Tuesday, October 13, 2009

Establish Paychex Inc. Covered Calls

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of Paychex Inc (PAYX) covered calls as follows:

Established Paychex Inc (PAYX) Covered Calls for Nov09:
10/13/09 Bought 500 PAYX @ $28.38
10/13/09 Sold 5 PAYX Nov09 $27.50 Calls @ $1.28

A buy/write day order at a net debit of $27.10 was placed early this morning for this transaction and it executed at 2:10pm Eastern Time this afternoon at the prices shown above. Since PAYX just made a $.31 quarterly dividend declaration this morning, I analyzed the return potential for either an early exercise (note: ex-dividend date is 10/29/09) or a later exercise upon the Nov09 expiration date. A potential exercise under either scenario provides a satisfactory return-on-investment result, so the buy/write order was established.

Paychex, Inc. provides payroll, human resource, and benefits outsourcing solutions for small- to medium-sized businesses in the United States and Germany. It offers payroll processing services, which include calculation, preparation, and delivery of employee payroll checks; production of internal accounting records and management reports; preparation of federal, state, and local payroll tax returns; and collection and remittance of clients' payroll obligations. The company also provides payroll tax administration services; employee payment services; and regulatory compliance services, such as new-hire reporting and garnishment processing. Its human resource outsourcing services include payroll, employer compliance, human resource and employee benefits administration, risk management outsourcing, and the on-site availability of a professionally trained human resource representative. In addition, the company offers retirement services administration; workers' compensation insurance services; health and benefits services; time and attendance solutions; and other human resource services and products. It also operates a professional employer organization. Paychex serves approximately 554,000 clients in the United States; and 1,600 clients in Germany. Paychex, Inc. was founded in 1971 and is headquartered in Rochester, New York.

Some potential results from this transaction are:

1. If Stock Exercised Early
It is likely that the owner of the long calls will exercise early on the day prior to the ex-dividend date if the $.31 dividend amount is greater than the time value remaining in the call option at that time. If this occurs, the overall performance results(including commissions) for the PAYX transactions would be as follows:

Stock Purchase Cost: $14,198.95
($28.38*500+$8.95 commission)

Net Profit:
(a) Options Income: +$627.30 (500*$1.28 - $12.70 commissions)
(b) Dividend Income: +$0.00
(c) Capital Appreciation: -$448.95
= ($27.50-$28.38)*500 - $8.95 commissions

Total Net Profit: +$178.35
= (+$627.30 +$0.00 -$448.95)

Absolute Return if Exercised Early on 10/28/09 = +1.3%
= +178.35/$14,198.95

Annualized Return if Exercised Early on 10/28/09 : +30.6%
= (+178.35/$14,198.95/$51,974.95)*(365/15 days)


2. If Stock Exercised at Nov09 Expiration
It is likely that the owner of the long calls will not exercise early, on the day prior to the ex-dividend date, if the $.31 dividend amount is less than the time value remaining in the call option at that time. If this occurs, the overall performance results(including commissions) for the PAYX transactions would be as follows:

Stock Purchase Cost: $14,198.95
($28.38*500+$8.95 commission)

Net Profit:
(a) Options Income: +$627.30 (500*$1.28 - $12.70 commissions)
(b) Dividend Income: +$155.00 ($.31 dividend * 500 shares)
(c) Capital Appreciation: -$448.95
= ($27.50-$28.38)*500 - $8.95 commissions

Total Net Profit: +$333.35
= (+$627.30 +$155.00 -$448.95)

Absolute Return if Exercised upon Nov09 Expiration on 11/21/09: +2.3%
= +$333.35/$14,198.95

Annualized Return if Exercised upon Nov09 Expiration on 11/21/09: +22.0%
= (+$333.35/$14,198.95)*(365/39 days)

________________________________________________________

What if cash-secured puts had been established instead of the covered calls?
At 2:10pm, when the covered calls were transacted, the bid/ask price for the Nov09 $27.50 puts was $.60/$.65. The potential overall results(including commissions) for a cash-secured puts position would have been as follows:

Cash-Securitization Cost: $13,750.00
= ($27.50*500)

Net Profit:
(a) Put Options Income: +$287.30 (500*$.60 - $12.70 commissions)
(b) Dividend Income: +$0.00
(c) Capital Appreciation: $0.00

Total Net Profit: +$287.30
= (+$287.30 +$0.00 +$0.00)

Absolute Return if Exercised upon Nov09 Expiration on 11/21/09: +2.1%
= +$287.30/$13,750.00

Annualized Return if Exercised upon Nov09 Expiration on 11/21/09: +19.6%
= (+$287.30/$13,750.00)*(365/39 days)

The slightly higher potential returns available via covered calls made them the preferred investment vehicle in this instance.

2 comments:

  1. Jeff,

    I continue to enjoy reading your blog to see how you are doing. Have you read any of Van Tharp's books on expectancy and risk/reward? I keep on going back to my trades and they all mimicked your most recent Paychex trade. $14198.95 on the line for $333.35 potential return. If I were to do CCs again, I could not sleep at night with that risk reward ratio. As your ultrashort loss shows, one stumble with CCs can easily wipe out 3-10 profitable trades. It should be the reverse, where you can have a string of 10 small losses offset by one good trade. Just my opinion, and I continue to wish you the best of luck. If you wake up tomorrow and Paychex has dropped $7 for whatever reason, months of covered call gains will at least be wiped out on paper.

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  2. Hi Mike,
    Thanks for your comments and your perspective. I am a strong believer in using quantitative analysis in evaluating potential investments. Fortunately, as a former Industrial Engineer, I am very comfortable with applying expected values and probabilities to investing. I have not yet read any of Tharp's books, but I will look into them. I do, however, value Warren Buffett's perspective in comparing gaming to investing. Buffett suggests that we focus on a company's underlying business, and then try to "weigh the probability" that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. By focusing on the economic aspects, an investor will be more accurate in his or her ability to judge relative probabilities.

    Regarding your feeling that the risk/reward potential of the Paychex position is inadequate, I respectfully disagree, especially considering the relatively short time frame of this investment. That's why I like to always calculate the potential annualized ROI -- it enables us to compare alternative potential investments of differing time frames against one another before we commit to our preferred investment.
    Regards,
    Jeff

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