k1 Project – Core Strategy II – The Premium Business

Becoming a Landlord

Imagine taking a long-term lease on a warehouse (the long leg of your spread) and then sub-letting the space to commercial enterprise for a monthly rent (the short leg of your spread). At the simplest level, this is the principle of the LTP strategy. There are additional benefits, most importantly that you own any equity (intrinsic value) that the property develops over the period of your lease.

Landlord and Tenant

Try to think of yourself as a landlord who takes a long-term lease on a property and your goal is to rent it to others on a month-to-month basis at a premium to what you pay. Both of you have expiration dates that you need to be keenly aware of and you have to decide each week (at least) if you have a good tenant (the bracket you sold) or if you need to evict him. Once evicted, do you replace him right away or hold out for more money. While you are holding out, the clock is ticking on your own lease and any good landlord will tell you there’s little value in an empty unit, unless you are VERY certain market conditions are improving at a rate significantly faster than the rents you are not collecting because, no matter what, the bank will want your mortgage payment (premium expiration) each month whether you have a tenant or not!

Opening an AAPL Jan100 Store

AAPL – The worst thing you can do is go in and out of these plays, you will always take a steep loss shutting them down early (as you saw with the put play). These are not quick money plays and you are not playing to “win” every contract you sell. You have opened a store, that store is an Apple Jan $100 store that you rented for the year for $10.30. You need to sublease your space to shorter-term renters who are willing to pay a premium. Your first tenant is the May $100 who is paying you $2.70 for 2 month’s rent. All you do here is wait. The only reason you need to worry is if the May drops by more than 1/2 it’s value, at that point you need to think about selling someone the $95 instead. Otherwise, these plays are all about the waiting but make sure your projected rents cover your own total or you need to rethink your position. The difference between the May $100s and June $100s is $2.30 and you have 6 months to rent out so your projected profit is about $4 for the year so any single month where you find yourself $1.50 ahead you should seriously consider taking out your caller and either selling down (like right now the $95s are $1.50 out of the money but when they go to $2.50 out of the money the 5% rule starts to go in your favor).

Two interesting concepts in this next post. First, the notion that you’re running a business renting out an option strike for a month. Second, and this is important, notice that even though your caller is betting that the option will finish ITM, the strategy does not care. This seems to be a major hurdle to overcome in really understanding the LTP (“the problem you have is you think you are betting that too but you’re wrong”).
Throw out your mindset about options

The simplest thing I can say is you have to throw out your mindset about options as you are not playing options when you sell in the same way a casino isn’t playing craps when they run a craps game. You are running a business and your business is selling premiums. You rent space (or really time but then it’s all relative) in, say, an Apple ‘09 $140 at $19.60. That is your business investment.

You then entice someone to play against you and you sell the Sept $135 for $7.40. That person is making a wager that Apple will finish higher than $142.40 on Sept 21st and he thinks you are betting that it won’t and the problem you have is you think you are betting that too but you’re wrong.

You don’t really care if Apple finishes even at $145 because, no matter what happens, you get his $4 premium. As long as you can roll your caller when he has little or no premium to another guy who pays you a $4 premium and (assuming you skip earnings months) you do that 11 time in 16 months, you will collect $44 in premiums against your $19.60 investment. This is good, old-fashioned commercial real estate style profits – the kind you can go to sleep at night with a 95% certainty they’ll be there in the morning.

That’s why make those plays, while I would not like for Apple to go down and it would be nice if it drifts up to $160 or so so I get my $19.60 back in Jan ‘09, it’s all incidental as long as my main business plan works out, which is to make $4 per month in premiums.

This next post details a position in AAPL after a huge gap up at earnings that put both legs of the trade deep ITM, requiring a big infusion of cash to roll the callers up. With the wrong mindset (and not enough cash to roll), this might be viewed as a “loss”. But Phil points out how the gain in equity on the long side balances the short side and prepares you to collect your next set rent payments.
AAPL

AAPL – barely positive but what a bank we have now! Lots of very deep in the money calls in quantities we never would have started with that we will be able to milk premiums out of for a year. It goes back to my rental concept. We invested $100K (example) and sold and bought calls since June to build our building (position) into $300K. Our investing partner (callers) left with all the cash and now we have a $300K building that we own clean (other than our $100K investment) and we expect to rent it for $30K a month. Now is this a disaster or a good thing? As many of you know, I have a lot of commercial realty and I can tell you – this is a good thing! We’ve taken a very speculative $100K of pure premium and turned it into $300K of pure equity and now we can expect to make $30K a month from our investment with very little risk to ourselves.

Detailed Examples
So your YHOOs for example…
Karmcon describing the approach

Deeper Issues

There’s a deeper comparison available in this analogy, relating the real estate concepts of Owner’s Equity and Leverage to corresponding concepts with options. But therein lies a conflict as well, or at least a complicated idea. As I started to wrap my head around the comparison to commercial real estate, I began to develop the (incorrect) idea that the goal was not just to pay for my long position, but to develop significant equity in it, in the sense of letting it go deeply ITM. Then one day, Optrader asked the critical question that exposed this idea, and Phil illuminated the darkness. Highlights of that exchange follow.

The discussion begins with some comments about how to manage a GOOG calendar spread going into earnings. Optrader asks how to prepare for what is likely to be a big gap up in the stock, without going into earnings uncovered.

Phil – I was wondering about adjustments to your calendar spreads strategy for earnings. I really like your strategy to sell “rent” every month, and have done very well following it on a couple trades. But how do you adjust it right before earnings? It seems really risky to stay short the front-month, when a really big move can happen overnight that would put your caller deep ITM with a very much higher delta than your long calls without having time to roll.

Phil answers with the following, and opens up a whole new world of issues:

As to your GOOG play I’m not sure what you mean about the IV not dropping much this week. Your $630 caller has $15 in premium and he WILL lose 100% of it by Friday at 4pm. Your Jan $600s have $32 in premium and may lose about 1/2 of it on Friday so that would be my concern as you are only covering your $37 of intrinsic value with $7 of his intrinsic value.

Optrader hears not only the direct answer to the question, but recognizes the thread to the deeper issue, how much ITM to allow your long options to be:

Phil – I just read for the 3rd time your post from this weekend about adjustments to GOOG’s calendar before earnings. I think I just understood something. I usually like to be long contracts where I am deeper ITM because I feel like I pay less for premium, and so it’s a better value for me. But what you are saying in that, especially when you expect high volatility, it is better to buy contracts with lower intrisic value. The reason being that you want as big as a percentage of your intrisic value to be covered by the intrisic value that you sell. This way if there is a big drop you are better covered.

Phil affirms – Deep ITM is for suckers

Hey Optrader – that was well put! Deep ITM is for suckers, you may as well buy the stock as you get all the downside and none of the upside. Premium is relative. I don’t really care about my premium (unless it’s bloated over earnings or something), I care about my premium relative to my caller. Look at the GOOG $600 puts I bought for $5 this morning, they gained 60%, better than almost any other strike price – that’s all that really matters in the end.

Very simply, I’m just looking for best gain/least risk so I want my caller to cover me reasonably (to around the lowest I think something will fall) but, much more importantly, to have a much higher premium (per day/week) than I do. That way I know that, in pretty much any direction, at least I will gain that money.

I would like to re-emphasize that last point – establish your position so that your caller has a much higher premium (per day/week) than you do.

Tying up $26 for a call on a $100 stock

Innocent question
Phil – I have some ATI 2010 $120, paid $26 per c. I have recovered some of the loss by selling calls. Is there anything I can do to improve the chances for a recovery.

Simple Answer: Yes, NEVER tie up $26 on a $100 stock again!

A little more detailed answer: $26/100 – You are too far in the money so your downside V is heavy. You want to have a significantly lower downside delta than your caller. It doesn’t matter if he outgains you 2:1 on the way up, you have 15-27 months to roll him up – what kills you is exactly what happened to you, getting hopelessly out of position so margin starts to become a problem for future sales. This can force you to make uncomfortable rolls either putting up much more money or cutting back on your position which halves your rate of return.

This is great stuff,written by someone we can identify with. It distills Phil’s underlying trading philosophy in an easy to understand format

k1 – This is excellent. There is so much great “Phil knowledge” in this site that needs to be pulled together and you are doing it. Many thanks to you!!

I still struggle though with the concept of how you make money when your caller goes ITM and am dying for that “aha” moment when I finally get it.

From Phil’s statement:
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You then entice someone to play against you and you sell the Sept $135 for $7.40. That person is making a wager that Apple will finish higher than $142.40 on Sept 21st and he thinks you are betting that it won’t and the problem you have is you think you are betting that too but you’re wrong.

You don’t really care if Apple finishes even at $145 because, no matter what happens, you get his $4 premium. As long as you can roll your caller when he has little or no premium to another guy who pays you a $4 premium and (assuming you skip earnings months) you do that 11 time in 16 months, you will collect $44 in premiums against your $19.60 investment.
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This assumes that the $4.0 premium you collect each month does not get eaten by the intrinsic value if the caller finishes $4.0+ ITM correct?

I still don’t get the math when the caller finishes ITM because if you have to “give back” the $4.0 premium when the caller finishes far enough ITM, you really only have the appreciation of your long side .. which I’m not complaining about, but I still don’t see the premium perspective.

Brian