The Covered Call

The credit bubble has made fools out of many people. Economists assumed housing prices couldn't systematically drop. Banks didn't care about the underlying credit worthiness of the home owners since they quickly repackaged the loans and sold them to Fannie, Freddie, or Bear Stearns. Economics has lived up to its reputation of being a backward looking study whose predictive ability stinks. Financial risk cannot be measured based on distributions of historical returns since history does not repeat itself. This time is, and will continue to be different than '29, '73, '87, or '01. Stockpickers, this site included, have made gutsy bets on downtrodden stocks only to see their market prices plummet further.

VIX

With the CBOE volatity index (VIX), "fear index" at all-time highs, options are steeply priced due to implied near-term volatility. A high VIX index, if you're a contrarian, is a bullish signal since markets tend to place too much emphasis on the recent past.

A short call

This particular strategy is an alternative to the 1.27% yield of a 6-month T-bill or could be a long-term investment with capped upside and limited downside. Here's the play: Find a stock whose fundamentals you aren't too afraid of. Simultaneously buy shares and sell a deep-in-the-money call option. I've selected Discover Financial, a previous long only recommendation.


DFS

Discover Financial (DFS) issues credit cards and processes payments. Charge-offs are rising but Discover has over $10B in cash, only 1.85B in debt, a mere 30M in mortgage-related securities, and $1B in loan loss provisions for those who are indifferent about poor credit records. Loans, like with American Express are securitized and are therefore off-balance-sheet. Lack of willing buyers of receivables is the most serious near-term concern. Yesterday Visa and MasterCard announced a $2.75B settlement with Discover over anti-competitive practices. That adds more of a cash cushion. This is a good business at a good price (not a great business at a fantastic price--these situations are obviously rare).

The possible payoff

A 7.50 Nov 2008 call sells for 2.55/2.95 (bid/ask). If you buy 100 shares at 9.68 + .05 per share commission and collect the 2.51 (2.55 - 4.00 commission) from the short call option you face a 74% loss if the stock goes to zero, a breakeven scenario at 7.27 and a maximum profit of 2.88% if the stock finishes above 7.50. The stock could drop a further 22% from the current price and you'd still make 2.88% (including commission). This could be compared to picking up nickles in front of a steam roller. I think the downside protection is sufficient to justify a short-term alternative for idle cash.

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Disclosure:
Faro has recently made this trade. Do this with only a small portion of your available cash. Don't get too greedy and only invest in a company whose fundamentals you believe to be sound. If I were long-only one credit card company it would be AXP (a similar covered position could be made with a slightly higher investment and a lower maximum payoff).

Image: http://blog.sellsiusrealestate.com/wp-content/credit-bubble.gif