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Wednesday, February 7, 2018

Established Covered Calls in Rio Tinto PLC

Today, a Covered Calls position was established in Rio Tinto PLC (ticker symbol RIO) with a March 16th, 2018 expiration and at the $50.00 strike price.  This position has an upcoming semi-annual ex-dividend on March 1st of $1.80 per share, so the potential return for this position, as detailed below, includes the possibility of early exercise because the ex-dividend is prior to the April 20th, 2018 options expiration date.  Because of the very large dividend payout, the April 20th expiration was selected to provide an adequate return-on-investment even if the time value in the Call options declines in value by the day prior to the ex-dividend date and the Call owners exercise their option in which case the shares are assigned. 

Rio Tinto just reported their annual earnings for 2017 this morning.  Rio Tinto is a London-based diversified mining company operating mostly in Australia. Largely as a result of increased commodity prices, their financial results were stellar.  Revenues increased to $40 billion, operating cash flow was an impressive $13.9 billion and earnings increased 69% above last year to $8.63 billion.  Mr. Jacques has been the Chief Executive for only about 18 months now, but he is demonstrating a very shareholder friendly management style.  A company record $5.2 billion will be distributed to shareholders in 2018 and an additional $1.0 billion will be used for share buybacks.

As detailed below, a potential return-on-investment result is +0.9% absolute return (equivalent to +15.5% annualized return for the next 22 days) if the stock is assigned early (business day prior to March 1st ex-date); OR +4.6% absolute return (equivalent to +22.8% annualized return over the next 73 days) if the stock is assigned on the April 20th options expiration date.

Rio Tinto PLC (RIO) -- New Covered Calls Position
The transactions were:
02/07/2018 Bought 300 Rio Tinto shares @ $54.04
02/07/2018 Sold 3 Rio Tinto 04/20/2018 $50.00 Call options @ $4.52
Note: a simultaneous buy/write transaction was executed.
03/01/2018 Upcoming semi-annual ex-dividend of $1.80 per share

Two possible overall performance results (including commissions) for this Rio Tinto Covered Calls position are as follows:
Covered Calls Cost Basis: $14,862.96
= ($54.04 - $4.52) *300 + $6.96 commission

Net Profit Components:
(a) Options Income: +$1,356.00
= ($4.52*300 shares)
(b) Dividend Income (If option exercised early on Feb 28th, the business day prior to Mar 1st ex-div date): +$0.00; or
(b) Dividend Income (If RIO assigned at Apr 20th, 2018 expiration): +$540.00
= ($1.80 dividend per share x 300 shares)
(c) Capital Appreciation (If RIO assigned early on Feb 28th): -$1,216.95
+($50.00-$54.04)*300 shares - $4.95 commissions; or
(c) Capital Appreciation (If assigned at $50.00 strike price at options expiration): -$1,216.05
+($50.00-$54.04)*300 shares - $4.95 commissions

1. Total Net Profit [If option exercised on Feb 28th (business day prior to March 1st ex-dividend date)]: +$139.05
= (+$1,356.00 +$0.00 -$1,216.95); or
2. Total Net Profit (If RIO shares assigned at $50.00 at Apr 20, 2018 expiration): +$679.05
= (+$1,356.00 +$540.00 -$1,216.95)

1. Absolute Return [If option exercised on Feb 28th (business day prior to ex-dividend date)]: +0.9%
= +$139.05/$14,862.96
Annualized Return (If option exercised early): +15.5%
= (+$139.05/$14,862.96)*(365/22 days); or
2. Absolute Return (If stock assigned at $50.00 at Apr 20, 2018 expiration): +4.6%
= +$679.05/$14,862.96
Annualized Return (If RIO stock assigned at $50.00 at April 20th, 2018 expiration): +22.8%
= (+$679.05/$14,862.96)*(365/73 days)

Either outcome provides a satisfactory return-on-investment result for this investment.  These returns will be achieved as long as the stock is above the $50.00 strike price at assignment.  If the stock declines below the strike price, the breakeven price of $47.72 ($54.04 -$4.52 -$1.80) provides 11.7% downside protection below today's purchase price.

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