Fri Apr 13, 2007: Another, Bigger Option Win on RIMM?

Exactly one month ago, on March 13th, we discussed a bearish option writing strategy on the stock of Research in Motion (NASDAQ-RIMM), now priced at $132.74 per share. The stock has declined less than two dollars during the month, about 1%, but our strategy has returned a 23% profit! That's the power of intelligent option writing. And we did it with limited risk, using call spreads.

Now let's consider doing it again for the next month, with a profit goal of 29% this time!

A May 140-145 call credit spread on RIMM could now be sold for a net credit of 1.15, which is $115 per spread. This would involve simultaneously writing (selling) a May 140 call and buying a May 145 call.

The margin requirement for putting on this position is the width of the spread minus the premium received, in this case $500 - $115 or $385 margin required. The net return if RIMM stock finishes unchanged is $115 / $385 = 29.9% excluding commissions, not bad for one month. Both call options would simply expire worthless.

If the stock goes down the result is the same.

If the stock goes up but stays below 140 the result is also the same.

Above 140, the upside risk comes into play. The 140 call you sold will have value equal to $100 for every point above 140. The 145 call you bought will be worthless unless the stock is above 145. Actually it would have some time value before it expires but for now we are only considering what happens at expiration.

Between 140 and 145, your call will be worthless and the call you sold will cost you $100 per point to buy back, with a maximum of $500 if it finishes in-the-money by 5 points at a price of 145.

Above 145, your net repurchase cost would still be limited to $500 because although the 140 call would be worth an additional $100 for each point up, your 145 call would also gain that much, offsetting the loss on the 140 call point-for-point no matter how high the stock finishes. So your maximum loss would be $385 because you received $115 income up front and have to pay off $500 net to close out the spread.

To close out the spread you would buy back the 140 call and then sell your 145 call.

In addition to having to pay another round of commissions when you close out a spread, you will also have to pay "slippage" which means that your net cost will actually be more than $500 to close it out if the stock is above 145. This is because of the difference in the marketplace between bid and ask prices. Typically you might end up having to pay approximately $520 plus commissions.

If you sell your 145 call before buying back the 140 call then the 140 call will be naked, subjecting you to a possible margin call as well as theoretical risk of unlimited loss should RIMM stock keep going up.

If the stock finishes between 140 and 145 you will still have to buy back the 140 call to close out your spread even though the 145 call you owned expired worthless. The repurchase cost to close it out will be approximately $100 for every point above 140, plus slippage and commissions.

If you do not buy back the 140 call and the stock finishes above 140 you will be "assigned" on your short call. The owner will exercise his or her right to "call" (buy) 100 shares of RIMM from you at 140. Even if the current market price is much higher you will still be forced to automatically sell it short in your account at $140 per share. In that case you would still get to keep the $115 and possibly also be able to sell your 145 call before it expires.

Until next time, best of luck with your option investments!