Did Doc Maher ‘jinks' Rauchcory's trade?
You are bullish on a stock, but comfortable with a modest gain. A covered call fits nicely into this thinking. Most often, the call sold in this strategy is out-of-the-money. This is the most aggressive and least risk averse arrangement. If you are more cautious (or more conservative), you may sell an at-the-money or even an in-the-money call. The additional premium of these more expensive calls pads the risk in the stock more so than the run of the mill variety. Nicole Wachs will cover the set-up followed by Doc Maher's analysis. The aftermath of this trade will be covered in the next post.
THE PLAY - Covered Calls
TRADE FORMATION
On June 9th at 9:45 am
Stock: Bought 700 ACAD at 8.34
Strike A: Sold to Open 7 ACAD June 7.50 calls (AQY FU) at 1.10
On June 9th at 11:24 am
Stock: Bought 100 ACAD at 8.44
Strike A: Sold to Open 1 ACAD June 7.50 calls (AQY FU) at 1.25
Average price:
Stock: Bought 800 ACAD at 8.35
Strike A: Sold to Open 8 ACAD June 7.50 calls (AQY FU) at 1.12
Covered call: 7.23 debit
Maximum gain: 7.50 - 8.35 + 1.12 = 0.27 (Strike A - average stock price + call premium)
Maximum loss: debit paid of 7.23
Break-even points at expiration: 7.23 (Average stock price - call premium)
In this case, a covered call was used because the trader is bullish on the stock and is willing to sell it at a specific, pre-determined price. While waiting for the sale to go through, the trader aims to collect additional income on the stock by selling calls against the stock position.
The objective for this specific set-up is for the stock to stay where it is or go higher, resulting in the trader's assignment of the short call (either early or at expiration). This would force the stock to be sold, leaving the trader without any open positions related to this stock. The maximum gain would be realized.
For more detail on this strategy, please login and go to TradeKing's Education Center. It is located in online version of The Options Playbook > Play #6.
FIELD CONDITIONS - the trading environment
The key factor is for the stock to stay above the break-even point of 7.23. If the stock falls below this amount, the trader will experience a loss. The lower the stock goes, the greater the loss. Time decay would normally be the second factor, with the passage of time benefiting the position. For this specific trade, volatility requires more of our attention. It is unusually high, possibly alluding to a drastic move in the stock in the near future. If the stock jumps higher, no worries. If the stock falls, it must stay above 7.23. Anything below will result in a loss.
ALL-STAR COMMENTARY - by Doc Maher
Rauchcory did a couple of covered call trades (ACAD and TLB) and started a forum discussion about them. This post is about ACAD. The trader bought ACAD stock at $8.34 and sold the June $7.50 call for $1.10. Looking at a three month chart (below) it looks like very little is going on and it hasn't been below the $7.50 price point for some time (Strike A).
Click here for a larger stock chart.
There are a couple of interesting things about this covered call that I thought were worth examining. First the trader sold an in-the-money (ITM) call with the expectation that he would get called away. Most of the time you see people selling out-of-the-money (OTM) calls for this strategy. One of the things this does is give Rauchcory a down-side cushion. He paid $8.34 for the stock and he has already decided to sell it for $7.50. As long as the stock stays above $7.50 he will get called away and his strategy will have worked. This means that ACAD can move $0.84 down and he will still get the maximum return. This can be seen below on the P&L graph for this trade.
Click here for a larger Profit & Loss graph.
So what is the return? If he gets called away at $7.50 he would get $7.50 (for the stock) - $8.34 (his cost) + $1.10(the call premium) = $0.26 profit. This is $0.26/($8.34-$1.10) = 3.5%. He entered the trade on June 9 and June expiration is June 20 so he only has to hold it for 2 weeks. It may not seem like much but a covered call that is in the money and pays 3.5% for two weeks is really a very good return. That's something like 90+% annualized.
So why is the return so high? As I have said in the past I always get suspicious when the return looks too good. What is going on here? Well as Rauchcory said it's a very expensive option. Look at the Implied Volatility in the image below - it's 135. That seems like a lot, but let's examine the IV chart more closely.
Click here for a larger volatility chart.
Wow, the IV which is usually between 60 and 80 went flying up starting in March to the 120s. What's going on here? The stock has been relatively quiet over the last three months as you can see in both the price chart (first image) and the dropping HV on this chart. In fact, looking solely at the price chart no one would suspect anything was going on with this stock but the IV tells us different. Something is most definitely going on here and we can see it in the option prices.
What kind of company is ACAD anyway? ACAD is Acadia Pharmaceuticals Inc. This is a drug discovery company. I looked to see if I could find any specific news that came out around the beginning of March that would have driven the IV so high but I didn't find any. They do have a drug for the treatment of Parkinson's disease that may be nearing the end of its testing for FDA approval, but I didn't find any mention of a date when that might happen. Based on the IV there seems to have been news expected anytime from March on.
Once that news hits, good or bad it will most likely send the stock flying up or tanking down. The market makers have anticipated this move and priced the options to reflect this, even though it's not affecting the stock price.
Since there is some risk that the news will hit before June expiration, the covered call looks particularly juicy. If there is no news before the 20th this covered call will probably play out as planned. If the news is good and the stock flies up, no harm however the covered call will not benefit from that. The stock might double but we will still get called out at $7.50. If the news is bad I would expect the stock to drop hard and pretty much overnight. If that happens there will be no way to exit the covered call without a loss. A covered call has a limited up side with greater risk to the downside (loss is limited because the stock cannot go below $0).
Whenever I see these "too good to be true" covered call opportunities, I caution people to make sure that they understand the risk. When the premium is very high there is a reason and it's a good idea to make sure that you know what that reason is and are willing to take the risk.
Clearly there is speculation going on here. When I look at the open interest I see that the June $7.50 calls have 818, but the June $10 calls have 3184. This is exactly what you see when people are betting on a big move up. They buy the out of the money options because they are cheap and if the news is bad they will get wiped out but if it's good a $0.40 call option could become a $5 call option.
The good news for this trade is that the news has been anticipated since before April and it hasn't hit yet plus it's only two weeks of exposure. So you have to weigh the potential gains and the risk and decide if you like that trade off or not.
I hope this helps people identify and manage their risk a little better.
"Income Trader"
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were completed on 6/12/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
