you opt for strategy one with the the higher profit if called, though higher cost basis if put? I hope not as if you look at the strategy again you’ll see the higher profit if called is actually a mirage. In strategy one you’re only selling half as many options, 5, instead of the 10 in strategy 2. So the two strategies have almost the same gain if called, 5*.35*1000 and 10*.17*1000 and the same cost basis if Put. In this case I’d opt for the simpler strategy. My point is ignore percentages, convert everything to dollars on a like for like basis.

My real reason for running through these two strategies is that I saw the first strategy extolled as an excellent strategy on an investing discussion board. I’ve tried to explain several times on that board that a put is equivalent to a covered call, but it appears the message has not got through. If you break down the ‘money tree’ strategy, you have a put and a covered call. As a put and a covered call are equivalent you really have two puts. Thus strategies one and two are the same, except strategy one is more complicated.

Can we do better? The great thing about options is there is always another option, but that’s enough for now.

If you’re a sucker for confirmation bias then Christina over at SMSF Investment Strategies recently posted about her exploits selling Telstra put options.

Disclosure: I own Telstra in various accounts and may open option positions in the near future. Telstra closed Monday at $3.25.

[Update] Crikey, blow me down, the Telecommunications Regulatory Reform release today has knocked Telstra for six, it trades at $3.16 as I write this. It look like the market doesn’t like structural separation. I said Telstra could trade under $3.21 today or within weeks, but sure didn’t think it would be within hours of posting this.

My main issue with the structural separation is it will distract management focus. My main interest in the story is one of opportunity. Telstra is now $3.10 with fear is in control.

During the early naughties I was a big, at least in my little world, Amgen call seller. I generally sold LEAP options and no doubt my broker thought I was insane selling naked calls. Little did they know that the calls were backed up by my partners employee options and that I was just locking in a sale price and getting paid a large deposit on something I couldn’t sell anyway. But that’s a story for another time. We still own a few Amgen shares, but I haven’t sold any Amgen calls since my disastrous bull spread of ‘08, which is yet another story I should relate. The takeaway was, take your profit and run. Which bring me nicely around to the point I wanted to make.

It was just over a day ago that I wrote about closing out my Vertex call after I had gained 2/3 of the sale price. The main reason to close an option early is to get out of harms way. When you sell options you’re in the hot seat and you should get out as fast as you can. For some strange reason I like warming my arse and tend to stay in positions too long. Call me lazy if you wish. Imagine how short option sellers in Amgen feel today? I need to keep that in mind more often when I’m in the hot seat. Though upside pain is seldom as bad as downside. [Volatility skew]

Amgen Rises After Denosumab Bests Zometa in Study

By Lisa Rapaport

July 8 (Bloomberg) — Amgen Inc. rose the most in four years in New York trading after the company reported its lead experimental product, a bone strengthening medicine, worked better than a potential rival in a study.

Shares of Thousand Oaks, California-based Amgen surged $8.16, or 16 percent, to $60.39 at 9:44 a.m. in Nasdaq Stock Market composite trading. Earlier the shares reached $60.95, the most since July 20, 2005, a day after the company reported a 38 percent jump in quarterly profit. Study results for the drug, called denosumab, were announced yesterday after the market closed.

Denosumab did a better job in the clinical trial than Novartis AG’s Zometa delaying fractures and other complications in breast cancer patients whose illness had spread to their bones, Amgen said yesterday. Analysts raised peak annual revenue projections for the drug and price expectations for Amgen stock.

“Superior efficacy could enable denosumab to establish a new standard of care,” said Ian Somaiya, an analyst with Thomas Weisel Partners LLC in New York, in a note to clients today.

Somaiya increased his target price for Amgen shares to $71 from $62 today.

The study results will allow Amgen to sell denosumab at the same price as Zometa, instead of at the 20 percent discount Somaiya said he had previously anticipated. He raised his revenue projection for denosumab to $2.1 billion in 2012, from a previous forecast of $1.8 billion.

via Amgen Rises After Denosumab Bests Zometa in Study (Update2) – Bloomberg.com.

I don’t think I’ve ever worked it out, so here goes on a real trade I placed recently. I’ll try to throw in some of my quaint Fusion Analysis as well.

Two weeks ago Vertex Pharmaceuticals Incorporated (VRTX) looked to topping out. You don’t really even need any TA to have an opinion on whether a stock is getting ahead of itself, but I do find TA to be a useful adjunct to my fundamental opinion.

VRTX was approaching its one year high, a level at which it appears slightly overvalued. The stock has dropped off these levels three times in the last year. With so many underpriced securities around, with many investors over the past three years having bought around these levels and with a good run up since April it looked like a good time to be selling my shares. But I still like the company and long term prospects, especially since Matthew Emmens took over as CEO back in February. People I respect in the pharma industry have called Emmens a golden boy with a midas touch (hopefully at 57 he’s flattered by being called a boy).

A quick look at the chart shows the price pushing up through it’s upper Bollinger Band, climbing well above it’s 50 DMA. As there is no big fundamental news expected in the near term, it seems unlikley that the price would continue to climb.

As I can no longer be bothered staying up late or interrupting my sleep to trade in the US I placed a sell limit at $1.80 on the July $35 Calls. It was tirggered that night, 26 June, with VRTX at $35.89.

I also didn’t want to sell the stock as that would give me an instant tax hit, right at the end of the tax year.

But, I can’t help think that I would never sell a Put on a stock I thought I was peaking, so why the hell do I sell a call? Is there something better I could be doing?

Should I Close Prior to Expiration?

The calls are now selling for $0.65 ($0.60-0.70).  I have got 64% of the value in 5.5 trading days and there are nine trading days to go for the remaining 36%. I normally don’t close sold calls, I’d like to say I prefer to let them expire, but the truth is I’m too lazy to follow them closely and make prefer to make fewer decisions. Hence I make one decision to sell the call and leave it and that. I haven’t analysed past trades, but it is likley I would be better off if I was more active with my option positions.

I’m not even sure the best way to analyse the trade to decide whether to close.

• When I sold there was $0.91 in time value ($1.80-0.89), now there is $0.65. So from a time value perspective I have only received $0.26 and there remains $0.65. Hold.
• As mentioned above 2/3 of original sales price already gained in 1/3 of time. Sell.
• The theoretical option value is $0.356, so the calls are expensive. Hold.
• My original plan was to hold to expiry.
  • If the shares were below $35, pocket the cash and decide whether to sell August Call. Hold.
  • $35-36.70, buy back call on final day of trade and sell August call.
  • $36.70- $38, sell August Put.
  • Above $38, wait and see.

I want to hold VRTX through to approval of their leading Hep C compound Telaprevir, but wish to squeeze some more juice out of it in the meantime. I always say there is no such thing as upside risk, yet as I look at VRTX the biggest risk I see comes from a takeover bid.

I feel like I could be playing this better and am open to any recommendations.

I just went and re-read my option post linked above, writing covered calls is not conservative, and this jumped out at me. Never sell a call as an exit strategy. Absolutely never ever sell a call as an exit strategy. If a stock has risen to fair value or above and you do not want to own the company for the long term then sell the stock or enter a collar (sell a call and buy a put). I think that is my problem with trades like this. The stock is at my fair value and I think it is peaking, but I want to own it long term. Next time I’ll look at the collar, I had totally forgotten at using that as a strategy in this situation.