— Venice, Italy
A subscriber wrote in last week with a question:
“Isn’t the Basic System just selling deep ITM covered calls? How is that any different from selling puts?”
1/ No, actually. ITM Covered calls is not the basic system but rather a simplified and low maintenance version. Today I run you through both for clarification.
2/ Covered Calls and shorting puts are theoretically and economically almost identical in most environments except covered call writers receive the dividends from the stock they hold as part of the covered calls. The vol and hence pricing between puts and calls can also differ depending on the market.
The Basic System is a modern adaptation of the warrant hedging system that Ed Thorp and Sheen Kassouf laid out in Beat the Market, 1967. Their version shorted overpriced warrants against long stock. They sized the short side in a ratio-mix. Not one-to-one. I have taken the idea and applied it to modern options.
The ITM covered call my subscriber described is not the system. It’s a way to get a lot of the benefit with a fraction of the effort. Yet it’s still a hedge and highly effective, whose best feature is its simplicity and extremely low maintenance required. Let me show you both. In order.
The goal of both is lock in a desired rate of return and make it as close to risk-free as possible.
How is this done?
By understanding and optimizing the mathematical relationship between an asset and its derivative.
Once you understand that relationship, you can hedge a trade by going long the stock and short its derivative or vice-versa. Ed used warrants, I favour options, which is the core of how I apply the Basic System.
Thorp's Basic System
Thorp didn’t hedge one-for-one. He shorted warrants against stock in a ratio, sized to the relationship between the two. He called it the mix. Here’s summary of the tenets listed in 1967 with my notes for modern use in brackets:
“Summary of the basic system
Identify the listed warrants. (options)
Limit yourself to warrants expiring in four years (I use 6-24 month options)
Further limit yourself to warrants whose stock is below 1.2 times exercise price. (Don’t write any more ITM than 20%).
Only short warrants at or above normal price (harder to do in today’s computerised options market, but putting sell orders at the ask in names with high vol is good enough for me)
Determine the ratio-mix. If you have no definite view on the stock, size off the slope of the normal-price curve →Ed constructed theoretical normal prices for warrants based off time to expiry and stock/exercise price ratio. I modify things with calls where I give the stock room to run by going OTM and then lower the delta/hedge via selling the calls in a ratio-mix.
Put it on, hold it toward expiry, adjust the mix opportunistically”
The mix: contracts short per shares long is the entire trade. Get it right and you’re not betting on direction. You’re harvesting a mis-pricing and/or embedded volatility while the position sits close to neutral overall.
Example: AEM. Stock $199. Buy 100 shares (1 call option equivalent) and short 3 of the the March19 ‘27 $300 Strike Calls). Stock/Exercise ratio of ~0.66
That, my friends is the Basic System. A ratio, sized off the relationship and adjusted as the price moves to maintain the stock: exercise ratio. I know, at first it can feel overwhelming, complicated and too much of a hassle.
So here’s the simplified version: The ITM buy-write.
Most people can’t be bothered to size a mix. When simplicity is my main aim I run this instead. I get the spirit of the system without the work: I buy the stock, sell one ITM call against it (still < 1.2 stock / exercise price as per above). 1:1 ratio means set and forget until expiry basically. Fixed.
Let’s use AEM again and examine a simple ITM buy write.
AEM. Stock $199. Buy 100 shares and sell 1 lot of the $195 call strike. Same expiration date.
Pro: it’s simple. The short call sits ITM, so the overall delta is significantly reduced — providing large downside protection. You put the trade on and leave it. No ongoing mix to solve for.
Con: it’s not neutral. Net delta on my one-to-one ITM buy-writes usually sits around +25 to +35. That’s a directional risk, although 75% less sensitive than owning the stock naked. Risk can further be mitigate by restricting trading to solid companies with no debt.
The real comparison was never buy-write vs. short put. It's buy-write vs. the Basic System. Not the same thing. What you give up for the simplicity is the dial that let Thorp size his exposure on purpose, instead of accepting whatever a flat ratio gives.
The verdict
The ITM buy-write is where most start. Hedged. Paid to wait. But it is a fixed, simple version of something sharper. Once understood, the ratio-mix version — which is the real Basic System — is where the edge is.
Update & Commentary
Today is my last day in Italy and my time here has been a dream come true. When I was 16 I won a scholarship to study here for 5 months and couldn’t do anything I wanted to do. I was not going to let this opportunity go to waste; I wrote a long list of everything I’ve ever wanted to see/do here and all the places I wanted to visit and did it all!
This is the power of the Machina. I live my dreams without falling behind financially as I can check in with my phone or laptop anytime.
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