Calculation Rules: Making Sense Of A Trade That Makes No Sense

 | Sep 11, 2016 03:15AM ET

Understanding option calculations is a necessary skill to become an elite covered call writer. The Ellman Calculator will do all the legwork but accurate and meaningful results are dependent on appropriate inputs. To highlight this point, let’s look at a real-life trade sent to me by Catherine who trades on the Toronto Stock Exchange:

Catherine’s trade

  • Stock price at purchase of BNS (Bank of Nova Scotia) at $61.75
  • Sell the $58.00 call at $2.10 (8 months to expiration)
  • Current stock price $62.00
  • Cost-to-close (buy back option) is $5.75

Why these stats make no sense

Let’s start with our basic premium equation:

Total premium = time value

Now, if the above stats are accurate, the $58.00 call generated $2.10 while BNS traded at $61.75 This cannot be because there is $3.75 intrinsic value + a time value component (with 8 months remaining to expiration) so a premium of $2.10 is impossible. I would expect a premium well over $5.00 depending on the implied volatility of BNS. I’ll bet most of you have figured this out.

I checked back with Catherine and sure enough the shares were purchased at a $61.95 but the covered call was sold after share depreciation to $58.00. Let’s say Catherine bought BNS 10 years ago for $5.00 per share which has now appreciated to $58.00 and then the $58.00 call was sold for $2.10. Does that mean her return for the 8-months remaining is 42% using a $5.00 cost basis (hint: rhetorical question)?

What is our cost basis when we write a covered call?

Tax issues aside, our cost basis is the price of the shares at the time the call is sold. Although Catherine paid $61.95 for the shares initially, the day the call was written the shares were worth $58.00. Had she paid $30.00 initially, the shares would still be worth $58.00 for purposes of covered call calculations. We cannot cloud our calculations by using irrelevant figures that have nothing to do with current positions.

Initial returns using current cost basis