Just started reading McMillan. Good book. Big, though.
So I've started to back-test a couple of strategies, and wanted to share the results. I'm not at all confident that my approach is appropriate, so criticism is appreciated.
I'm looking for an approach that doesn't involve market timing at all--although I'm assuming that other option transactors can't time the market either. I'm also looking for an approach that allows me to reap the benefits of good stock selection (ha).
The strategy I modelled was this: every month, write covered calls on all of your holdings, 10% out of the money. Somewhat unconventionally, I'm looking at the problem in terms of affecting the number of shares I own, rather than in terms of the underlying cash value (except at the end of the decade, when i cash out). That's because these are shares I'm confident in long-term; I want to be an owner, so I want to maximize the number of shares I own. If I get called, I'll buy back as many shares as I can.
So these are the potential payoffs (I'm excluding transaction costs and taxes):
Begin with 100 shares bought at 50, write 1 call at 55 (10% otm). "Premium" is the premium. "Price" is the price at the exercise date. "Return" is Price / 50.
Return > 1.1: Shares = 100 * 1.1 / Return + 100 * Premium / Price
Return < 1.1: Shares = 100 + 100 * Premium / Price.
Now I would have expected that this strategy doesn't do much better than straight holding long-term, because you lose out big when the stock runs away from you. In fact, though, when I back-tested this strategy against 10 years of data (1990-2000) of MSFT, CSCO, BRKA and IBM, I found some interesting results. This strategy tends to underperform straight holding for the great stocks (MSFT, CSCO), but beats straight holding by a wide margin for the OK stocks. For instance, if the premium is always at 1%, Microsoft's total return is cut in half (100 bagger --> 50-bagger), CSCO's is cut tenfold (1000 bagger --> 100-bagger), BRKA's doubles (7.5-bagger --> 15-bagger), and IBM's grows 50% (4-bagger --> 6-bagger).
That's a pretty good hedge. If you were to tell me that if I happen to hold any future 100-baggers, they'll turn into 50-baggers, but my 10-baggers will become 20-baggers, I'll be pretty happy, because I'm more apt to have the latter (If I have the former, I'm on easy street anyway).
Plus, things get much, much better if you assume better premiums than 1%. I don't know what premiums were like in the 90's, and I'm sure they're lower than they are now, what with the recent volatility, but today's are just crazy. For instance, May RMBS 20s, which are 20% OTM, have bids of .9, for 4.5%.
I'll post the actual summary of the results in the next post, because of SI's hokie fixed font stuff. |
