Tuesday, June 17, 2008

Recipe #11: Calendar Call Cake Example

Today we'll be closing out yesterday's calendar call recipe by providing an example which will show how the returns are calculated. For this example, let's look at Microsoft (MSFT). Why did I select Mr. Softie? Not because I think it's a terribly compelling buy right now, but because it is widely held and has very liquid options. What with Microsoft itching to expand its web presence, it's not unreasonable to expect that they will be successful and with prudent acquisitions and business ventures, the stock could make a decent comeback over the next couple of years.

Microsoft traded off of its major support level at $27 on June 11th and if we had purchased the 2010 January 25 LEAP call on the day, we could have picked it up around $6.00. The stock has risen since then and looks like it's heading higher. It has a minor resistance level around $30 and if it bounces back off of that, then I'd look to sell the Jul 30 call.

Return Calculations
Let's say that Microsoft does exactly that in a week or so. Using my handy Black-Scholes calculator*, the value of the July 30 call will be about $1.00. Let's compare the return statistics for this trade.

If the stock returns to its $27 support level at option expiration on the third Friday in July, a regular covered call would yield a return of 3.7%, and the calendar call would give a 16.7% return. See the difference? Better yet is the cost of getting into the trade. A hundred shares of Microsoft would have cost you $2700, but one LEAP contract (one contract represents 100 shares of stock) would have cost only $600. You could then apply the extra $2100 to other trades or even use it to buy more LEAP contracts.

The maximum risk you take on the calendar call is the net debit of the transaction. If this is the first time you're writing a call against your LEAP, then the net debit is the price of the LEAP minus the price of the short call, or $5.00 in this case. As you write more calls, your effective LEAP price is reduced. In fact, if you can successfully take in a buck each time you write a call, you'll only need six write cycles to break even on your LEAP. This is good news because right now there are no August or September options available. However, they can become available one month prior to the date. But even so, many times these “out of cycle” options can be thinly traded.

What if Microsoft is trading above $30 at July expiration? You'll be assigned on the short side which means you'll either have to buy stock at market price or close your spread. Even though you'll lose your LEAP, you will enjoy a profit since your LEAP will have increased in value. You'll need your options calculator again to determine the amount of this increase. In this example, my options calculator shows an assigned return of 51.9%. (The annualized return is 412%.)

Conclusion
There are many other return statistics that I haven't included here such as downside protection and the break-even point. I felt they involved too much math and were of secondary importance, but for those of you who are you really interested in those numbers, you can study them at your leisure on the options links at the top. Now you have an alternative to the standard covered call recipe so be bold and take a LEAP!

*I subscribe to an options pricing program which provides an easy to use options pricing calculator. Some brokerage firms also provide this, so check and see if yours does. Also check the above options links or try a web search for “Black-Scholes options pricing calculator.”

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