Thursday, October 21, 2010

Call Options

Option trading is considered high risk, but this is far from true. It depends on the way you trade options. Sounds familiar? Real Estate investment ranges from low to high risk depending, for example, on the amount of leverage.

What is an option? An option provides you the right (the choice) to buy a good at a certain price somewhere in the future. On the other side is the option seller or ‘writer’ who sells the right to buy a good at a certain price somewhere in the future. For example, I have the option to buy an average single family house in Calgary for $400,000 (strike price) five years from now.

Such a property you could buy right now for around $350,000. So why would I want to pay $400,000 instead? Well chances are that 5 years from now, this property (based on an average annual appreciation rate of 6%) will be worth $468,377. So now I have the right to buy 5 years from now an average single family house worth $468.377 for $400,000! Oops that is quite profitable; especially if I had to pay very little for this option in the first place. So 5 years from now I pay $400,000 to buy the property and sell it that same day to a buddy of mine for $468,377! During the 5 years I could have invested that $400,000 in a GIC. If I had bought the house for $350,000 outright using a big mortgage I would have to pay interest on the mortgage say 4% annually or some $14,000 per year. Thus, after 5 years I might have paid close to $70,000 in interest. In case you are wondering, Rent-to-Own transactions could be considered an option to buy.

You can do the same with many other investments. Investors trade in options to buy or sell shares at a specific price that expire a certain time from now. Typically traded stock options (not the ones issued by an employer) are valid for a certain time; say a month or, more common, 3 months. Options that expire 12 months or longer after purchase are often referred to as LEAPS (Long Term Equity AnticiPation Security) options.

If you WRITE or SELL the right to buy a share of say the Bank of Montreal 3 months from now for $62.00 (strike price), then the buyer of that option has the choice to buy that share for $62 regardless of what it trades for at that time on the stock market. Say BMO trades three months from now for $50 per share. The option buyer will say “thanks but no thanks, it is cheaper for me to buy BMO right now on the stock market rather than paying you $62.00”. Your option then expires without being exercised
But suppose a share of BMO would be worth $70 three months from now. Then the buyer of your option would love to buy your share for $62 dollars (i.e. exercise his option) and make a quick profit of $ 8 per share. You, the issuer of the option are obliged to sell the share for $62.00. Why would you do such a stupid thing?

Well maybe it was not such a stupid move after all. See, you the seller owned already the BMO share. You bought it a year ago for $50 and right now it is trading at $60.85. You could sell it for a tidy profit and feel that holding on much longer would not add a lot to the profits. But suppose you could sell it for $62 a few months from now? Of course there is a chance that the share price will fall again. Hmmm... if this is a good investment sooner or later BMO will sell for $62 anyway, holding on a bit longer may be worth the extra money earned for writing a ‘call’ option.

Right on! You can write or sell a call option say for $1.00. The buyer of the option would have the right to buy your share for $62.00; a price you are happy to get. You have the chance not to sell for the current $60.85 but for $62 plus another $1 proceeds for selling the option. In the meantime, over the coming 3 months BMO would also pay another 70 cents of dividends, so that would bring the potential proceeds to $64.70 or an extra $2.90 in profits. And... if the share price falls, you have no problem holding on to the BMO share somewhat longer while getting paid an extra dollar on top of the $0.70 dividends. You could even write another call option once the first one was expired earning even more!

Now if the writer of the call option did not own BMO shares and the share price rose to $70.00 he would be forced upon expiry of the option to buy one for $70 in order to sell it for $62 to the option buyer. So for the chance to make a buck betting on BMO trading below $62.00 three months after selling the option, he now has to pay an extra $7 to buy the BMO share. If BMO had risen to $100, the seller of the call option would not be $7 but $29 in the hole.

If the option had expired worthless the seller would have made $1 on a 0 investment, i.e. an infinite return but he ran the risk of losing a lot more. Selling or writing a call option on a share you already own is called ‘selling a covered call’ and it is low risk. Selling a call option without owning the underlying share is called ‘selling a naked call’ – it is high risk and extremely speculative.

Here is a way I like to play with call options. Suppose I consider investing in BMO a good idea. It pays a $2.80 dividend. It earned $4.64 last year (of which $2.80 is paid to the share owner and $1.84 is reinvested in the company to make even more profits). Next year, analysts expect BMO to earn $5.48. So I’ll make 5.48/60.85 = 9% based on earnings. Compare that to 3% on a 10 year Bond of the Government of Canada. Especially, since in terms of cash flow, I will receive $2.80 or 4.6% in tax advantaged dividend. Also, the dividends will likely increase over the years along with earnings while the interest I get on the bond will not!

So I buy a share for $60.85. Pity I couldn’t buy cheaper! But wait a minute, if I write a call option, I can get $1.05 in today’s option market. Basically, I get a buck and five cents off the share’s purchase price. What do I do for that? Well say I write an option for the right to buy my share 3 months from now at a strike price of $62.00. If it gets ‘called’ or exercised I can decide to be happy with the results. After all, I made $1.05 from the option sale, I made another $62-60.85 = $1.15 in capital gains over 3 month and oh... I collected 3 months worth of dividends or 70 cents. Wow, that is 1.05+1.15+0.70=$2.90 profits on $60.85 invested in under three months or 27% on an annual basis.

If the call option is not exercised, I own a good investment on which I can write another option and chances are that I will be able to sell it 6 months from now for $64 rather than $62 dollars plus 2 times the quarterly dividend of 70 cents. That would be a respectable ROI of 21%.

In the table above are the profit calculations for both scenarios. An earlier posting on this blog shows the profits you could make on a typical Canadian Bank as a long term hold. Writing on a regular basis call options would increase your profits even more.

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