Tuesday, February 21, 2012

Establish Rio Tinto PLC ADR Covered Calls (Possible Early Assignment)

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of Rio Tinto PLC ADR (Ticker Symbol RIO) covered calls as follows:

Established Rio Tinto PLC ADR (RIO) Covered Calls for Mar2012:
02/21/2012 Bought 300 RIO @ $58.24
02/21/2012 Sold 3 RIO Mar2012 $57.50 Calls @ $1.80

This covered calls investment is a strategic one that explicitly considers the upcoming dividend of $.91 with an ex-dividend date of Feb 29th. If the current $1.06 [$1.80-($58.24-$57.50)] time value (i.e. extrinsic value) remaining in the short call option decays to less than $.91 by Feb 28th (the day prior to the ex-div date), then there is some possibility that the call options owner will exercise early and will call the stock away (i.e. early assignment) to capture the dividend. As shown below, two potential returns for this position are:
+45.8% annualized return if the stock is assigned at Mar2012 expiration
+77.7% annualized return if the stock is assigned early

Based on these returns, the Covered Calls Advisor prefers that the options owner is enticed to exercise early -- which would result in a higher annualized return-on-investment for this position. In short, it is better to earn a $1.06 profit per share in 8 days (average of $.1325/day) than a $1.97 profit ($1.06 options premium plus $.91 dividend income) in 26 days (average of $.076/day).

As shown on the table below, this investment meets all 10 criteria established by the Covered Calls Advisor for establishing a Potential Early Assignment covered calls position:

Two possible overall performance results(including commissions) for the Rio Tinto PLC ADR (RIO) transactions would be as follows:
Stock Purchase Cost: $17,480.95
= ($58.24*300+$8.95 commission)

Net Profit:
(a) Options Income: +$528.80
= ($1.80*300 shares) - $11.20 commissions
(b) Dividend Income (If stock assigned at Mar2012 expiration): +$273.00
= $.91 per share x 300 shares
(b) Dividend Income (If option exercised early on day prior to Feb 29th ex-div date): +$0.00
(c) Capital Appreciation (If stock assigned at $57.50): -$230.95
+($57.50-$58.24)*300 - $8.95 commissions

Total Net Profit(If stock assigned at Mar2012 expiration): +$570.85
= (+$528.80 +$273.00 -$230.95)
Total Net Profit(If option exercised on day prior to Feb 29th ex-div date): +$297.85
= (+$528.80 +$0.00 -$230.95)

1. Absolute Return (If stock assigned at Mar2012 expiration): +3.3%
= +$570.85/$17,480.95
Annualized Return (If stock assigned at Mar2012 expiration): +45.8%
= (+$570.85/$17,480.95)*(365/26 days)

2. Absolute Return (If option exercised on day prior to Feb 29th ex-div date): +1.7% = +$297.85/$17,480.95
Annualized Return (If option exercised early): +77.7%
= (+$297.85/$17,480.95)*(365/8 days)

The downside breakeven price at expiration is $56.44 ($58.24 - $1.80).
Using the Black-Scholes Options Pricing Model in the Schwab Hypothetical Options Pricing calculator, the resulting probability of making a profit (if held until Mar2012 options expiration) for this Rio Tinto covered calls position is 68.5%. This compares with a probability of profit of 50.2% for a buy-and-hold of Rio Tinto over the same time period. Using this probability of profit of 68.5%, the Expected Value annualized ROI of this investment (if held until expiration) is a very attractive +31.4% (+45.8% * 68.5%).

The potential annualized return of +45.8% if the stock price remains above the $57.50 strike price on the Mar2012 options expiration date is a very attractive annualized ROI. It widely exceeds the Covered Calls Advisor's minimum threshold of +20%. The Implied Volatility (IV) in these RIO call options was 25.0 when these options were sold today.

The upside crossover price at expiration is $60.21 ($57.50 + $1.80 +$.91 dividend).
This is the price above which it would have been more profitable to simply buy-and-hold Rio Tinto stock until Mar 17, 2012 (the Mar2012 options expiration date) rather than establishing this covered calls position.

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