A fool and his money

[bongo]

I'm curious how Lao's option trading strategy is holding up in the recent volatility. Too soon to say?

[Laocoön]

Oh, I got smacked hard, bongo! I think most of my longer-term loss will be due to my over-exposure to transportation, which you pointed out to me but which I decided I was comfortable with -- what could POSSIBLY keep people from traveling more in the future than they do today? I have a lot of time-value losses with puts, but nothing that I'm uncomfortable with.

[Anonymous]

My options trading strategy is kicking ass. It made a huge profit pre 9/11, and is making insane money post 9/11. Soon I'll have to reset it, and start another round.

[Laocoön]

Here's the bad news, as of 10/20 option expiration:

Market: 67419.90
Me: 60894.08

It would take a strong partial recovery among air travel related stocks for me to make up the lost ground in the short term, and that doesn't look like it will happen.

[Laocoön]

As of 11/17 option expiration:

Market: 71672.95
Me: 71894.35

My beta is at about 2 right now.

[Anonymous2]

Lao, are you short or long the airlines? Here I present a case for never being a long term holder. The barriers to entry are small. Many people are in love with the idea of flying, and losing $100 million is worth the risk of potentially having your own airline. The exit barriers are high, large up front fixed costs with smaller marginal costs mean constant price wars as any marginal revenue is better that none. Chronic overcapacity plagues the industry.

This does not exclude short term plays or owning one carrier while shorting a basket of its competitors. What do you think?

[Laocoön]

Regretably, I have been long AMR, BA, TSG, and MAR. Only AMR is directly an airline; the rest are airline or travel related.

I think you over-simplify the case against airline stocks. It is true that in the past the industry has been subject to only sporadic periods of profitability and to frequent shake-outs, but I think that (prior to 9/11) this was reasonably taken into account in prices and in the positioning of the major carriers.

First, while niche markets are subject to new entry, it is much tougher to become a major carrier. Even Southwest can be called a niche player, with their multi-hop flights and their lack of seat assignments: I expect that they are under-represented in business flight, which is the primary source of profit for the majors.

Second, the most recent epoch of shake-outs is pretty much over with the takeover of TWA by AMR. The rest of the majors were pretty solid pre-9/11, and they have essentially planned for industry slow-downs by keeping hoards of cash on hand. A lot of the challenging periods for the industry have been caused by the various carriers pursuing "end game" strategies, where they pursue highly competitive tactics in order to kill off weak rivals or in the pursuit of their last, slim hopes for survival. Prior to 9/11, there was little cause for any of the majors to adopt an end game strategy. Southwest might have tried to leverage its cost advantage, but that would involve jumping into an arena (business travel) where they had less familiarity than their competitors and risking having all of their competitors go after them at once, as well as running into diminishing return problems with growth.

Now, the industry does have very real ongoing problems. One of them is their high capital investments and the inability to back out, which you mentioned. Another is that they deal with very powerful unions. But I think that, pre-9/11, these were fairly priced in: most airlines were trading with PE ratios of 6-8 (which also belies your assumption that people will over-buy airlines out of a love of flying).

Post-9/11, the situation has changed, obviously. The cash hoards are gone or quickly going away, and future prospects are much diminished, at least in the short-term. A new end game round might result, so it would be prudent to avoid any carrier that is recognizably weaker than the others, and profits could be trashed for longer than just what is directly due to the drop in traffic. But the future should be bright for those that survive to see it.

[Anonymous2]

You make a good argument for the future of the airlines. Warren Buffet seems to agree. In the post 9/11 crash he picked up some AMR. If this industry becomes normal with profits per share growing 10% per year, the valuation could shoot up to 20 times earings. I just don't believe that the consolidation has gone far enough. When there are 3 carriers that carry 90% of global traffic, It will be a good time to invest.

[Laocoön]

As of 12/21 option expiration:

Market: 73609.22
Me: 77293.80

[Laocoön]

End of year:

Market: 73989.65
Me: 78455.41

Eked out a 6.0357% advantage. This exceeds my original target of beating the market by 1%, but not my shortly pre-9/11 goals of first a 10% and then a 15% advantage. Was ahead by a little better than 10% just before 9/11 (8/31: Market: 71056.56; Me: 78439.12), then behind by as much as 28% in the first weeks thereafter (9/21: Market: 60608.52; Me: 43549.12).

[bongo]

I'm very surprised that you ended up ahead. I would have expected that the extreme volatility would have made your options positions highly unprofitable. Apparently that is what happened on the way down, but I would have expected that on the way up your call positions would have killed you as well. Did you stop writing calls in Sept/Oct? Was there some timing luck involved?

[Laocoön]

Bongo:

I didn't have too many call contracts expire in September-December; I count ten different stocks that I had them on. I was not too aggressive in replacing them -- usually with something near-term with a fairly high exercise. I don't think I did too well with those replacement calls, but they weren't too significant. Mainly, the market recovered a lot faster than I would ever have expected, and pulled me almost back to my pre-9/11 position with it.

There is a probably unmeasurable stability in the market in that risk preference changes probably move prices more than any changes in expectations and information, and risk preference should be assympotically bounded. Though not by design, my strategy is usually aided by the effects of this when they appear.