Friday, November 5, 2010

online discount brokers, part 3: conservative option plays and the importance of cheap commissions

Many risk-takers love options and the huge leverage they can give their gambling -- but a growing number of prudent, conservative investors are acquiring a growing taste for the extra income they can give their conservative portfolio, and I count myself among the latter. Thomsett's classic "Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk", and simpler, breezier books such as Kadavy's "Covered Call Writing Demystified" (the latter comes, when you email requesting them, with some useful spreadsheet that I had no trouble loading into Google Spreadsheets and customizing to my preferences), blaze the way, as do websites such as this one.

BTW, Ken Fisher's new and overall worthwhile book Debunkery "debunks", in its point 13, the myth that selling naked puts is any riskier than selling covered calls -- though he omits to mention that for that purpose it's crucial to have your put entirely cash-secured [no margin!!!], and strangely seems to think the mathematical equivalence means that selling covered calls is risky, while obviously the reality is that selling naked, cash-secured puts is just as secure and conservative, and that the people needing to hear about this are conservative-investing options buffs (which is silly, since popular books by and for such readers, such as Groenke's "Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income", show the equivalence quite as clearly and describe it in more detail) -- obviously those who need to hear it said and repeated are the regulators and the majority of brokers that make it so much harder for the investor to qualify to sell cash-secured puts, as to sell covered calls (requiring more experience, a margin account, higher minimum account sizes and/or income and wealth, or any other such silly differentiation between two mathematically identical strategies!!!)

Anyway, buying a call is like buying a lottery ticket: limited risk (just the ticket's price or the call's premium), potentially huge upside (the jackpot lottery prize, a sudden hockey-stick in an underlying price that owning the call option lets you get for a pittance)... and yet not a sensible choice for an investor, because the probability of winning the big jackpot is just too low, so the expected value of the purchase is definitely negative.  But consider that (net of commissions, and we'll come back to that key point!-) the trading of options is a zero sum game: if it's negative for the buyer, it must be positive for the seller.  The seller of lottery tickets will once in a while be giving up a huge upside (when he sells the rare ticket that happens to be fated to win the jackpot -- he could have kept it for himself and cashed the jackpot...!-)) -- but gets a steady, modest, secure stream of income through his selling, nevertheless.   That, roughly speaking, is what you can get by selling covered calls (or cash-secured puts, but despite the mathematical equivalence I've noticed that selling calls is a bit more lucrative than selling puts: maybe there are more gamblers wanting to buy calls, than ones wanting to buy puts, and option prices after all are set by demand and supply -- the underlying math matters, but doesn't entirely determine the prices in the market).

But let's get back to that "net of commissions" provision, which is very important.  In the previous post I've noticed that for a moderatively active investor/trader on stocks, like me, MerrillEdge's 30 free stock trades a month end up meaning basically free trading (say $50/year for a few trades exceeding the monthly limit out of 200 total yearly ones) while (e.g.) Schwab's commissions could cost me about $2000/year (Fidelity's a tad less, Ameritrade's a tad more, but, same ballpark).

But now consider that out of (e.g.) the 30 stocks I own, every month I may want to sell calls on about 20 (I'll use another future post to explain why you don't want to sell calls on every stock every month, and why selling monthly options is best -- at least if your commission's low enough), say typically for about 6 contracts (600 shares) each, with a typical expected profit of (again, typical numbers) $200 for the premium and another $400 if exercised (out of the typically 240 calls [out of the money!] that I sell every year, experience tells me that only somewhere between 20 and 30 will be exercised in a typical market -- fewer in serious bear markets, more in crazy bull markets -- call it 25!-); so, expected revenue around 240 * $200 + 25 * $400 = 58,000/year, about 12% of the portfolio's overall value (and _that_ 12% yield is why I'm so keen to sell covered calls!-), gross of commissions (and taxes).

But -- what about the commissions...?  With MerrillEdge's 4.95+0.75/contract (and $4.95 on exercise), they would be: 240 * (4.95 + 0.75 * 6) + 25 * 4.95 = $2391 -- call it 2400 (we're using round numbers anyway!-), reducing profit to 55,600 before taxes.  With Schwab's $8.95 + 0.75/contract (as an example, since it's smack in the middle between cheaper Fidelity and costlier OptionsXpress), and $8.95 on exercise, we'd have 240 * (8.95 + 0.75 * 6) + 25 * 8.95 = $3451, almost 50% higher cost than MerrillEdge's, reducing pre-tax profig to 54,550.  I know, no world-changing difference, but, high enough to smell bad to this skinflint!-)

Whence, the quest for cheap commissions becoming especially important for options trading (and very very frequent trading even just of stocks, of course, but that's not really my case).  I'll reveal what broker I ended up choosing a couple posts from now, but, as a foreshadow -- its commissions are $2.95 for stock trades, and $5 for up to 5 contracts (plus $1/contract over five -- there's another possible commissions schedule you can opt into, changing only before the start of the trading day, if you usually trade more than 10 contracts at a time).  So in this case we'd have 240 * 6 + 25 * 2.95 -- $1513, a full third less than MerrillEdge, and that kind of saving really gladdens my heart!-)

The online discount broker I tried next after MerrillEdge, Zecco, has commissions of $4.50 for stock trading, $4.50 + 0.50/contract for options [Merrill gives qualifying customers 30 free stock trades/month, Zecco 10, but in each case I'm assuming the free trades, just like the "first 100 trades free" &c offers of other brokers, are exhausted on trading actual stocks, before options trading and exercise is considered], so the cost would be 240 * (4.50 + 0.50 * 6) + 25 * 4.50 = $1912, only 15% more than the one I ended up with and a good 20% less than MerrillEdge -- so that wouldn't have been so bad, price-wise, it's for other reasons that I found myself really unsatisfied with them... but, I'll go into that in the next post.

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