Politics is and politics does

I discovered a good way to reduce my stress levels. I stopped getting het up when what politicians did was completely at odds with what they said. Often I didn't really care much about what they were doing anyway, so why should it matter if they said something completely different? And yet for some reason it did matter, to me, anyway.

There should be some kind of competition each year, like the Emmys, where politicians are awarded kudos for the most barefaced bullshit.

And, old George W has won it this month, no doubt about it. The transportation bill, signed into law by the president yesterday, consists of more than 6,300 projects. It will cost $286bn. Er, that's about a thousand bucks for every man, woman and child in the US. Now, if this were put together in a joined-up-writing kind of way that would radically improve the transportation infrastructure of the US, one could see the economic arguments in its favour. But politics is and politics does; things don't work that way in the US.

Chairman of the House Transportation & Infrastructure Committee, Don Young gained nearly $1 bn for Alaska, where few people live and no-one visits. (This includes $231m for a bridge near Anchorage to be named "Don Young's Way"). And House Ways & Means Committee Chairman Bill Thomas got $700m for the area in and around his home district of Bakersfield, California. Oh, and Speaker Dennis Hastert, of Illinois (where Bush signed the bill into law) got the third-highest amount in the US for his state.

In terms of fiscal responsibility, in other words, this ranks about nought out of ten. And Bush's justification? "The bill I'm signing is going to help give hundreds of thousands of Americans good-paying jobs". Well, that's alright, then. It's New Deal economics. Franklin Roosevelt is alive and well.

Now I have no beef with pork barrel politics (to sort of mix carnivorous metaphors). I know that's how the world turns. And I now have no beef with politicians who say one thing and do another. But I do get a bit annoyed when people are fooled by it. C'mon, is Bush a fiscally careful president or not? The only difference I can see between this and the spending of Gordon Brown in the past few years is that Bush will spend it on roads, while Brown spent it on hospital administrators. Both are likely to fail in their ostensible aim, but are likely to be remarkably successful in the hidden aim -- to get their party re-elected.

Covered Calls

PB9617 mentioned in his blog that he had been selling covered calls (in Oracle, as it happens) for ages, and that not one of them had ever been exercised. "It's been free money", he said. Then he read about the topic of options in someone else's blog (Jonathan Kaplan's) and mused, probably correctly, that now that he understands the bloody things a bit better, he will probably start losing.

Whenever you enter any kind of financial trade, particularly one involving derivatives, the thing to ask yourself is, "what am I buying or selling here?"

When selling a covered call, the obvious (but wrong) answer is "it's a no lose deal! If the price of Oracle goes up, the option is exercised, but I own the shares, so I sell the shares at a profit to pay for the call option. If the share price doesn't go up, the option expires and I pocket the money!" Indeed, I saw an article in the Sunday Times a few years ago claiming that, by using this method, you could get 20% a year return on your shares.

Clearly, if something looks like easy money, there is a flaw in the argument. So what is that flaw?

What you have to look at here is a whole series of options in a stock. Let's price it at 100p, with the 120% option costing 10% of the stock price at opening. Let's now take a series of prices at the time the option expires.

100
109
95
100
105
95
80
90
100
105


Kerching! 10 covered calls sold, 10p per share profit every time. Easy money!

Now, what about this one.

100
90
80
70
60
50
40
40
40
40

This time, not so kerching. Your options have still never been exercised, so you have made 61p total per share. But you have lost 60p in the share's value. Oh well, you say, but that means I am still 1p better off than I would have been if I had just owned the shares and not written the options! So it's still a good deal.

What about this sequence?

100
130
180
210
260
300
400
700
800
1100

Hmm, now it doesn't look so rosy. The options have been exercised virtually every time, so you had to sell the shares. But if you want to carry on with the trade, you have to buy them back again. "Oh well", you say, "I'm still covered. I haven't lost any money. The rising share price has seen to that." But, of course, you HAVE lost money. You've lost the 1000% return on your money that you would have made if you had not written any call options at all. "Ahh", you say, "but money never seen is money never missed!" OK, have it your way.

Let's try this one.

100
150
90
160
100
180
80
140
80
100

Whoops. This time it's a bit more complicated. Several times you will have had the calls exercised. You then buy your new shares, and they drop in value, so you make the money on the call option, but lose on the value of the shares. Then someone moves in and buys the options at the sub-100p price, which then zooms up to 160p, so you sell the shares to cover the call, but you have to buy them back again. The share price then drops, and so the miserable sequence continues.

So, when you are writing covered calls, basically you are selling volatility. If stuff stays still, then you make money. If it moves in a uniform direction, then your "hedge" (the actual owning of the shares) covers you against your writing the call. But if the share price gyrates wildly before ending back where it started at the beginning, then you do your bollocks.

In this sense, the assertion that you should not write naked calls is a red herring. Covered calls are a hedge against one kind of volatility (a uniform trend), but not against wild up-and-down swings. If you really want to sell volatility, why bother owning the share at all? Just buy collars.

The reason that selling covered calls gained a following was because it's a bit like backing a long odds-on shot in a race, the rules of which you don't really understand, but you don't care so long as you keep getting paid. On the surface it does indeed look like a "no-lose" play. Only when you delve beneath the surface do you see that your trade is a gamble, just like any other.