Monday, March 12, 2012

Options – cash generator or money loser? What if scenarios 2

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
The classic Covered Call strategy requires an investor first to buy 1 share of the underlying company, in our case the Royal Bank (RY) on the Toronto Stock Exchange. The RY current share price is $53.51 (see cell C7). We the investor (that is the Royal We) are intending to keep the share for at least 3 months and as such, we will be collecting dividends for at least 1 quarter of the year. Cell C8 shows that the RY dividend is $2.16 per year or $0.54 per quarter.

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.
Now let’s write a covered call as shown in columns F-H, rows 8-12 in figure 1. The covered call symbol is: RY C 21APR12 52.00 which means the option is for a Royal Bank share (RY) where the C indicates it is a ‘call’ and the expiry date is April, 21 2012 with a strike price of $52.00.

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.
Figure 3 shows the impact of the RY call option combined with the share purchase. The call option premium of $1.95 is added to the sale proceeds of the Royal Bank share. However, whenever the RY share price exceeds the strike price of $52.00, the call option may be exercised. Exercising the option means that we, the writer or seller of the option are obliged to sell a RY share for $52 to the option buyer rather than for the prevailing market price. Thus, our maximum sale proceed is $52.00 for a share that we bought for $53.51. In fact, we made a loss of $53.51 minus $52.00 or $1.51. Offsetting this loss is the $1.95 option premium plus dividends of $0.54 for the one quarter during which we owned the share (provided the option was not exercised prior to the ex-dividend date). The total proceeds are a gain of $0.94 on a $53.51 investment. That is a Return on Investment (ROI) of 0.94/53.51 over 4 months = 1.75% or 7% on an annualized basis. That $0.94 return would be the same for any RY share price above the $52.00 strike price, hence the vertical line on the graph starting around $52.00.

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.
When writing a naked call, you’re selling a call option without owning the underlying share. So when selling RY C 21APR12 52.00 you take on the obligation to sell a RY share for 52.00 in return for a premium ($1.95 in our example). Since you don’t own the underlying share, you won’t be collecting the dividend of $0.54 and when the option is exercised you will have to buy a RY share at the then prevailing price, which could range from $0 to millions of dollars and thus your risk is infinite.

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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