derivative "income" bumhunting

Friends,

I use the following example all the time because it makes it makes the distinction between premium and income plain.

You’re long a $100 stock.

• It’s fairly priced because it’s 90% to be 0 and 10% to be $1000.
• You overwrite by selling the 500 strike call at $45.

Did you earn income?

A courageous response to my question on Twitter:

There is no problem here. You take your $45 and move on with your life. If you get called away you make 5x, and if your stock goes to $0 you came out with only a 55% loss.

Umm, incinerating money when you think you are investing is actually what I would call a “problem”.

You make $445 10% of the time and lose $55 90% of the time. You are literally better off betting on roulette.

If you overwrite a call that’s actually worth $1 at a price of $.95 because call markets are faded low for sellers, you are stuck with roulette odds. Factor in your brokerage costs (implicitly or explicitly) and effort.

I’d rather get a free hotel room.

As a market-maker when you sell a call you might book the difference between the trade price and what you think the option is worth as “theo p/l”. And even in that case marking-to-model is only going to show a few cents of edge.

Derivative “income” ETFs treat the entire option premium as yield. Guessing disclosure rules prohibit them from selling ITM calls and labeling the intrinsic as yield. Is the distinction that a hard arbitrage bound can’t be marketed as income but a soft one can be? After all, if you buy a .25d call in a random stock for 0, you’re like 99% to make an arbitrage profit with a series of delta hedges. If I sold the call for 1 cent, I can call that yield? Ok. Well, I call that “semantic arbitrage”.

Looking at the AUM growth of these funds, their cheerleading has worked. They don’t need any boosting. Turns out I’ve been collecting the critical takes on these ETFs for a few months. Are they biased? Of course. But I’ll excerpt and weave the arguments so you can form an impression to weigh against what “income” marketers claim.

You will hear the arguments from:

• quants
• a former options market-maker who runs an RIA that uses options
• a very familiar vol manager (who allowed me to re-publish their firm’s take which is nothing short of violence)
• a tax specialist
• a bit from me (and more next week, as I plan to get my hands dirty with some data)

Onwards…

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