Tuesday, February 13, 2007

My stock option insurance business

Back in November, I wrote my very first covered call option. Since then I've been struggling to understand how I ought to evaluate these transactions—especially when the option expires worthless.

Oracle slid from $19.48 to $17, so there was no possibility that the option would be exercised. On the one hand, I certainly didn't lose any upside. On the other, if I had sold my shares instead of the call option, I would have avoided a worse than 11% loss. I'm not terribly upset about the "loss", however, since I wasn't committed to selling Oracle. $20 is at the low end of the stock's intrinsic value, and I'm interested in becoming at buyer again now that Oracle is priced under $17. From the perspective of the option buyer, the option was well worth its price. Instead of out-right buying Oracle and taking an immediate loss, the buyer has the luxury of buying at much cheaper price or taking a pass altogether. So who won and who lost in this transaction?

If you think of an option as an insurance transaction, it becomes more obvious that there don't need to be losers (though often there are). Although the option buyer lost the premium paid to me, their bigger concern was to avoid the sell-off that did, in fact, occur. And although I suffered a big, unrealized loss, I would have suffered it whether or not I'd sold a call option. So like an insurance contract, the party (me) that could afford a sudden price drop sold protection to the other party that couldn't afford it.

Insurance writing is usually evaluated with a metric called the combined ratio. It takes any losses, costs or dividends to policy holders and divides by total premiums. Ratios greater than 100% indicate underwriting loss. Insurance companies prefer to operate at the lowest possible combined ratio, but can still be profitable thanks to investment gains on the premium float, which is the money that has been paid in and has not yet been paid out in claims. Based on a single option, my combined ratio is 21.37%, so I'm currently making an underwriting profit.

The paper loss on the underlying asset (Oracle) is unfortunate, but not really relevant to the activity of writing call options. Think of the underlying asset as a reserve that is required to ensure that I can pay out a loss. When my reserve shrinks, it is the result of an investment decision to not sell not because I wrote a call option against it.

I expect that in the future, I will make a small profit on covered call options. Thankfully, USAA lowered my commissions, which will lower my cost. But I will also probably suffer some loses when options I write are exercised and I imagine I will accept smaller premiums than I did with Oracle.

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