Interview #9 – Lyn Alden

Lyn Alden runs a blog where she shares her view and analysis on the economy and stock market. She is featured on many websites. She also trades options and uses stock analysis to define trades. Great inspiration for value and dividend investors that look to trade options. Check out here newsletter!

Q: Tell us about yourself

My background is a blend of engineering and finance.

I started off with a bachelor’s in electrical engineering, but always had a passion for finance and economics.  After working as an engineer for a while, where I designed electrical systems for aircraft simulators, I went back to school part time and got a master’s in engineering management, for which I focused heavily on engineering economics, financial modeling, and resource management.

Now in my organization, I serve as the lead electronics engineer, but I also write the annual budget for our facility and oversee all the technical procurement we do throughout the year for products and engineering services, manage our credit line set task priorities for many of our workers on all of our projects, and manage our contracts with vendors.

I started my website because investing is a passion for me and I enjoy writing about it.

At this point I have about 12 years of investing experience, including 5 years as an option-seller.

Q: How did you get an interest in option trading?

I started investing in equities back when I was a teenager, and was that weird kid that would read the Wall Street Journal for fun.

I’m a value and dividend investor at heart, so I was heavily into that for a while.  Back in 2007/2008, though, the market was expensive, so I started to put a lot of my assets into cash, especially since I barely had any money back then.

During the March 2009 stock market bottom, when so many stocks were undervalued, I put most of my net worth back into equities, and enjoyed the huge surge from there, and kept contributing money each month.

By around 2012, though, the market was fully-valued.  The cyclically-adjusted price-to-earnings value of the market was well over 20, and I wasn’t really finding too many significantly undervalued companies.  The market wasn’t really overvalued either, but it was hard to find great buys with a margin of safety.

So I started selling put options to obligate myself to a lower cost basis than what the current market prices were offering, and began selling covered calls on some of my existing positions to generate more income from them.

Q: What actions did you take to learn about option trading?

I already had decent experience with investing at that point.  I had read hundreds of corporate annual reports, many of Warren Buffett’s shareholder letters, and plenty of investing books.  I had taught myself how to do discounted cash flow analysis from free tutorials online years before that, and learned it again in graduate school along with other financial modeling topics.

To start my options experience, I learned details about how covered calls and cash-secured puts work, just from basic online sources.  It was easy to integrate that knowledge into what I already could do with regards to stock valuation, since I wasn’t interested in any of the really complicated strategies.

I would determine a fair value for a stock like I had always done, but simply would add the extra step of looking up the options table to see what types of puts I could sell on it instead of buying it outright.  I’d ensure that my obligated cost basis of the trade was below my calculated fair value of the security, and that the annualized rate of return I’d get if the option was not exercised was over 12% or so.

Q: What is your goal/ambition?

To become financially free in my 30’s.  I’m 29 currently.

My life has been a bit more financially crazy than most people, for better or worse.  I was homeless for two years as a child, for example, and then grew up in a trailer park with a single parent after that.

At 18, I didn’t really have a choice other than to move out of my home, so I racked up a lot more student debt in college than most people because I had very little financial support and had to pay for all my living expenses in addition to tuition.   I still had a small portfolio back then so that I could keep developing my investing experience, though.

In my early twenties, I had some big medical issues that hit my net worth pretty hard, and now in my late twenties, I’m already in a position where I’m financially supporting a parent indefinitely, out of necessity for them.

So for me, it has been important to generate a high income and a high return on my investments, and live as a minimalist.  Within five years of graduating college, I was able to increase my net worth by $150,000, despite some big expenses I had to take care of.  And I’ve continued to increase it since then.

I don’t necessarily plan on retiring as a finance/engineer any time soon, because I enjoy my job, but I have a hardcore goal to attain investments and side income be able to cover all my expenses within the next few years.

In later years, once I achieve my personal financial goals, I’d like to get into philanthropy.

Q: What options/derivatives do you trade and why?

As far as options are concerned, I strictly sell cash-secured puts and covered calls.

Investing is not usually an area where added complication results in higher returns.  Most mutual fund managers with pedigree backgrounds fail to beat the market, Wall Street has shown that it can’t even manage its own risk let alone the risk of its clients, and an average investor with little knowledge can beat a lot of them with a low cost index fund.

I’m a long-term focused value/dividend investor that happens to use option-selling as one more tool in my arsenal.  Selling options is a great strategy for fully-valued or over-valued markets, in particular.

Q: What broker do you use?

I use Charles Schwab and Fidelity and am very happy with both.

Q: How do you describe your style? Did this evolve over time?

I refer to what I do as “option weaving”, for lack of a better term.  I sell puts to get paid to wait to enter wide moat companies at great prices.  Then if I eventually get assigned them I either just hold them over time, or I sell covered calls on them that are well above my calculated fair value of the stock.

Over time I incorporated precious metals into my investments, to diversify a bit more from equities, and because they finally achieved reasonable prices compared to their highs in 2011.

The main problem with commodities and precious metals is that they don’t produce cash flow.  But by selling options on them, you can fix that.

For example, you can sell cash-secured puts to get paid to wait to buy the iShares Silver Trust ETF (SLV) or the SPDR Gold Trust (GLD) when they dip.  Eventually if they decrease in price and you get assigned those shares, you can now sell covered calls at higher prices.  When they eventually get taken away from you, you can sell cash-secured puts at lower strike prices to get paid to wait to re-enter the position.  You just keep generating tons of income from them.

It’s important to only do this when silver and gold are reasonably priced relative to a few metrics, like AISC (all-in sustaining cost of mining them per ounce), how their current prices compare to their historical inflation-adjusted price, checking the gold/silver price ratio as it compares historically, checking the gold/S&P 500 ratio to see how that’s doing, etc.

Q: Markets are efficient. Then why should any of this option writing business work?

The market price of a stock takes into account all known short-term and long-term information at once, meaning it has to optimize for the blend of both of them simultaneously rather than optimize for just one of them perfectly.  At any given time, price is partially based on people and programs doing technical analysis, partially based on investor concerns about the next jobs report or quarterly earnings release, partially based on the general “mood” of the market, partially based on analyst price targets (for which they have a problematic conflict of interest anyway), and partially based on people sitting down and doing discounted cash flow analysis on it and determining a fair value with regards to a five-year time horizon or longer.

In other words, the market is a big collection of people playing checkers and chess all at the same time, and the result is that it’s decent at both of those games but perfect at neither.

If an investor focuses on just the short-term or just the long-term, then they’re not playing the same game as the market as a whole is.  For me, I tune out all the short-term noise, and just focus on the long-term value of a security based on expectations of future cash flow.

There are a few more things to consider:

-As evidenced by silly bubbles like the Dotcom Bubble (or Japan’s asset bubble in the late 1980’s which was TWICE the magnitude of overvaluation as the US Dotcom Bubble), the market is not truly efficient, because investors as a group are not rational.

-The options market is far smaller than the equities market.  Sometimes I’m the only one that sells an option on that stock at that price and expiration date in a given day, for example. Even in cases where the contract volume is in the hundreds or a couple thousand for a given option, it’s far less than equity volume.  This creates interesting inefficiencies sometimes.

-Private investors can take advantage of the career risk of professional investors.  Asset managers for clients and institutions often feel like they need to always be doing something.  If they just use a low-cost, low-turnover, tax-optimal strategy, they will feel like they’re not doing enough to earn their paycheck, and their client might think the same.  And they’re afraid of volatility, because a decline in portfolio value, even if it’s not due to a mistake they made, could lead to them losing clients or getting fired.  So they’re often buying put options for protection (which I’m happy to sell them), or doing closet-indexing.  A private investor, who is accountable to nobody but herself or himself (and maybe their spouse!) can invest without a third party looking over their shoulder, without the pressure to do certain things or to focus on the short-term.

-Robert Shiller, a professor of economics at Yale and a Nobel laureate, has shown with 130 years of evidence that the cyclically-adjusted price-to-earnings ratio of a market is a useful predictor of stock market returns over the next 10 or 20 years.  And yet every time it gets high, and discounted cash flow analysis also demonstrates that stocks are expensive, enough investors say, “this time it’s different”, and then invest heavily at the market top late into a business cycle.

Q: How much time do you spend on trading options?

I don’t need more than 2 hours per month to manage all my portfolios.  Anything on top of that is just for fun.

I sell longer-term options than most traders; anywhere from 2-month contracts all the way up to 14-month contracts, depending on a few variables.

As a result, I only make about 2 moves per month on average, which takes all of five minutes to execute.  The rest of my time spent is on research.

I put in a lot of time in the past, and that pays dividends now because there are so many companies that I’m already familiar with, and don’t need to research them from scratch each time.  I just have to update myself on their current conditions, update my valuation model, check the options tables, etc.

In reality, I spend far more time than that, because reading investment news is enjoyable to me.  And now that I run a website, it’s a part-time job because I’m scaling any research I do for the benefit of my readers.  So I separate it into two buckets: the time I actually have to spend on my own investments (very little), and the time I spend on it because I want to (quite a bit).

Many investors assume that options investing is a time-consuming strategy, but it doesn’t need to be.  One of my goals is to make option-selling more accessible to people, and to show how there are methods to save time.

Q: How do you deal with the risk that comes with option trading?

I sell options to mitigate risk, rather than use them in a way that requires risk mitigation.

I don’t use leverage, I usually stick to wide-moat companies, I obligate myself to a cost basis that is below my calculated fair value of the security, and my positions are always covered by the appropriate cash or stock as opposed to being uncovered speculations.

My portfolio is designed such that if the S&P 500 were to fall 25% tomorrow, the equity portion of my portfolio would most likely only fall 15% or so.  That’s why I especially use this strategy in highly-valued or overvalued markets.

Generally speaking, covered calls and cash-secured puts are more conservative than just buying and holding stock outright at current market prices, because your cost basis is lower.  Especially for puts, usually.  Now, in truth it’s more complicated than that because you also have the opportunity cost risk of missing out on upside, but that’s where using appropriate valuation techniques comes into play.  When the market is already overvalued, there is less potential upside you could miss out on.

I traveled to Hong Kong this autumn and didn’t check my investment accounts.  Didn’t even think about them.  Options can be part of a very stable, conservative portfolio.

Q: What tools/sites/blogs/podcasts do you read on option trading?

I read articles on Seeking Alpha quite a bit for company information.  I also check Macrotrends.net about once per month for useful historical macroeconomic data, especially for precious metals.

Charles Schwab provides investors with free access to Morningstar and Argus reports (among others), so I read those as well.

I use my own spreadsheets to streamline the process of calculating option information.  And I have long tutorials on put-selling and covered calls on my site that show the process I generally go through when selling options:

Tutorial on Selling Puts

Tutorial on Covered Calls

Q: What is the size of your option trading account?

Rather than use a separate options account, my option trades are incorporated into my general accounts.  Currently I have about $80,000 specifically invested in options positions.

I keep three accounts for my equities.  One is a purely indexed 401(k).  Another is a Roth IRA that has mostly dividend stocks and option positions.  The other is a taxable account that also has mostly dividend stocks and options positions.  And then there are other accounts for non-equity alternative investments.

The way I view it, option-selling is a tool that is more appropriate for some conditions than others.  As such, rather than keeping it in its own account, I use different tools in my primary accounts depending on which tool is the best for the situation.  In fairly-valued and over-valued markets like this, options trading becomes an optimal tool to employ.

Q: Where do you get inspiration for trades?

From companies I’m already familiar with, for the most part.   At any given time, there are plenty of companies I know and that I’d be happy to buy at the right price.  When that price becomes available or their option tables become attractive, I move in.

Also, the Morningstar reports and other sources I mentioned before help with inspiration.

Q: How do you track your trades and P&L?

For my own investments, I just let my broker account do it.  Since I make about 2 moves per month, and have very low portfolio turnover, it doesn’t require much external tracking.

For my website newsletter, I update the portfolio positions in Excel before each monthly issue.

Q: What is the worst trade ever you did?

I’ve never lost serious money on an options trade.

There were a couple times where I sold an option, and then reconsidered, and bought the option back a few days later, and just wasted a few bucks on fees or minor price differences and considered it a lesson learned.  In those circumstances, the case is that I got more aggressive than usual, and sold a position on a company without much of a moat that I later decided was not appropriate for my risk tolerance.

There were also some cases where my put options were exercised and I had to buy the stock, but that’s part of the plan in the first place.  When that happens sometimes I lose a few percentage points on paper and then recoup it over time because it’s a great company at a great price.

Over my investing career, I’ve taken a few big hits on positions, but they were not options positions.  I’m sure at some point one of my cash-secured put holdings will take a big hit as well, but that’s the nature of risk and diversification.

Q: What is the best trade ever you did?

My very best trades in terms of total returns were not option positions, because each option I sell has limited upside.

2015 was a great year for selling options, though.  When oil prices crashed, so many energy stocks went down, even if they had little exposure to changes in energy prices.

Magellan Midstream Partners LP went down from about $85/unit to $60/unit in 2015, and it had among the best balance sheets in the industry and only about 15% exposure to energy prices.   It was comfortably covering its distribution at a 1.3x rate (well above other MLPs), and continuing to grow it.  As a pipeline company, it naturally had a very wide moat.

So I sold 13-month put options with a strike price of $55 for $7.59 in premiums.  That means my cost basis if assigned would have been only $47.41 per unit, along with a high rate of return if it’s not exercised.   MLPs have very low option volume and they tend to have interesting premiums during times of volatility, so this is an example of inefficiency.  The risk/reward ratio was silly here.

And I made well over 20% returns selling 13-month in-the-money puts on Spectra Energy Corporation as well that year, for similar reasons.  My cost basis again would have been well below market value if assigned.

Because these were LEAPS positions expiring this month in early 2017, the taxes are for the 2017 calendar year and are thus deferred until I pay them in about March 2018, even though the investment was made in late 2015.

Railroads also went down hard that year, due to reductions in coal volume, even though railroads can easily adjust themselves to market conditions by reducing their engine numbers.  (Every single Class I railroad in the US remained profitable through the Great Recession, for example.)  So I sold 3-month puts options on CSX in late 2015, got assigned due to a price dip, and then held for a little while and eventually sold way out of the money calls that would expire in 6 months, and the stock surged and those call options were exercised as well.  I ended up making well over 30% returns on that investment in under 11 months.

These are examples of very low frequency, low time commitment investments in wide moat companies.

Q: Where/how can we follow your progress?

I have a free investment newsletter you can sign up for on my site.   I talk about market valuations around the world of different asset classes, alternative investments, and utilize option weaving for wide moat companies, REITs, MLPs, and precious metals.

Thanks so much for the interview opportunity, and have a wonderful day!

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