Option Writing - treat with caution

Buying shares and writing options against them may appear to offer an escape from meagre yields in bond and money markets but investors should be careful. This strategy and those involving implicit options (like reverse convertible bonds) should not be used in a mechanical fashion without any attention to the market direction. There is a time for selling volatility and there is a time when it should be avoided. Selling any option always carries the risk of major loss should the investor misjudge the overall price trend of the underlying instrument.

CoCo's are NoNo's

One would have thought that the main lesson of the Credit Crunch and Financial/Economic Crisis is the danger that can be created by newfangled and little-understood financial 'innovations'. The need for banks to raise additional capital has led to the design of 'Contingent Convertible Bonds' (CoCo's for short). These bonds lure investors with relatively high nominal interest rates that make them appear attractive to those who are desperate to get some positive return on their investments. Even so-called sophisticated investors in large financial institutions get tempted. Partially because they do not play with their own money or they will long have moved on to other jobs or positions when the proverbial s*** hits the fan. They may also not be as sophisticated as their clients (pensioners, mutual fund savers and private clients) assume. It will be interesting to see how regulators treat these securities if they become more of a mainstream investment option. They will have to decide whether their role is to protect the banking establishment or the investors. We know on which side they should be and we are definitely siding with the investors on this issue. Dangerous bets such as CoCo bonds should not be in any investor's toolkit but should be strictly reserved for regular visitors to casinos and betting shops. Not for nothing the link above talks of a ticking time-bomb with respect to these securities.

Danger of being short volatility

I usually try to avoid investment jargon and warn clients to be suspicious when they are bombarded with exotic terms that require at the very minimum an advanced degree in mathematics in order to be understood. I use the term 'being short volatility' in order to send a wake-up call to readers. In the ordinary course of investment it is recommended not to write naked options as the investor is exposed to an open-ended risk. Sometimes these option exposures are cleverly packaged (hidden?) in complicated structures that look perfectly innocent to the naked eye.

Reverse Convertibles - do you really understand the maths?

An article in today's Wall Street Journal (16 June 2009) points out the dangers of this form of bond. The investor gets a seemingly very attractive coupon but most investors are not aware that the high coupon payment is the result of an embedded put option that the investor sells.
Most retail investors - and we would include so-called 'High Networth Individuals' - are unlikely to understand the detailed workings of options, let alone the possible pitfalls of selling a naked option.
Investors are easily persuaded to go for these 'free lunches' and take the high current income which is dangled in front of them by eager salesmen of financial 'advisors'. But the danger that is in most cases only mentioned in the small print and glossed over during the sale process is the fact that the investor may end up with the underlying shares of the issuing entity if they have declined by a specified amount by maturity.
These shares are likely to be worth considerably less than the stated principal of the convertible bond and their value will on average be 20 - 30% below nominal value of the bond depending on the terms of the bond issue.