Wednesday, February 15, 2012

Options – cash generator or money loser? Call Options

Before talking in more detail about ‘put options’, lets investigate the ‘call’ option with symbol RY C 21APR12 56.00.  The option premium lies somewhere between the bid and ask price (between $0.37 and $0.43 per option). With the continuous stream of incoming bids and asks in the option market, it often doesn’t take long that a bidder (buyer) and asker (seller) want the same price and the deal or trade will be executed.
Click on image to enlarge.
The bids and asks depends on the value of the option as perceived by the market participants. At the moment the above screen was valid, the value of the underlying shares of the Royal Bank traded at $53.60 per share. So the buyer of the above option would not want to exercise this option right away. After all, why would the buyer want to pay $56.00 for a share that currently can be bought in the stock market for $53.60. But chances are that within the next month or two, before April 21, 2012 the Royal Bank’s shares will trade at $56 or even higher. The buyer of the option speculates on the potential future stock price. Suppose the share price is trading on April 1, 2012 at $58.00, the option buyer then has the right to demand that the option writer sells the buyer a royal bank share for $56.00. As soon as the buyer receives the share, he sells this share for $58.00 and pockets the $2.00 price difference.

Let’s do the math. The call option buyer bought the option for say $0.47. He did not buy one option; he bought one contract for 100 shares. So the purchase price was 100x $0.47= $47 (we’re leaving commissions out for now). Next on April 2, he exercised the option and called his right to buy 100 royal bank shares for $56.00 each or a total price of $5,600. He then sells the shares immediately for $58.00 per share and makes a profit of $2 x 100 = $200 as return on his initial investment of $47.00 The option buyer made $200-47=$163 profit on $47.00 or 347% in less than 2 months; on an annualized basis his ROI is 2082%. Wow that is some profit!

Now you may say, oh that poor option writer, he made only $47 dollars and he missed out on $200.  Booooohooooo!! Eh, wait a minute that is not entirely true. Remember that when the call option was sold, Royal Bank shares were priced at $53.60. So if the writer of the call at that day had also bought 100 shares of the Royal Bank, he would have paid $5360 minus the $47 he made or $5313. When his option was called some 2 months later, he received $56.00 per share or $5,600. Not only that. Since he owned the shares over those two months, the call option writer also received a dividend which currently is $2.16 per share per year or 0.54 cents per quarter or $54.00 for 100 shares. Thus the call option writer received $5654 for his shares which he bought for $5360 or $341 on an investment of $5360 in two months. That is a respectable ROI of 6.4% in two months or… 38.5% on an annual basis.
Now, let’s go one step further and use leverage! Our option writer borrowed the money to buy his Royal Bank shares at an annual interest rate of 7%. So he has to pay interest over 2 months: 7% x $5313 x 6/12 = $61.99. So the total investment was… $61.99 and the profit was $341.00 minus $61.99 = $279.02 or a 2 months ROI of $279.02 on an investment of… eh… zero? Yes on zero money invested. His ROI is infinite!

What? Are there no losers here? Is there no risk?  Why doesn’t everyone do this? Well there is a real down side which we’ll discuss in the next post.

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