I have previously written about the primacy of value investing, and in this article I want to examine the “advanced” practice of “writing covered calls,” a cash-producing technique that consistently creates profits and mitigates downside for shrewd and patient investors. In the stock market, the people who rely on this simple (yet often misunderstood) transactional tactic repeatedly reach the cash line and build bankrolls. As you probably anticipate, I believe that the exercise of writing covered calls is applicable to fantasy sports in general and MLB in particular.
This is the 30th installment of The Labyrinthian, a series dedicated to exploring random fields of knowledge in order to give you unordinary theoretical, philosophical, strategic, and/or often rambling guidance on daily fantasy sports. Consult the introductory piece to the series for further explanation.
Consistency and Plus/Minus
When you’re using our Trends and Models tools to construct lineups for cash games, what is most important is that you prioritize Consistency and Plus/Minus. If you can find a cohort of players who routinely hit their salary-adjusted expectations and historically fit the profile of players who exceed those expectations, then you have an excellent chance of doing well in your cash games over the long term.
Especially in MLB DFS does this focus on consistent salary-adjusted performance pay dividends. Whereas the NFL has a relatively small number of slates and the NBA has too many slates based on only a few professional contests — thereby increasing the possibility that DFS players can get screwed by the randomness of small samples — MLB offers many slates with many players who are potential candidates for cash games. With the larger sample size, MLB is a sport that encourages one merely to do the research, trust the numbers, and benefit from the fact that, regardless of what happens in the short term, over a longer period of time the results tend to smooth out in a positive fashion.
Because MLB lends itself to a steady focus on performance that consistently meets (or exceeds) expectations, the philosophy of value investing is highly applicable to it, since the flipside of the “Rule No. 1: Don’t Lose Money” coin is “Do progressively accumulate money through high-percentage methods.” In a very real way, playing MLB DFS properly is value investing, especially if one thinks of DFS as a diversified investment in a larger portfolio.
Writing Covered Calls: As Uncomplicated as Condoms
Warren Buffett, the de facto godfather of value investing, uses a number of tactics that are applicable to DFS, but the one I want to explore in this piece is “writing covered calls.” This technique involves the use of option or derivative trading — futures trading, as it is more commonly called in the commodities business — and so many people (who don’t understand it) tend to think of it as risky.
In many ways, options are like condoms. Despite what an inordinate number of people in this country think, condoms aren’t inherently dangerous. What makes them dangerous is people who use them, many of whom never actually learned how to use them properly. In fact, when employed suitably, condoms can provide a high measure of utility and safety. And quite often not using them at all is more dangerous than using them correctly.
Basically, just think of options as the condom function for stock investments. They are what value investors use to make sure that something they thought was a good idea at one point doesn’t cost them their private fortunes or family jewels later. Options can be misused by the trading equivalent of hedonistic nymphomaniacs — but that doesn’t mean that options are bad or that the people who regularly use them in a sensible manner are irresponsible.
In fact, I believe that if throughout the country all high-school students had seminars in which they learned about not only options trading but also the basics of how to do it safely, even if they were doing it in the backseat of a car without parental permission, then we as a nation wouldn’t be in the position of having me mix that metaphor in the first place.
So rid yourself of the illusion that options are bad. If old dudes like Buffett use them all the time, they’re probably alright.
What is a Covered Call? It’s Free Money (Part 1)
I’m going to give you some basic information on options so that you can understand what a covered call is. It’s not important that you entirely understand the mechanics of it. For our purposes, it’s more important that you appreciate the philosophy that guides the practice.
In the stock market, when one person sells a hundred shares of Microsoft (MSFT), someone is on the other side of that transaction, buying those shares. The same is true in the options market. When one person “writes” (or creates) an options contract to sell, there is someone who buys it. And, in general, one options contract covers 100 shares.
There are two types of options contracts: “calls” and “puts.” We will focus on calls (but if you care to know anything about puts, just know that they work similarly to calls, except in reverse). If you buy a MSFT call option, you will have the option (but not the obligation) to buy 100 shares of MSFT by a specified date at a specified price. Generally, if you buy a call, you are expecting shares of MSFT to reach or exceed the specified price within the timeframe covered by the contract.
And if you write (or sell) a MSFT option, you will have the obligation to sell 100 shares of MSFT at a specified price if called upon to do so by the holder of the option within the specified timeframe. Generally, if you write a call option, you are expecting shares of MSFT not to reach the specified price within the timeframe.
Let’s explore a real example. As I write this, before the market opens on March 30, 2016, MSFT trades for $54.71 per share. And MSFT May 20, 2016, $60 call options have lasted traded for $0.31. (Also, I really should say that I am not recommending that you buy these options or invest in MSFT. I just picked that stock because everyone knows what MSFT is and it’s big enough to have a fairly active options market.)
Now, “MSFT May 20, 2016, $60 call options” are contracts that give the buyer the option (but not the obligation) to buy 100 shares of MSFT by May 20, 2016, at a strike price of $60 per share. So, as of this moment, someone could pay a premium of $0.31 (per prospective share) to have the right to buy 100 shares of MSFT for $60 per share.
Why would someone do this? If you think that MSFT is going to be around $80 by the middle of May, you could look to profit from that information in two primary ways.
- You could take $5,471 sitting in your account and buy 100 shares of MSFT at $54.71 per share. You would hold those shares for about seven weeks, watch the price go up to $80 per share, and then sell them at that price for a total sum of $8,000. In total, you would make $2,529 in seven weeks on an initial investment of $5,471, which translates into a return on investment of just over 46 percent. That’s really good. But what if you don’t have $5,471 to invest or don’t feel like investing that much upfront?
- You could buy a MSFT May 20, 2016, $60 call option for $31 total at $0.31 per share covered by the contract. You would then watch MSFT go up to $80 in a seven-week period, and on or before May 20 you would “exercise the option,” meaning that in one smooth process you would buy 100 shares of MSFT at $60 (from the person who wrote the option) and then immediately sell those 100 shares of MSFT at $80 in the open market. From this transaction, you would receive $20 per share. In sum, you would make $2,000 on an initial investment of $31, which is a return on investment of 6,452 percent.
And what if you had decided to invest $5,471 in those call options instead of MSFT directly? Then you would make just a hair under $353K.
So, basically, call options = free money.
What is a Covered Call? It’s Free Money (Part 2)
Wrong!
Right now, through its valuation of the MSFT May 20, 2016, $60 call options, the market is saying that the odds of MSFT going up to $80 are very low. In fact, it’s even saying that the odds of MSFT going up to $60 (or $60.31, the breakeven point for the options) are low.
So, in a manner of speaking, call options often are equivalent to free money — for the people who write and sell them. The vast majority or call options go unexercised, and in those cases the people who write them get to keep the premiums — in the example of the MSFT May 20, 2016, $60 call options, that would be $31 — and they don’t need to sell 100 shares of MSFT.
Writing a call option without owning underlying shares of the stock to which the option pertains is called “writing a naked call.” It’s a little bit dangerous because, say, if MSFT does jump up in price, then the writer of the option would need to buy MSFT shares in order to be able to sell them (at a loss) to the person who holds the option. So that’s a little bit like eating a banana without the skin on it, if you know what I mean.
Writing covered calls is what you do when you write a call option and own the underlying shares. In this instance, let’s say that you own 100 shares of MSFT and you write a MSFT May 20, 2016, $60 call option. You get $31 for selling that option to someone. That’s not a lot, but it’s something. And since you hold the shares, you also could get some dividend from MSFT just for holding the shares.
Now, there are three main scenarios that could happen:
- The share price doesn’t go up to $60. In that case, you made extra money simply by writing a covered call and holding a stock that presumably you wanted to hold anyway.
- The price goes past $60. In that case, you sell your shares for $60 per share, meaning that you profit because right now shares are selling for $54.71 per share. So you get $5.29 per share from selling the shares (on top of the $0.31 per share for writing the option). That’s just over a 10 percent gain in seven weeks. Who wouldn’t take that?
- The price drops below where it is now. In that case, you’ve lost money by owning the shares — but not as much money as you would’ve lost because you’ve supplemented your holdings with the premium you received from writing covered calls. So, in effect, the covered calls helped you mitigate the downside of owning the stock.
And here’s the real trick to all of this. The smart value investors who write covered calls: They don’t do it just once. They do it every single month. If they judiciously select the stocks the own and covered calls they write, they can make between 15 and 30 percent per year on this ultra-conservative strategy.
And if the price of the stock drops? It doesn’t really matter, because they’ve been making at least a steady 15 percent per year on that stock for years. What does it matter if the price drops 50 percent when they’ve made 115 percent on it the last five years through dividends, price appreciation, and covered call premiums? They will just continue to write covered calls on the stock, and when the price eventually moves back up, they will profit through appreciation and more call premiums.
Of course, the “downside” (if you can call it that) to writing covered calls is that your upside is capped. If MSFT goes above $60, you don’t make extra money. You make only about 10 percent. OK, that’s true. But here’s the thing:
- Based on the market valuations, MSFT is unlikely to go above $60 in the next seven weeks.
- If a strategy’s “downside” is still making money, that’s a pretty good strategy.
In my opinion — and I don’t purport to be a financial expert, so take my opinion for what it’s worth — writing covered calls is one of the most consistent, low-risk strategies for steadily accumulating money. When done right, it’s the closest thing to free money as there is in the financial industry. And yet so few people do it, because those who know about it think that it’s boring and those who don’t know about it think that it’s risky.
MLB DFS: Stacking Batters on High-Scoring Teams
Let’s bring this back to DFS. I contend that stacking batters on high-scoring teams is the MLB equivalent of writing covered calls. The people who do know about it might find it boring at this point. It’s an approach that isn’t inventive, and it might have less upside than some other lineup strategies. The people who don’t know much about stacking might view at as the risky thing you do only for tournaments. But, as Bryan Mears has recently highlighted, stacking batters on high-scoring teams is a consistent approach that historically has yielded good results.
Over the last two years, focusing on batters in the top half of the order on teams projected by Vegas to score at least five runs has been a consistent, cash-producing strategy:
Very arguably, not stacking — not targeting these players for your cash-games lineups — is dangerous. It’s true that over short stretch of games, you could potentially get screwed by variance. But baseball offers a lot of strong slates every day for months. Over that span, variance will be minimized, and the trend will prevail. Additionally, even if one player in the top half of a high-scoring offense doesn’t do well, his teammates (who match this positive trend) could compensate for him.
In stacking players from one team, you are likely capping your upside, in that you won’t be able to roster a slew of No. 3 and No. 4 hitters from lots of teams. It’s unlikely that the five best hitters in any given slate will all be on the same team. So, yes, you are probably capping your upside with this strategy.
And yet, if you are thinking from the perspective of a Buffett-esque value investor who is content to cash consistently with covered calls (“The Five Cs,” as I call it), then you will realize that upside is not highly important. All that is important is employing a strategy that relentlessly targets reliable, productive players and steadily builds a bankroll.
In grinding out MLB cash games each slate, you are not looking to create an utterly dominant lineup. You are looking to lock-in a profit, and that’s it. When you stack five batters from a team with a high projected run total, you will encounter some opponents here or there who have stacked the same five players. That’s fine. You did your job on those players, and your research that led to the other players in your lineup (who could also be stacked) will still give you a chance to win that particular contest.
Remember, using a conservative and proven strategy in cash games isn’t about winning every contest or slate. It’s about steadily winning over an extended period of time.
Staying on Wall Street
There are a lot of people on Wall Street who got there by buying call options and hitting it big. But a lot of those people won’t be on Wall Street in 10 years, because very few investors can consistently spot the big moves.
Rather, the people who stay on Wall Street are those who sell call options. It’s not sexy. At the end of the day, no trader ever leaves the office in an orgasmic frenzy because (s)he happened to sell a lot of call options that are highly likely to expire worthless. But writing call options is how a lot of people on Wall Street ensure that they beat the market. It’s how they get to stay on Wall Street.
If you want to keep (and build) a bankroll in MLB DFS, you need to use a steady strategy that is unlikely to result in your losing your shirt.
There’s no such thing as free money in DFS — but regularly stacking batters from high-scoring teams is about as close as it gets.
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The Labyrinthian: 2016, 30
Previous installments of The Labyrinthian can be accessed via my author page. If you have suggestions on material I should know about or even write about in a future Labyrinthian, please contact me via email, [email protected], or Twitter @MattFtheOracle.
