Large Returns Can Be Enticing: We Must Do the Math to Make Sensible Trades – April 4, 2022
Our covered call writing and put-selling trades initially generate cash into our brokerage accounts. The amount of cash can be impressive on the surface but we must break down the components of these premiums, calculate our potential returns and measure the risk inherent in these contract obligations.
In November of 2021, Peter wrote me and inquired about a trade involving Intel Corp. (Nasdaq: INTC):
- 11/1/2021: Buy 300 x INTC at $50.00
- 11/1/2021: STO 3 x 6/17/2022 $30.00 calls for $6120.00
- Does this trade make sense?
Based on the email I received, the attraction of the trade was the $6120.00 premium. Since the cash premium was based on 3 contracts, let’s simplify the returns to 1-contract percentages which will be the same for the 3 contracts.
Initial calculations using the multiple tab of the BCI Elite Calculator
- The length of the trade is approximately 7 1/2 months
- The annualized return is 2.1%
- The time-value return if 1.3%
- The downside protection of the 1.3% is a robust 40%
- The breakeven price point is $29.60
Risk evaluation
A 7 1/2-month contract obligation will bring us through 2 more earnings reports which could negatively impact our overall trade position despite the huge downside protection. Is this the best place to invest $15,000.00 (300 shares at $50.00)?
My personal evaluation
Each investor must determine the strategy goals and amount of risk we are willing to incur. For me, annualized return of 2.1% while incurring the risk of 2 earnings reports eliminates this trade from my consideration. It may be appropriate for others.
Discussion
When evaluating potential option trades, the cash we generate from the sale of the contracts must be analyzed from calculation and risk perspectives. Large premiums that result in much smaller time-value returns and subject us to high-risk events can be deceiving and lead us to making inappropriate investments.
Strike selection is as much an art as it is a science. We must first establish our initial time-value return goal range. From there, we factor in personal risk-tolerance and overall market assessment. With these factors considered, strike selection will result in a well-thought-out plan.
Author: Alan Ellman