Fri Feb 3, 2006: Occulogix (NASDAQ-RHEO) A Covered Call Gone Bad

Investors in RHEO stock were surprised today by the large sudden drop at the open of trading, with the stock staying down all day and finishing at $4.15 per share, down $8.65 which was a drop of 67.84%. This is worthy of comment for several reasons.

First, it is a classic example of a covered call yield that seemed too good to be true, and was. One-month RHEO covered call options were paying an income of nearly 20% in the weeks leading up to today's crash. Often when you see this type of yield, there is big risk in buying the stock for the purpose of covered call writing because it's so volatile that the potential loss from the stock can easily offset the income from writing the covered calls.

Other factors added to the risk in this particular situation. RHEO is a research-stage medical company lacking steady income from sales to established customers. Its prospects are primarily based on a single line of research for an as-yet incurable disease. The stock pays no dividend and had a low book value relative to its price. The price was bid up high in anticipation of positive results from an experimental study (which turned out to be disappointing). It was recently touted as a buy recommendation on a popular stock market television show, driving the price up even higher.

The good news for investors stuck holding the stock is that the painful lesson learned today can, over the long run, more than pay for itself many times over when future option trading opportunities are considered. Especially for small investors just starting out, learning lessons like this now can help avoid much larger losses later in their careers, when they have a lot more money on the line. Paper trading is very useful, but nothing can make a lesson sink in better than losing real money.

Diversification (not putting all your eggs in one basket) can help limit the damage done to a portfolio by a single position gone bad. Of course in retrospect it always appears foolish to have been caught in a losing situation, but it is never that easy in advance of such an event and no investor can be right about every decision. Every investment involves uncertainty. Without that there would be no opportunity for profit. Keeping position sizes small is a good rule of thumb to practice.

Second, what happened today points out that no option strategy is the best strategy for all situations. People who bought put options on RHEO doubled or tripled their money today. Those one-day returns of 100% or 200% etc. make the 20% monthly yield from covered call writing appear small by comparison. Other strategies besides covered call writing, for example credit spread writing, can offer more limited risk while still providing the premium income and out-of-the-money advantages that option writers seek. Ratio writing (selling more calls than the amount of underlying stock owned, that is, some covered and some naked) is also an approach that can help cushion the blow of a declining stock.

Third, I heard many investors today complaining about dishonest manipulation blamed on various parties. Such talk is a waste of time and energy. There is manipulation in the stock market, it is true, of both the legal and illegal kind. But that is one of the risks of trading, and it is not something you can control. Further, "manipulation" such as large continuous buying by institutions often benefits small investors who own the stock. If there was manipulation in RHEO stock, it certainly benefited put option holders today, as well as naked call writers. My point is that investors should focus on what they can control. Maintain appropriate position sizes for the amount of money you can afford to risk. Select option strategies with risk/reward characteristics that you understand, and that match your expected price outlook for the underlying stock.

Finally, realize that nobody knows the future. Don't expect to make money on every trade. Nobody does. RHEO stock might easily have gone in the other direction today - up. It might have gone up a lot more than eight points, had the study results turned out differently. Consider what might have happened to various option strategies if that had been the scenario. Use this as a learning opportunity, as all losses are. Unfortunately we usually learn little from our victories, because we are too busy celebrating.