September 28, 2012 Update

    Cash:                             $ 13,486.80
    Accrued Dividends:                     170.20
    Stocks:                            113,092.42
    Options:                           (10,889.64)

  Account Value:                      $115,859.78

  Equity:                             $126,758.40
  Margin Requirement:                   73,386.51
  Available Funds:                      53,371.89

  Regulation T Margin Requirement:     100,002.19
  Special Memorandum Acct:              43,539.31

On September 29, a $172.00 dividend was paid for 400 shares of ARCC; $2.00 was paid for 200 shares of CSE; and $10.00 was paid for 100 shares of FTR.

The account value of $115,859.78 compares with the value a month earlier of  $114,037.23, a return of 1.60%. This compares, however, with the change in the S&P 500 Index from 1,406.58 to 1,440.67. Adding an estimate of a quarter percent dividend payment (one twelfth of 3%), this gives a return of 2.67% for the S&P 500, so my portfolio underperformed the market in the month of September. This is not too surprising to me because the market did very well during the month, and my strategy is designed to start to bail out when the market does particularly well.

Understanding Utility Theory

Uncertainty and risk have long confounded human reasoning: the syllogisms of basic logic assume certainty in all assertions, and allow no conclusions to be drawn until all factual states are decided.

And, in practice, people often demonstrate themselves to be remarkably poor at making decisions based on uncertain conditions, foregoing much needed insurances while over-paying for absurdly unlikely coverage, for example.

Within this confusion, the intuitively appealing notion of a "risk premium" has arisen. In general, the notion of a risk premium is that reasonable people will not accept risk without an expectation of, on average, profit above and beyond what is available without risk.

Utility theory is a method of quantifying the notion of a risk premium.

The main premise of utility theory is that we should concern ourselves not with the cash value ("wealth") of anything, but rather with the utility (which I guess is just a of saying "usefulness" with a word derived from Latin ...) of the wealth. And then there are just two parameters that the utility function of wealth are held to have to satisfy: the utility of more wealth is always greater than the utility of less wealth; and the rate of increase of utility relative to wealth decreases as the absolute level of wealth increases.

Mathematically, these two properties are stated as follows:

1. dU/dW > 0; and
2. d²U/dW² < 0.

And this is really all that standard utility theory tells us.

There are, however, a couple more things to know about utility theory.

The first is that, in standard financial theory today, utility theory is the beginning and end of how risk is understood. This can perhaps be seen most clearly through a 1963 article by Paul A. Samuelson, "Risk and Uncertainty: A Fallacy of Large Numbers", and through a 1995 article that is largely a reprise of the same argument: "On the Risk of Stocks in the Long Run" by Zvi Bodie (sorry, no link).

"Risk and Uncertainty" relies upon utility theory to demonstrate that if you will not accept, due to risk concerns, a single wager with a positive expected return, you also should not accept any multiple repetitions of the same wager, even if the possibility of any loss under the multiple repetitions is almost zero. "On the Risk of Stocks" uses Black-Scholes options pricing theory -- which is based on utility theory -- to dismiss the proposition that, if your time horizon is long enough, the higher expected return on stocks will make them a more suitable investment than investments with more certain returns, even though you would want the more certain investments for a shorter time horizon.

The second thing to know about utility theory is that it seems to have almost no predictive value whatever in determining how economic agents, like investors, actually behave. In traditional science, having no predictive value is the hallmark of a hypothesis (not a theory ...) that must be rejected.

September 26, 2012 Trade

Opened:
 Pos    Symbol                   Price     Comm       Net
 -2    BHP 16MAY13 45.0 P         1.05     0.76     (209.24)

September 25, 2012 Trade

Opened:
 Pos    Symbol                   Price     Comm       Net
 -3    JCI 19APR13 20.0 P         0.50     0.03     (149.97)

September 24, 2012 Trades

Opened:
 Pos    Symbol                   Price     Comm       Net
 -4    BMY 19OCT12 34.0 C         0.26     1.52     (102.48)

 -2    RIG 19OCT12 50.0 C         0.76     1.52     (150.48)

 -4    C 15MAR13 25.0 P           0.85     1.52     (266.48)

 -4    ABX 19APR13 30.0 P         0.70     3.04     (276.96)

 -2    DDS 17MAY13 60.0 P         2.95     1.13     (588.87)

September 21, 2012 Options Expirations and Update

Closed:
 Pos    Symbol                   Price     Comm       Net
 -4 BMY 22SEP12 34.0 C            0.00     0.00        0.00
     Basis 05/21/2012:                              (345.09)
     Profit/(Loss):                                  345.09

     Value 08/31/2012:                               (53.43)
     Post-August Profit/(Loss):                       53.43


 -2 RIG 22SEP12 50.0 C            0.00     0.00        0.00
     Basis 08/20/2012:                              (274.48)
     Profit/(Loss):                                  274.48

     Value 08/31/2012:                              (224.17)
     Post-August Profit/(Loss):                      224.17


 -3 CE 22SEP12 30.0 P             0.00     0.00        0.00
     Basis 02/23/2012:                              (222.94)
     Profit/(Loss):                                  222.94

     Value 08/31/2012:                                (3.72)
     Post-August Profit/(Loss):                        3.72


 -2 EMR 22SEP12 35.0 P            0.00     0.00        0.00
     Basis 03/23/2012:                               (89.35)
     Profit/(Loss):                                   89.35

     Value 08/31/2012:                                (0.01)
     Post-August Profit/(Loss):                        0.01


 -2 NSC 22SEP12 60.0 P            0.00     0.00        0.00
     Basis 01/23/2012:                              (418.94)
     Profit/(Loss):                                  418.94

     Value 08/31/2012:                                (0.59)
     Post-August Profit/(Loss):                        0.59


 -1 V 22SEP12 90.0 P              0.00     0.00        0.00
     Basis 01/23/2012:                              (533.97)
     Profit/(Loss):                                  533.97

     Value 08/31/2012:                                (0.00)
     Post-August Profit/(Loss):                        0.00

Also since the last update, effective September 20 a $170.00 dividend became payable for 1,000 shares of GE, and on September 21 a $142.01 dividend was paid on 400 shares of WM.

September 19, 2012 Trades and Update

Closed:
 Pos    Symbol                   Price     Comm       Net
 -4    GE 22SEP12 20.0 C          2.49     3.79    (2,493.79)
     Basis 01/20/2012:                             (1,002.74)
     Profit/(Loss):                                (1,491.05)

     Value 08/31/2012:                              (827.26)
     Post-August Profit/(Loss):                    (1,646.23)

Opened:
 Pos    Symbol                   Price     Comm       Net
 -4    GE 16MAR13 21.0 C          1.89     9.48    (1,880.52)

This pair of transactions was made in advance of an GE ex-dividend date of September 20, with a dividend amount of $0.17 per share.

Also since the last update, effective September 12 a $172.00 dividend became payable for 400 shares of ARCC and a $2.00 dividend became payable for 200 shares of CSE, and an $82.50 dividend was paid on September 12 for 300 shares of WAG.

September 11, 2012 Trades and Update

Closed:
 Pos    Symbol                   Price     Comm       Net
 -4    ARCC 22SEP12 16.0 C        1.70     0.04     (680.04)
     Basis 06/18/2012:                              (117.09)
     Profit/(Loss):                                 (562.95)

     Value 08/31/2012:                              (519.80)
     Post-August Profit/(Loss):                     (160.24)

Opened:
 Pos    Symbol                   Price     Comm       Net
 -4    ARCC 16MAR13 17.0 C        0.85     0.04     (339.96)

This pair of transactions was made in advance of an ARCC ex-dividend date of September 12, with a dividend amount of $0.43 per share, consisting of $0.38 regular dividend and $0.05 special dividend.

Also since the last update, effective September 5 a $10.00 dividend became payable  for 100 shares of FTR and a $142.00 dividend became payable for 400 shares of WM.

A Comment On Margin

The portfolio statistic that I keep my eyes most closely on is the "Available Funds," which is the difference between Account Equity and Account Margin Requirement. When Available Funds falls to zero, you get a margin call, and you have to liquidate positions whether you want to or not.

The August 31 summary statistics for the account I'm following on this blog are repeated below:


    Cash:                             $ 12,287.18
    Accrued Dividends:                      82.70
    Stocks:                            110,606.66
    Options:                            (8,939.31)

  Account Value:                      $114,037.23

  Equity:                             $122,995.54
  Margin Requirement:                   68,797.67
  Available Funds:                      54,197.87

  Regulation T Margin Requirement:      94,941.99
  Special Memorandum Acct:              43,637.69

Generally, if you are not borrowing money and you are not shorting any securities, you don't have to worry about margin. You can also sell covered calls without having to worry about margin.

The portion of my trading strategy that involves margin is selling naked puts, which also happens to be where I expect to make the best return on investment; covered calls, to my thinking, mainly serve to mitigate risk.

Anyway, if you are trading with margin, it's important to know how the margin requirements for your account are determined. There are legal requirements that must be met, but most brokerage firms will have additional requirements, and the ones that matter are those that your brokerage firm enforces. I'll review my broker's requirements, but be aware that there may be differences with your broker, and that the differences will not be subtle when it matters.

First, Equity is just the sum of Cash, Accrued Dividends, and Stocks and Bonds (in my case, just Stocks). There is a slight difference between this sum in the numbers above and the Equity reported, due (I believe) to differences in how bid-and-ask spreads are dealt with for Account Value purposes (which is where I took the basic numbers from) and for Equity purposes.

The margin requirements for stocks are 25% of the stocks' market value. For covered calls, the requirement is any in-the-money amount. To a certain extent, this doesn't make sense: for a stock trading at $100 with a covered call exercizable at $100 as well, the equity is $100 and the margin requirement is $25, for net available funds (equity less margin requirement) of $75; if the same stock goes up to $110 (the covered call remains exercizable at $100), the equity is $110 but the margin requirement is $27.50 for the stock and $10 for the covered all, for a total of $37.50 and net available funds of $72.50. So a stock with a covered call that is in the money (which is in fact a more certain position) adds less to available funds that a stock with a covered call that is exactly at the money.

Regardless, I don't make the rules, I just have to abide by them: the upshot of this for me is that I try to have my covered calls out-of-the-money in order to avoid the counter-logical hit to available funds. For Regulation T requirements, which include a margin requirement of 50% of market value for stocks, the hit is more severe: available funds for the covered call example above would go from $50 at-the-money to $40 in-the-money. More on Regulation T later.

The margin requirement for a naked put is the market value of the put plus the greater of (a) 10% of the strike price, (b) the strike price less 80% of the market value of the stock, and (c) $2.50. Items (a) and (b) together create a point of inflection at one-and-one-eighth (1 1/8 or 112.5%) of the strike price: if the stock price is above this, the margin requirement will be the market value of the put plus 10% of the strike price; if the stock price is below this, the margin requirement is the strike price less 80% of the market value of the stock. The latter situation is one I generally try to avoid: given that the market value of the put is also moving, the margin requirement is very volatile when is is based on the strike price offset by 80% of the stock's market value. I tend to open naked put positions such that the stock price is 125% of the strike price or higher, which gives some wiggle room before the margin requirement reaches this volatile situation.

Where the naked put strike price is less than $25, the item (c) $2.50 addition to the margin requirement will dominate the 10% of the strike price amount, so there will be a different inflection point, but otherwise the same considerations apply.

In addition to the regular margin requirements outlined above, an account using margin must also meet "Regulation T" requirements.* The Regulation T margin requirement calculations are the same as the regular margin requirement calculations except that the margin requirements for stocks under Regulation T is 50% of market value rather than 25%. This would normally make Regulation T requirements more restrictive than the regular requirements, but Regulation T requirements are applied differently: the "Special Memorandum Account" (SMA) is what really determines available funds under Regulation T, and this is determined on a daily basis as the minimum of (a) the current Regulation T margin requirement and (b) the SMA from the prior day adjusted by the Regulation T margin effects of any transactions within the account during the day. So basically, the SMA will never drop solely due to changes in market prices: it is locked in at a prior amount, subject to changes due to actual transactions in the account. It can, however, go up due to changes in market prices.

Also, note that because of the 50% margin requirement for stocks, Regulation T is a lot more lenient about naked put positions than it is about covered call positions, in spite of the fact that they are essentially identical: the change in value to a covered call position with a strike price of X will be exactly the same as the change in value to a naked put position on the same stock with a strike price of X.

* -- My brokerage firm allows a "Portfolio Margin" calculation to replace the Regulation T requirement if you elect it and if you keep your account equity above $110,000. I have not elected this, and my account equity is not so securely above $110,000 that I'd feel comfortable doing it at this point. Also, I don't mind too much that Regulation T reins me in from doing anything too stupid ...

A Starting Point: August 31, 2012

I have been actively trading equity options since 1998, beginning with covered call until I built up enough equity to trade naked puts as well. For reasons that I'll eventually get into, I have always exclusively held short options positions.

Beginning in July 2001, I began making my living trading options. In the financial crash of 2008, I was essentially wiped out in my main, non-IRA account, which is something the reader should keep in mind if he chooses to follow my investing strategies. After a couple years back in the working world, I resumed living off of investment income in June 2010.

In order that a live example of my options trading strategies can be followed, I'm going to post trades made to my main non-IRA account. Note that I have income from outside of this account, so I am able to take risks with it that otherwise lead easily to catastrophe. In general, I hope to generate an average of $1,000 a month in cash flow from this account, or a little better than 10% per year, while growing or at least maintaining the account value.

But options trading always has to be considered in the context of an entire portfolio, so to start things out, here are my account positions at the close of trading on August 31, 2012:

    Cash:                             $ 12,287.18
    Accrued Dividends:                      82.70
    Stocks:                            110,606.66
    Options:                            (8,939.31)

  Account Value:                      $114,037.23

  Equity:                             $122,995.54
  Margin Requirement:                   68,797.67
  Available Funds:                      54,197.87

  Regulation T Margin Requirement:      94,941.99
  Special Memorandum Acct:              43,637.69

  Pos   Symbol/Name                      Price      Value

  400 ARCC ARES CAPITAL CORP  17.27  5,908.00
   -4 ARCC 22SEP12 16.0 C                1.30  (519.80)
(  09/11/2012  +4 ARCC 22SEP12 16.0 C     1.70      680.04    )
(      Post-August Profit/(Loss):                  (160.24)   )

  400 BMY BRISTOL-MYERS SQUIBB CO  33.01  13,204.00 
   -4 BMY 22SEP12 34.0 C  0.13  (53.43)
(  09/21/2012  +4 BMY 22SEP12 34.0 C      0.00        0.00    )
(      Post-August Profit/(Loss):                    53.43    )

 1000 GE GENERAL ELECTRIC CO  20.71  20,710.00 
  -10 GE 22SEP12 20.0 C  0.83  (827.26)
(  09/19/2012  +10 GE 22SEP12 21.0 C      2.49    2,473.49    )
(      Post-August Profit/(Loss):                (1,646.23)   )

  200 RIG TRANSOCEAN LTD  49.03  9,806.00 
   -2 RIG 22SEP12 50.0 C  1.12  (224.17)
(  09/21/2012  +2 RIG 22SEP12 50.0 C      0.00        0.00    )
(      Post-August Profit/(Loss):                   224.17    )

CE CELANESE CORP  38.26
   -3 CE 22SEP12 30.0 P  0.01  (3.72)
(  09/21/2012  +3 CE 22SEP12 30.0 P       0.00        0.00    )
(      Post-August Profit/(Loss):                     3.72    )
 
EMR EMERSON ELECTRIC CO  50.72 
   -2 EMR 22SEP12 35.0 P  0.00  (0.01)
(  09/21/2012  +2 EMR 22SEP12 35.0 P      0.00        0.00    )
(      Post-August Profit/(Loss):                     0.01    )

NSC NORFOLK SOUTHERN CORP  72.46 
   -2 NSC 22SEP12 60.0 P  0.00  (0.59)
(  09/21/2012  +2 NSC 22SEP12 60.0 P      0.00        0.00    )
(      Post-August Profit/(Loss):                     0.59    )

V VISA INC  128.25
   -1 V 22SEP12 90.0 P  0.00  (0.00)
(  09/21/2012  +1 V 22SEP12 90.0 P        0.00        0.00    )
(      Post-August Profit/(Loss):                     0.00    )


  300 WAG WALGREEN CO  35.76  10,728.00 
   -3 WAG 20OCT12 33.0 C  3.14  (940.89)

DD DUPONT AND CO  49.75
   -2 DD 20OCT12 40.0 P  0.10  (20.29)

INTC INTEL CORP  24.83
   -5 INTC 20OCT12 25.0 P  0.99  (494.90)

SNDK SANDISK CORP  41.22
   -3 SNDK 20OCT12 35.0 P  0.55  (164.04)

STX SEAGATE TECHNOLOGY PLC  32.01
   -4 STX 20OCT12 28.0 P  0.76  (303.14)

UPS UNITED PARCEL SVC INC          73.81
   -2 UPS 20OCT12 60.0 P  0.06  (12.47)

COP CONOCOPHILIPS  56.79
PSX PHILLIPS 66  42.00
   -2 COP1 17NOV12 60.0 P  0.22  (43.43)

HES HESS CORP  50.53
   -3 HES 17NOV12 40.0 P  0.48  (145.47)

MDT MEDTRONIC INC  40.66
   -4 MDT 17NOV12 29.0 P  0.11  (44.41)

CREE CREE INC  28.20 
   -5 CREE 22DEC12 15.0 P  0.14  (68.97)

DOW DOW CHEMICAL CO  29.31
   -4 DOW 22DEC12 25.0 P  0.62  (248.12)

NE NOBLE CORP  38.14 
   -3 NE 22DEC12 30.0 P  0.66  (199.08)

POT POTASH CORP  41.07 
   -3 POT 22DEC12 32.5 P  0.50  (150.20)

TIE TITANIUM METALS CORP  12.24
   -5 TIE 22DEC12 10.0 P  0.29  (142.82)

TM TOYOTA MOTORS CORP  79.62
   -2 TM 20OCT12 55.0 P  0.01  (2.47)

  200 CSE CAPITALSOURCE INC  6.93  1,386.00 
   -2 CSE 19JAN13 7.0 C  0.43  (85.02)

  200 PG PROCTER & GAMBLE CO  67.19  13,438.00 
   -2 PG 19JAN13 67.5 C  2.04  (408.53)

  400 WM WASTE MANAGEMENT INC  34.58  13,832.00 
   -4 WM 19JAN13 37.0 C  0.41  (164.21)

CMI CUMMINS INC  97.11
   -2 CMI 19JAN13 45.0 P  0.21  (42.14)

HON HONEYWELL INTL INC  58.45
   -3 HON 19JAN13 40.0 P  0.38  (114.47)

MMM 3M CO  92.60
   -2 MMM 19JAN13 55.0 P  0.13  (26.60)

UTX UNITED TECHNOLOGY CORP 79.85
   -2 UTX 19JAN13 50.0 P  0.41  (82.69)

A AGILENT TECHNOLOGIES INC         37.16
   -4 A 16FEB13 25.0 P  0.49  (194.81)

CAT CATERPILLAR INC  85.33
   -2 CAT 16FEB13 60.0 P  1.13  (226.38)

PH PARKER-HANNIFIN CORP  79.98
   -2 PH 16FEB13 60.0 P  1.69  (337.73)

STT STATE STREET CORP  41.60
   -3 STT 16FEB13 30.0 P  0.57  (169.59)

IR INGERSOLL-RAND PLC  46.76
   -4 IR 16MAR13 25.0 P  0.31  (125.13)

JPM JPMORGAN CHASE & CO  37.14
   -4 JPM 16MAR13 25.0 P  0.54 (215.80)

UNH UNITEDHEALTH GROUP INC  54.30
   -3 UNH 16MAR13 40.0 P  0.95  (283.94)

  400 VZ VERIZON COMM INC  42.94  17,176.00 
   -4 VZ 20APR13 43.0 C  2.04  (815.63)

LOW LOWE's COMPANIES INC  28.48
   -5 LOW 20APR13 20.0 P  0.56  (278.17)

MAR MARRIOTT INTL INC              37.68 
   -4 MAR 20APR13 29.0 P  1.05  (418.42)

  200 TSM TAIWAN SEMI-SP ADR  14.70  2,940.00 
   -2 TSM 18JAN14 15.0 C  1.70  (340.37)

   34 DYNIQ DYNEGY INC  0.49  16.66 

  100 FTR FRONTIER COMM CORP  4.62  462.00 

Introduction

I hope to create with this blog a resource with which people may learn about the theory and practice of options trading, at least as I do it.

I believe that most investors can fine-tune their investment portfolios through the use of options, reducing risk and enhancing return more efficiently than can be done with basic securities. Part of this is due to the essential nature of options, which allow investment return profiles to be shaped to closely fit the perceptions and preferences of the investor. Another part is due to what I believe is a systemic error in how options are priced today.

The entries in this blog will generally be of two types: discussions of theory, and live-tracking of trading in my most active trading account. If anyone happens to read the blog, I'll try to respond to comments either directly or in future blog entries.