There are a lot of ‘What If’ questions to consider when
trading options. What is the option value when it is in the money (ITM)? What
if it is OTM or what is the combined value of a share and a covered call? This is where the rubber hits the road! We’re
pulling out our trusted spreadsheet (see below in Fig. 1).

**Figure 1. |Royal Bank Covered Call Simulation**

Thus, when selling RY after 3 months, we would receive $0.54
plus share appreciation. The appreciation or capital gains depend on the stock
price 3 months from now, the RY value could range anywhere from 0% to 1000% of
today’s price; possibly higher. In the
spreadsheet, we populated Column A with a possible price range from 50 to 150%
(using 5% increments) of the RY purchase price, or as calculated in the
B-column the sell price could range from $26.76 all the way up to $80.27 and
the sale (including the $0.54 dividend) could range from a loss of $26.22 to a
gain of $27.30 per share. This is graphed in Figure 2 below.

**Figure 2 range of possible profit or loss (including dividend) from the sale of one RY share when bought at $53.27 and sold during the following 3 months at a price (Y-axis) between 50% and 150% of the purchase price.**

Entered in the spreadsheet (cell G12) is the premium of
$1.95 offered in the market at the time of sale. Cell G8 shows whether the call
option is sold (written) or bought. You may notice the on/off flags in cells C5
and G5. When ‘on’ the option (G5) or share (C5) transaction is included in the
total proceeds calculation (not shown in figure 1) of the combined share/option
transaction. When the flag is ‘off’ the share/option transaction is not
included in the calculation. In Figure 2 only the share purchase (and sale) is
included without considering the effects of options.

**Figure 3. The results of a combined share purchase and covered call sale.**

If the RY remained below the $52.00 strike price, the option
would expire worthless; it is then OTM (out of the money). The premium ($1.95)
would be yours – the writer or seller of the option. The dividend of $0.51
would also be yours for a total of $2.46. Yet if you sold your RY share you
would sell it at a loss. If RY was sold at $49, you would have incurred a loss
of $53.51 - $49 or $4.51 minus $2.46 = $2.15. If you sold at $48, your loss
would be $3.15; at $47 it would be a loss of $4.15… and so on. That is the
downward sloping line to the left of the vertical plot line in figure 3.

It is similar to the losses incurred on the graph in figure
2. Except that the loss is $1.95 less at every point along the way (you
collected dividend in both scenarios). If the share price ever fell to zero,
you would have still $1.95 more than if you had not written the call option. So
your call option has softened the blow in case of a falling share price, it
created extra cash flow along with the dividends if the share price remained
more or less the same but it limits your potential upside to a maximum profit
of $0.94 in 3 months or a ROI of 7% on an annual basis.

Options may be great for an income investor; but you may
lose out on a lot of potential capital gains if the RY happens to take off in a
stock market rally during the term of the option. Before closing this part of
the review let’s quickly look at what happens with a ‘naked call’ (Figure 4).

**Figure 4. With a naked call you get a bit of cash flow ($1.95) in exchange for a loss that has no theoretical limit.**

It would not be likely the call would be exercised unless
the share price approaches the strike price. If the option expires without
being exercised you pocket the premium, in our example that would be $1.95. Not
bad since you didn’t put up any money. However, if the share price is above
strike, your losses can add up dramatically and in terms of ROI, since your
initial investment was $0.00 your return on investment would be an infinite
loss. E.g. if the share price at exercise is $58, you would buy a $58 share to sell
it for $52 or a loss of $6 minus your $1.95. Your loss would be $4.05. If the share price was $59, your loss would
be $5.05; at $60 your loss would be $6.05, and so on. You can see your proceeds
at various share prices graphically depicted in figure 4.

Now you may think that a loss of $5.05 is not much, but don’t
forget an option contract comprises 100 shares; that is the minimum trade
volume. Your loss on one contract would be $505.00 (plus commissions). You took
this risk for a premium of $1.95 per option or $195 for a contract (minus
commission). The question you and every other investor have to ask is: what are
the odds that you would make such a loss and is the $195 premium you make in
case the option is not exercised worth taking this risk?

Naked options are quite speculative, the odds are not as bad
as a lottery but then we’re investors not lottery players.

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