I'm a big fan of your analysis (many thanks), but in this particular case I believe you a case can be made for the 'risk/reward' evaluation that would cause some investors to prefer to write calls on their stock holdings, thereby, as you say, foregoing the maximum possible upside.
In your CIBC Jan26@50 example, a stockholder would own the stock, collect the 6.7% dividend yield for two years, and lock in an additional $4.00 regardless of outcome (so 100% probability or zero risk), thereby enhancing their outcome by ~4% over simply holding the stock.
For a conservative investor that disparity between the theoretical Black-Scholes value with a greater than 50% chance of a complete loss and the cash in hand might be compelling. And if the stock is likely to be called away after two years (most option contracts are not called before the expiry date), the investor has two options remaining - let it go and reinvest at the higher price with the same strategy (because if the return remains compelling, why not?) or buy back the option and write another at a higher strike price.
Obviously, the rise in excess of $56 wouldn't be captured, but the conservative investor would be in approximately the same investment position as two years earlier. And of course if the stock is below $56 the conservative investor comes out ahead. (This is not to imply that the management expenses with a Covered Call ETF are providing any additional value over 'convenience'.) Thanks!
Your final probability analysis is in error. The obvious single error is that I'm pretty sure you meant to calculate 15 * 20% as 3, not 5. However, I think the problem with your calculation runs deeper in that you shouldn't be multiplying those option values by _cumulative_ probabilities in the first place.
Thanks. You are right the table should display 3 not 5. I believe you are wrong about the use of the assigned probabilities which I argue is appropriate for the point being since the option can be exercised at any time during its life. Black-Scholes assumes stock prices are log-normally distributed and that volatility is constant over the duration of the option and integrates the possible outcomes to arrive at a value for the option. The rough-and-ready approach I used is a dumbed down binomial tree approach. Calling them "cumulative probabilities" was misleading on reflection.
Bottom line with so many covered call funds, it creates a larger supply, to some extent the writing is predictable so smart folks can take advantage of the situation.
Dear Mr. Blair,
I'm a big fan of your analysis (many thanks), but in this particular case I believe you a case can be made for the 'risk/reward' evaluation that would cause some investors to prefer to write calls on their stock holdings, thereby, as you say, foregoing the maximum possible upside.
In your CIBC Jan26@50 example, a stockholder would own the stock, collect the 6.7% dividend yield for two years, and lock in an additional $4.00 regardless of outcome (so 100% probability or zero risk), thereby enhancing their outcome by ~4% over simply holding the stock.
For a conservative investor that disparity between the theoretical Black-Scholes value with a greater than 50% chance of a complete loss and the cash in hand might be compelling. And if the stock is likely to be called away after two years (most option contracts are not called before the expiry date), the investor has two options remaining - let it go and reinvest at the higher price with the same strategy (because if the return remains compelling, why not?) or buy back the option and write another at a higher strike price.
Obviously, the rise in excess of $56 wouldn't be captured, but the conservative investor would be in approximately the same investment position as two years earlier. And of course if the stock is below $56 the conservative investor comes out ahead. (This is not to imply that the management expenses with a Covered Call ETF are providing any additional value over 'convenience'.) Thanks!
Yes, that is an alternative but offers a maximum return that is too low for me.
Your final probability analysis is in error. The obvious single error is that I'm pretty sure you meant to calculate 15 * 20% as 3, not 5. However, I think the problem with your calculation runs deeper in that you shouldn't be multiplying those option values by _cumulative_ probabilities in the first place.
Thanks. You are right the table should display 3 not 5. I believe you are wrong about the use of the assigned probabilities which I argue is appropriate for the point being since the option can be exercised at any time during its life. Black-Scholes assumes stock prices are log-normally distributed and that volatility is constant over the duration of the option and integrates the possible outcomes to arrive at a value for the option. The rough-and-ready approach I used is a dumbed down binomial tree approach. Calling them "cumulative probabilities" was misleading on reflection.
Bottom line with so many covered call funds, it creates a larger supply, to some extent the writing is predictable so smart folks can take advantage of the situation.