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Tuesday, March 6, 2012

Establish Morgan Stanley Covered Calls

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of Morgan Stanley (MS) covered calls as follows:

Established Morgan Stanley (MS) Covered Calls for Mar2012:
03/06/2012 Bought 500 MS @ $17.35
03/06/2012 Sold 5 MS Mar2012 $17.00 Calls @ $.76

Today, Morgan Stanley had declined by more than 5.0% when this position was established. The implied volatility in the options sold had risen to 46.9, so the options premiums had increased to a very attractive level. Because of the stock market's current spike in volatility, a somewhat conservative in-the-money position was established.

The 10-year chart below shows that Morgan Stanley is now trading at a historically low valuation relative to its book value. It is is now priced at about 50% of book value per share versus a historical norm above 100%.
Morgan Stanley Stock Chart

Morgan Stanley Stock Chart by YCharts

With Morgan Stanley's primary financial metrics now slowly improving, the stock's downside risk seems relatively small compared with its estimated 50% upside potential for the next year ($26.00 target price).

A possible overall performance result(including commissions) for this Morgan Stanley position is as follows:
Stock Purchase Cost: $8,683.95
= ($17.35*500+$8.95 commission)

Net Profit:
(a) Options Income: +$367.30
= 500*$.76 - $12.70 commissions
(b) Dividend Income: +$0.00
(c) Capital Appreciation (If MS exercised at $17.00): -$183.95
= ($17.00-$17.35)*500 - $8.95 commissions

Total Net Profit(If MS exercised at $17.00): +$183.35
= (+$367.30 +$0.00 -$183.95)

Absolute Return if Assigned at $17.00: +2.1%
= +$183.35/$8,683.95
Annualized Return If Assigned (ARIA) +70.1%
= (+$183.35/$8,683.95)*(365/11 days)

The downside 'breakeven price' at expiration is at $16.59 ($17.35 - $.76).
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 Morgan Stanley covered calls position is 71.9%. This compares with a probability of profit of 51.5% for a buy-and-hold of MS over the same time period.

The 'crossover price' at expiration is $17.76 ($17.00 + $.76).
This is the price above which it would have been more profitable to simply buy-and-hold MS until March 17, 2012 (the Mar2012 options expiration date) rather than establishing the covered calls position. The probability of exceeding this crossover price at expiration is 40.3%.

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