In our previous publication, "Market Observation - Trailing Stop and PPN Booster" on April 5, 2023, we discussed the concept of trailing stop and demonstrated how it aligns with Poseidon's philosophy of wealth preservation and succession. This week, we delve further into options and showcase how we activate positions in our portfolios to achieve the goals of value investment through the application of selling covered calls.

Abstract

• Options provide investors with flexible investment strategies and leverage, granting holders the right to buy or sell assets at specific prices in the future
• As option sellers, receiving premiums is akin to collecting insurance premiums. However, sellers must possess an understanding of the underlying investment to cover potential losses in the event of option execution
• Options are essentially value investments based on discounted cash flows and provide investors with an opportunity to buy or sell at target prices. Due to the time value component in options, sellers have a higher probability of profiting compared to buyers
• Sell covered calls, a strategy where one sells call options while holding the underlying asset, is suitable for those with a negative short-term outlook but a positive long-term view on the underlying asset and a willingness to hold it for the long term. Higher market volatility generally favors sell covered calls.

Understanding Options

Options are significant financial instruments that grant holders the right to buy or sell assets at specific prices within specific time periods. Option holders (buyers) can choose whether to exercise this right based on market conditions, while option sellers receive premiums for selling options. However, once the buyer decides to exercise the option, the seller cannot refuse.

One major advantage of options is leverage effect. Since options only require payment for the option contract and not the actual assets, they offer the potential for greater returns with a smaller investment.

The option market typically involves two types of options: Call and Put. Call options grant holders the right to buy assets at specific prices within specific time periods, while put options grant holders the right to sell assets at specific prices within specific time periods. These two types of options provide investors with flexible investment strategies, regardless of whether the market is rising or falling.

Sell Covered Calls and Sell Put Options

The single option strategies for option sellers can be divided into sell covered calls and sell put options.

Taking Nvidia as an example, with the current price at $386.54 per share:

Sell Covered Calls

Assuming Investor A is bullish on Nvidia and expects it to continue rising to $420 in a month, and currently holds corresponding positions, they can arrange a 30-day Sell Covered Call option (with Investor B as the counterparty: A sells a covered call option to B, equivalent to B buying a corresponding Buy Call option), with a strike price set at $420. According to Bloomberg's calculation formula, A can receive a premium of 1.65%, which amounts to $6.38 per share ($386.54 * 1.65% = $6.38). The premium calculated by Bloomberg is a theoretical value, and the final price is subject to market makers after considering market liquidity.

1. If Nvidia rises to $430 after a month, above the $420 strike price, Investor B will decide to exercise the option, buying Nvidia at the strike price of $420. For Investor A, selling the covered call results in a profit of $39.84 per share ($420 - $386.54 + $6.38 = $39.84) (10.30% return on investment based on the original share price).
2. If Nvidia rises to $418 after a month, below the $420 strike price, Investor B will not exercise the option to buy Nvidia at $420. For Investor A, the option expires, and they receive the premium of $6.38 per share, while retaining the appreciation in the Nvidia stock.
3. If Nvidia rises significantly to $500 after a month, Investor A still has to sell it to B at the price of $420, resulting in a profit of $39.84 per share. The gain from $420 to $500 is unrelated to A and is captured by B, who bought the Buy Call option. From A's perspective, the $420 to $500 increase is not the intended profit, as it falls under speculation, whereas the $386.54 to $420 range represents the value investment.
4. If Nvidia falls to $350 after a month, below the $420 strike price, Investor B will not exercise the option to buy Nvidia at $420. For Investor A, the option expires, and they receive the premium of $6.38 per share, while still holding the stock, effectively reducing the cost basis from $386.54 to $380.16.

In the above scenarios, (1) and (2) revolve around the vicinity of the option's exercise price, offering the best experience. (3) Essentially involves selling the stock at a price around $35 higher than the estimated value. (4) Essentially involves not waiting for a desired price above the estimated value to sell the stock, compensating for the premium received by lowering the cost basis.

Sell Put Option

Assuming Investor A believes that Nvidia will fall to $360 in a month and currently has sufficient cash on hand, they can arrange a 30-day Sell Put option (with Investor B as the counterparty: A sells a Put option to B, equivalent to B buying a corresponding Buy Put option), with a strike price set at $360. According to Bloomberg's calculation formula, A can receive a premium of 1.66%, which amounts to $6.42 per share ($386.54 * 1.66% = $6.42). The premium calculated by Bloomberg is a theoretical value, and the final price is subject to market makers after considering market liquidity.

1. If Nvidia falls to $358 after a month, below the $360 strike price, Investor B will decide to exercise the option, selling Nvidia at the strike price of $360. For Investor A, buying the stock at $360 minus the premium received ($6.42), the actual cost is $353.58, which is $32.96 cheaper compared to buying it at $386.54 a month earlier.
2. If Nvidia falls to $362 after a month, above the $360 strike price, Investor B will not exercise the option to sell Nvidia at $360. For Investor A, the option expires, and they receive the premium of $6.42 per share, which is still significantly cheaper compared to buying it at $386.54 a month earlier.
3. If Nvidia falls to $340 after a month, Investor A buys Nvidia from B at $360, and after deducting the premium of $6.42, the actual cost is $353.58, which is $13.58 higher than the market price. In A's reasoning, although there was an opportunity to buy at $340, which is cheaper than $353.58, buying at $353.58 is still reasonable for A.
4. If Nvidia rises to $400 after a month, for Investor A, the option expires, and they receive the premium of $6.42 per share, but they also miss the opportunity to buy at $386.54.

In the above scenarios, (1) and (2) revolve around the vicinity of the option's exercise price, offering the best experience. (3) Essentially involves buying the stock at a price around $6.42 lower than the estimated value but temporarily in a floating loss position. (4) Essentially involves not waiting for a desired price below the estimated value to buy the stock, compensating for the premium received.

Benefits of Being an Option Seller

Options and Insurance

From the examples above, both Sell Call and Sell Put  are equivalent to selling insurance. Selling insurance allows you to collect premiums, and selling Call and Put options allows you to receive option premiums. When selling insurance, it is crucial to have a clear understanding of the underlying risks to be able to afford the claim payout. Similarly, when selling Call and Put options, knowledge of the underlying asset is essential, and actions should be taken within one's capabilities. For example, when the stock is ultimately put to the seller, there should be sufficient cash to buy the stock at the strike price, and when the stock is called away, there should be enough shares in the account and a willingness to sell them at the strike price.

Options and Value Investing

The essence of selling Covered Call options and selling Put options is based on value investing, taking into account the discounted future cash flows. The difference lies in the fact that options strategies provide an opportunity to buy or sell based on the investor's estimated value. Even if this opportunity does not materialize into an actual trade, the seller still receives the option premium.

Option Price = Intrinsic Value + Time Value. Whether it is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM), the time value of an option diminishes to zero at expiration, providing certainty. Decay of time value is the main source of profit for option sellers.

According to statistics from the Chicago Board Options Exchange, about 55-60% of option contracts are closed out before the expiration date, 10% are exercised at expiration, and 30-35% expire worthless. The profit or loss from closing out contracts early may be difficult to assess, but expiring worthless at expiration certainly benefits the seller.

Options and Compounding Investment

For investors who already have a demand to sell the underlying stock, option selling strategies offer compounding investment effects and can effectively control the risk of significant losses.

For example, let's assume Investor A holds a certain company's stock and can set a target price for selling Covered Calls for any desired period. In a year with 52 weeks and 40 trading weeks, with an average weekly Call yield of at least 1%, the annualized return can reach 40%. Selling Calls equivalent to 3% of the stock's value each month can achieve an annualized return of 36%. Evaluating the annualized return is essential, considering the profitability and turnover rate for options of different durations.

Limit Order to Sell the Underlying Stock Directly

• Pros: Can sell all at once
• Cons: Depends on market conditions to reach the target price; missing the target price during the order period can be disappointing
• Cons: Does not generate income during the order period

Institutional Investor Strategy: Sell Covered Call

• Pros: Set a target price, with options expiring in one or two months; if the target price is reached at expiration, sell at the target price, similar to the benefits of placing an order
• Pros: Generates dividend income, with an annualized return of 8-10%. It can increase the returns from holding the underlying stock, covering loan interest expenses.
• Cons: If the stock rises above the target price, it still needs to be sold at the target price.

Further Understanding of Sell Covered Call

Selling a bullish call option, known as a Sell Call, offers advantageous prospects for the seller as long as the stock remains below the strike price, allowing them to earn the corresponding premium upon expiration. Thus, investors employing the Sell Call strategy have three possible market outlooks:

1. The underlying stock is on a downward trend.
2. The stock is range-bound, fluctuating within a certain range.
3. The stock experiences a price increase, but the magnitude remains below the strike price of the Sell Call.

At its core, this strategy reflects a belief in the unfavorable short-term trajectory of the stock while maintaining a strong conviction in its long-term prospects, as the seller is willing to hold the stock for an extended period.

When arranging a Sell Call, it is essential to set the strike price above the current stock price, primarily to profit from the time value of the option.

• Typically, sellers do not want the option to become in-the-money. Therefore, when selling a Call, it is advisable to consider the Delta indicator, which measures the sensitivity of option price changes to underlying asset price movements. The higher the Delta, the greater the potential variation in option price with asset price changes, allowing for larger premiums to be earned.
• Additionally, since sellers aim to capture time value, it is recommended to choose an expiration date within 1-3 months. Within three months, option time value diminishes rapidly (the daily decay represents the premium earned by the seller), with the most significant decay occurring in the 2-4 week period.

The premiums for Puts and Calls are influenced by short-term price fluctuations. A significant short-term rally favors the Sell Covered Call strategy, while a substantial decline benefits the Sell Put strategy. When stock prices stabilize, the premiums primarily derive from the time value of the option, resulting in relatively lower returns for short-term options. However, during periods of price volatility, option premiums stem from market sentiment and time value, offering attractive returns for both short and long-term options.

For Sell Calls, the greatest risk lies in selling the corresponding stock to the counterparty. The upside potential of the stock is unlimited, and if the seller does not hold the stock, they would need to purchase it from the market upon exercise and subsequently sell it to the counterparty at the strike price. If the stock's price rises significantly during this time, the losses incurred cannot be offset.

Therefore, we recommend that investors consider implementing the Sell Covered Call strategy, selling covered options by purchasing the corresponding stock prior to selling the Call. This way, the stock serves as collateral, and in the event of exercise, there is no need to buy the stock at a high market price; instead, the seller can sell the stock already in their possession. Additionally, if the investor already holds an adequate number of shares, no margin requirement would be imposed, maximizing the utilization of capital.

Investment Ideas and Suggestions

Due to the impact of China's economic recovery falling short of expectations, Hong Kong stocks have declined by nearly 20% since their peak in January. Given the policy vacuum in China and the high sensitivity of foreign investors to geopolitical factors, we hold a pessimistic short-term outlook for Hong Kong stocks. However, if the People's Bank of China implements specific policies to support economic growth in the future, we remain optimistic about the long-term prospects of Hong Kong stocks, especially in the high-tech sector. Consider the following strategies:

1. For stocks held in the account, directly implement the Sell Covered Call strategy.
2. First, acquire stocks with a positive long-term outlook and then implement the Sell Covered Call strategy.