Selling options and the Evergrande crisis

I guess sometimes the best way to understand the psychology of how our minds work is to just do a little trial and error experiment.

The Starting Point

In my earlier post (see below), I was going through my mind of formulating a strategy of selling options as an income strategy.

Thoughts on the income strategy (Selling Options) (read here)

I think if you go through it, I think the key point I was trying to bring across (to myself) is as mentioned at the bottom of the post (to quote):

“However, the main difficulty probably lies in finding that proverbial psychological sweet spot whereby it becomes passive enough, and the income stream more or less stabilised so that we can spend less time monitoring the stock market (and not be overly fearful of any volatility or being too greedy).” 

Actually with most investments, be it stocks, investment properties, crypto, etc…. if I may (at the risk of over generalising), there are basically two starting points:

1) We may start off with the intention of hitting a min. target by a certain period. To achieve a certain figure as a primary goal, and we would be willing to take on more risks to achieve that goal.

2) On the other hand, we may start off with the intention of creating a system to generate a more sustainable (recurring) amount. It could be a very low amount (depending on our available resources at the point of time), but it is within our risk tolerance, and we are not willing to take on more risks to achieve higher returns.

I see (1) as a more speculative approach, while (2) as a more passive and sustainable approach (or rather invest to within ‘sleep level’). Sure with (2), the rate of growth is not much, more of the slow and boring method.

Let’s take the example of stocks. Within the stock markets there are a myriad of stocks (growth, old economy, various sectors, mega cap,, small cap, etc), ETFs, REITs, etc. There are also various ways to invest. If my primary objective is to reach XXXX figures fast in so and so period, than perhaps followig a slow buy and hold strategy of building up a dividend growth portfolio might not be the right approach. I may allocate most of my funds (if not all) to a few growth stocks (or just one stock), going for a more focussed / concentrated approach, and may need to take on margins to achieve my goal (my ‘KPI’) as fast as possible.

Uncovering The Risks Of Covered Calls And Cash Secured Puts (read here)

To quote the above article (emphasis mine):

“If you sell covered options, you should get clear on the type of benchmark you’re looking for. An annualized 20% return from selling covered options is possible but also carries higher risk.

On the other hand, a 10% annualized return from options premiums is more doable and carries less risk. You can also aim for a conservative 5% annual return and take on very little risk.”

Selling options can be accelerated or decelerated at my own pace. However, acceleration typically comes with much more risks.

When I was reading up on selling options (or watching YouTube videos about this topic), I often came across articles or videos with titles such as “I made XXXX amount per month (or XXXXX amount per year) selling options”. On the other hand, I have yet to come across articles or videos with the title “I sold options during a market crash or in periods of extreme volatility and I slept like a baby”. Perhaps I was not searching hard enough. Or perhaps the latter is just plain impossible.

I am sure the former articles or videos will get more views (more eyeballs), as compared to the latter articles or videos. However, the latter is more of what I am truly interested in (if that is at all possible).

Context

Oh yes, back to my earlier point of trial and error. So yes, I did sold some put options (on Chinese Tech stocks) with the intention that if prices do indeed drop to the strike prices (worst case), I would not mind purchasing the underlying shares.

I think different people have different circumstances. So let me just tell you a bit about my portfolio. My portfolio is dividend stocks heavy. There is a small percentage of growth stocks. And I have some cash as war-chest.

So primarily, my investment strategy is a dividend income strategy. However, a few objections moving forward: I intend to increase the proportion of the growth stocks in my portfolio, and to generate income from cash (and if possible growth stocks which I am already vested in).

I am sure we are all aware that Chinese Tech stocks are being ‘hammered’ for the past few months, starting with Alibaba late last year. Depending on how one views it, it could be a call to sell or buy.

Personally, I see it as a buying opportunity although I will refrain from saying it is a ‘throw all in, once in a lifetime’ buying opportunity. As with any correction or drop, I tend to buy in dips over a period of time. For this case, I see it as a long drawn, “unlikely to be resolved quickly” situation.

So that created the framework for me to see if I could incorporate selling options as an income strategy. It also created certain limitations.

Firstly, I have a really low percentage of Chinese Tech stocks in my portfolio (2.8%). See below. Secondly, my war-chest is limited.

Why limitations? There are certain guidelines I created for myself.

I do not intend to sell naked options. Eg. I need to have sufficient cash reserve on hand when I sell put options (Cash reserved put options) and I need to have sufficient stocks (vested) in my portfolio to sell call options (Covered call options). So yes, that sort of limit what I can earn (from option premiums), but hey I want to sleep at night (priority number one).

Given the current market sentiments (fear on Chinese Tech stocks), I tend to focus on the Chinese Tech stocks in my portfolio (Alibaba-9988.hk and Pinduoduo -PDD).

I have three other growth stocks in my US Growth stock portfolio (Alphabet, Mastercard and The Trade Desk). For obvious reasons, I probably won’t look at Alphabet when thinking about selling put options, given the fact that the share price of Alphabet Inc Class A at the time of writing this post is USD 2,844.30. 1 lot of option which translate to 100 shares means I need around USD 284,400 (or around SGD 384, 900) in cash reserve, just to sell 1 lot of Alphabet put option, or 100 shares of Alphabet vested to sell covered call options.

Fortunately 9988.hk and PDD do not need that much cash reserve for 1 lot of options (still within my comfort zone with 1 lot). At the point of writing, the stock price of 9988.hk is HKD 144.30. 1 lot of option= 500 shares (for HKEX listed shares), which translates to HKD 72,150 (or SGD 12,545.83). The stock price of PDD is USD 94.55. 1 lot of option= 100 shares, which translate to USD 9,455 (or SGD 12,796.16).

I also have more than enough Alibaba shares to sell covered call options (eg. min 500 shares), but in general the amount is still relatively low since I don’t really have a lot of Chinese Tech stocks anyway, as mentioned earlier.

However, I see selling options as being complementary to my dividend portfolio. My primary goal and main strategy which I am comfortable with, is still to build up my stock portfolio (bar-bell portfolio with both growth and dividend portfolios) and increasing my passive dividend income.

So with that in mind, I just sold 1 or 2 lots (put options or call options) at any one time, typically for short duration to expiration (eg. 1 week to 1 month+).

The Crisis

I guess the best way to test out any strategy is during a crisis.

Well, I did not have to wait long.. before the Evergrande crisis struck (and at the point of writing this post, it is still unresolved).

Evergrande on brink of collapse: 4 things to know (read here)

In one day (20 Sept 21, Mon), all the counters in my HK dividend portfolio turned red, and so did many of the counters in my SG dividend portfolio. In addition, with regards to the put options which I have sold, the stock price within that day fell really close to the strike prices.

China Evergrande crisis rocks markets across globe (read here)

To quote the article above (emphasis mine):

“While Chinese and Hong Kong property groups bore the brunt of the sell-off, the impact was felt across European and U.S. stock markets. China Evergrande, whose liabilities amount to almost a third of a trillion dollars, is facing deadlines this week for payments to banks and bondholders.…..

The Nasdaq closed down 2.2% and the top three decliners were all Chinese companies: Pinduoduo, Baidu, and JD.com. The S&P 500 finished down 1.7%. It was both indexes’ worst day of trading since May.”

There were a few thoughts in retrospect after 20 Sept 21.

1) Selling put options have some limitations.

For myself, as a long term investor, I tend to like to accumulate stocks. Actually a correction or a crisis presents a good opportunity to accumulate more stocks. However, selling cash reserved put options and buying stocks on dips both require the same precious asset / resource – cash. On a long term horizon, between the two strategies, I would much rather buy stocks during a correction than sell options at that time and end up not assigned to the underlying stocks . I reckon the former would be more rewarding moving forward.

“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” Warren Buffett

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful,” Warren Buffett

On a long term basis, since I am still in the process of accumulating stocks, my war-chest level will always be relatively stagnant, while the quantity of stocks in my portfolio should increase. So if my current comfort level allows me to sell X number of put options base on my current war-chest level, it is likely that I can’t increase this number moving forward given my stagnant war-chest level. Having said that, I can start building up my war-chest with the intention of using that as cash reserves or buffers for selling more put options. Eg. two sets of war-chest (1 for buying stocks during dips and 1 as cash reserve for selling put options).

There are articles stating that from a purely yield based perspective, given the same amount of capital, one can achieve a higher yield by just selling options (as compared to the yield achieved from a basket of dividend stocks). However, I reckon, overtime, on a long term basis, the cost yield of a basket of good dividend stocks would trump the yield from selling options (well, I did not go into what is the cumulative amount I can get overtime from these 2 strategies though)…

The Math Behind Making $100,000 Each Year Selling Options (read here)

Which brings me to my second point…

2) With more growth stocks vested over time, selling covered call options seems more viable.

The quantity of growth stocks I have in my portfolio should (and hopefully) increase over a long period of time. Nevertheless, the downside (of selling covered call options) is that I may cap the upside to the stocks if price suddenly move upwards and I did not close the options in time and have to sell what I am vested in (… need to buy back later, hopefully at lower price.. which may not happen anytime soon, and I would have missed the upside, with price continually going upwards).

Note: If you intend to sell covered call options using Tiger Brokers, please remember to contact Tiger Brokers and inform them to activate the covered call feature in your trading account, so that no margin capital is required. Otherwise you may face the issues as per the posts below.

Tiger brokers doesn’t support covered calls. Should I transfer my shares to another brokerage (read here)

3) It would be really hard to sleep if I sold naked options.

It is one thing to sell put options with the intention of buying the underlying (100 or 500) stocks at the strike price while having the means to do so, and it is another thing to sell naked put options to get as much premium as fast as possible while not thinking about the maximum amount one would need to pay to buy the underlying stocks if the stock price does go beyond the strike price. In the case of call options, it would be the case of not having enough stocks to sell (and having insufficient margin).

If I have sold naked put options which are way beyond my comfort limit, especially put options, without sufficient cash reserve when the markets trend rapidly downwards… I would probably find it hard to sleep. Really, the premium is just not worth it. Moreover if I am selling options of US listed growth shares, it is literally impossible for me to monitor the US markets overnight (Singapore time). Prices can fluctuate wildly in just one night…. and there is no way I can predict the outcome or close the positions during market hours.

To me, recurring income is good but a good night sleep is more important.

I Have Been Selling Naked Options For Income – Dr Wealth (read here)

How I Blew Up A Full Year’s Salary In My Trading Account (read here)

4) I realised that perhaps selling options with longer durations of 2 weeks to a month as compared to a few days to 10 days are perhaps better .

Sure with shorter duration options, I get to collect premiums more frequently. However, with shorter duration options, to achieve decent premium I will be forced to choose strike prices which are much closer to the stock prices.

The risk of the options being exercised will be higher, as there isn’t sufficient duration for the effects of time decay to work. I also noticed that I looked at the stock prices more often (than I preferred).

5) If I am already in the profit, and the option is left with only a few days to expiry and the stock price came very close to the strike price, it might be better to just close the option.

In gist

After thinking through, writing down my thoughts, going through the post again, it is apparent that it is possible to earn some premium (XX or XXX amount) through options monthly. To increase this amount is also possible. However, it will not be fast and should not be fast.

It takes time to build up a war-chest or build up the quantity of (growth) stocks in my portfolio, and by choosing options with longer durations I don’t get premium as often (and overall monthly premium amount ought to be lower). It can’t be fast.

Perhaps to use an analogy… selling options is like “A game of Poker + Selling Insurance”.

Like stocks & poker, it can be said that one is dealing with odds (as what Howards Mark would like say). At certain point in time, the odds will tilt in your favour.

In addition, options are often bought by traders as a tool (hedge) for their positions in the markets, and on the other end, the option sellers are like sellers of insurance. And like being the insurer in the stock market, there must be sufficient liquidity when a crisis happens.

To be able to sleep well at night is more important.

There is this phrase from Tiger Brokers that is catchy, and I sees it every time I enter into its desktop site, see below: Money Never Sleeps.

Well, personally, I don’t really like that.

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