Saturday, February 18, 2012

Options – cash generator or money loser? The downside to call options

What about risk?

When buying a call option such as RY C 21APR 56.00 there is certainly risk. The underlying stock (in our example: Royal Bank) may fall rather than rise in value. Once expired and below its strike price, the option will not be exercised and the $47.00 premium (see previous post) is lost, i.e. a 100% loss. The Royal Bank may rise in value but never exceed the strike price and again the options expire worthless. Statistically, 75% of call options expire worthless. This risk is greatest in a declining market, in particular a bear market and much less so in a rising market. When the underlying shares trade below the strike price, the call option is said to trade ‘out of the money’ (OTM), when it trades equal to the strike price it is ‘at the money’ (ATM) not to be confused with a cash spewing apparatus at your local bank. Only when the option is above strike does it become truly profitable and that is called… ‘in the money’ (ITM).
Click on image to enlarge
 For the call option writer, there is risk as well, sometimes very high risk. When expiring, the $47 premium belongs to the call writer. Well, that is minus commission charged by the broker. At full service brokers, the commission may be as high as several hundred dollars and thus you would never make a profit. That is why ‘writing options’ is a discount broker game. TD Greenline charges $9.90 plus $1.25 for every contract. For 5 contracts the commission is 9.99+6.25= $16.24. Thus, when selling 5 contracts the real call option proceeds are 5 x $47.00 -$16.24= $218.76.
The lowest risk form of writing call options is when you also own the underlying stock, in our example 500 shares of the Royal Bank. If you buy the shares when you sell the option, risk is lowest. Say you bought when the RY shares were $53.60. That is you invested 500x $53.60 plus 9.99 (commission) = $26809.99. The options expire above strike and are called or assigned by the broker. You will receive 500 x $56.00 (strike price) - $42.50 (assignment commission) = $27957.5 or a profit of $1147.51 plus the option premium for a total return of $1366.27.  Of course, you could have made more profits (which you forewent in return of the option premium). Those missed profits are equal to 500 x (Actual Share Price – Strike Price). For example, if the share price upon option exercise was $60.00 then you missed out of 500 x $60-56 = $2000 in profits in return for $218.76 in premium proceeds. Hmmmm – painful?
However, if you bought the RY shares at a price above the strike price some months ago then things may become even more painful. Upon exercising the option, you will experience a capital loss (your acquisition costs minus $56.00) per share! You could buy the shares back from the market right away using the share sale proceeds and other cash reserves. But then this capital loss is ignored by the tax man – no tax deduction). When the call option expires and it is exercised, the broker will charge you another commission for the stock assignment to the buyer of the call option. Not for the customary $9.99 commission but at $42.50 (commissions vary depending on the size of portfolio and type of client). Your option premium proceeds have been further reduced from $218.76 - $42.50=$176.26.
What if the price at the time of exercise is above strike? What if it was $57? If you buy back immediately you lose your capital gains loss (tax deduction) AND you have to pay an extra $1 per share, i.e. you lost out on 500 x $1 of profits. That is $500 that you would have made if you had not written the option. Now your option has really delivered a loss of $176.26 minus $500 = -$323.74. Oops!
If you had written a naked call, i.e. you did not own the underlying RY shares then you would have made of loss a -$323.74 plus another $9.99. The $9.99 is the commission you owe because you would have to buy the RY shares upon expiry and assignment (at market price, i.e. $57and sell at $56). So your loss is -333.73 on an initial investment of $0. If you had borrowed the money to buy the underlying shares then you should also ad interest to your losses (but you would also have received any dividends that were paid out during the term of the option). 

And… every $1.00 per share that the RY share price is above the strike price adds another 500 x $1 or $500 to your losses. Thus if RY expired at $58.00 rather than $57.00 the loss would have been -$323.74 minus $500 = -$823.74.  If you just experienced a strong stock market rally and the RY shares had increased to $60.00 then your losses would have been -$1823.74. Ouch! And… there is no limit to how high your losses could go.
With the covered call, you would not have lost that much money, but you would have lost out on making profits. Imagine you held your RY shares patiently for several years and went through ups and downs with almost no appreciation or even with a paper loss. Next you write your option and you lose your shares for a measly $176.26 instead of making a profit of $500 x $60-56 = $2000 in profits. Wow, how would you feel about that?

So before writing call options, you have to know what the chances are that the share prices will take off on you. Ironically, this depends on the company stock, i.e. not every company behaves the same in the option world. There may be a large difference in risk between selling call options on the Royal Bank and on Johnson & Johnson. Even worse, overtime company stock behavior may change. Do you still feel that investing in (covered) call options is safe?
In the next post on options, we’ll discuss how to 'roll-over' your options, which is an alternative to being forced to sell the shares that underlies the option.

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