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Tuesday, February 14, 2012

Establish Transocean Inc. Covered Calls (Possible Early Assignment)

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of Transocean Inc.(Ticker Symbol RIG) covered calls as follows:

Established Transocean Inc.(RIG) Covered Calls for Mar2012:
02/14/2012 Bought 200 RIG @ $47.58
02/14/2012 Sold 2 RIG Mar2012 $45.00 Calls @ $3.50

This covered calls investment is a strategic one that explicitly considers the upcoming quarterly dividend of $.79 with an ex-dividend date of Feb 22nd. If the current $.92 [$3.50-($47.58-$45.00)] time value (i.e. extrinsic value) remaining in the short call option decays to less than $.79 by Feb 21st (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:
+38.6% annualized return if the stock is assigned at Mar2012 expiration
+78.8% 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 $.92 profit per share in 8 days (average of $.115/day) than a $1.71 profit ($.92 options premium plus $.79 dividend income) in 32 days (average of $.053/day).

Two possible overall performance results(including commissions) for the Transocean Inc.(RIG) transactions would be as follows:
Stock Purchase Cost: $9,524.95
= ($47.58*200+$8.95 commission)

Net Profit:
(a) Options Income: +$689.55
= ($3.50*200 shares) - $10.45 commissions
(b) Dividend Income (If stock assigned at Mar2012 expiration): +$158.00
= $.79 per share x 200 shares
(b) Dividend Income (If option exercised early on day prior to Feb 22nd ex-div date): +$0.00
(c) Capital Appreciation (If stock assigned at $45.00): -$524.95
+($45.00-$47.58)*200 - $8.95 commissions

Total Net Profit(If stock assigned at Mar2012 expiration): +$322.60
= (+$689.55 +$158.00 -$524.95)
Total Net Profit(If option exercised on day prior to Feb 22nd ex-div date): +$164.60
= (+$689.55 +$0.00 -$524.95)

1. Absolute Return (If stock assigned at Mar2012 expiration): +3.4%
= +$322.60/$9,524.95
Annualized Return (If stock assigned at Mar2012 expiration): +38.6%
= (+$322.60/$9,524.95)*(365/32 days)

2. Absolute Return (If option exercised on day prior to Feb 22nd ex-div date): +1.7% = +$164.60/$9,524.95
Annualized Return (If option exercised early): +78.8%
= (+$164.60/$9,524.95)*(365/8 days)

The downside breakeven price at expiration is $43.29 ($47.58 - $3.50 - $.79 dividend).
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 Transocean Inc.(RIG) covered calls position is 81.3%. This compares with a probability of profit of 50.0% for a buy-and-hold of Transocean over the same time period. Using this probability of profit of 81.3%, the Expected Value annualized ROI of this investment (if held until expiration) is a very attractive +31.4% (+38.6% * 81.3%).

The potential annualized return of +38.6% if the stock price is unchanged on the Mar2012 options expiration date in this position is very attractive, exceeding the Covered Calls Advisor's desired minimum threshold of +25% annualized ROI. The Implied Volatility (IV) in these RIG call options was 37.9 when these options were sold today.

The upside crossover price at expiration is $49.29 ($45.00 + $3.50 +$.79 dividend).
This is the price above which it would have been more profitable to simply buy-and-hold RIG stock until Mar 17, 2012 (the Mar2012 options expiration date) rather than holding the covered calls position.

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