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).
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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