dividend increase 16, JCI Covered Call Trade Pays Off

On January 21, 2016, we wrote about an investor who made a $10+ million covered call trade in Johnson Controls (JCI). As a recap, he purchased 335,800 shares of JCI at $34/share and then wrote 3,358 in-the-money April calls with a strike of 31:

Action Price
Buy JCI stock $34.00
Sell April 31-strike call $3.90
Net Debit $30.10

The call premium received ($3.90/share) lowered his cost to $30.10 ($34 - $3.90). Max profit for the trade would be achieved if JCI closed above the strike price, 31, on April 15.

Fortunately, JCI closed at $39.17 yesterday, and the investor made 0.90/share (31 - 30.10), or 3% (0.90 / 30.10) in 86 days. That's an annualized return of 12.7% (3 / 86 * 365).

However, JCI also paid a 0.29 dividend in March, which this investor received. Therefore, the total profit per share is 0.90 plus 0.29, or 1.19 per share. The profit at expiration was 3.95% (1.19 / 30.10) in 86 days, or 16.8% annualized. Nice work, my friend.

Covered Call vs Buy And Hold

Yes, in this case the investor would have been better off buying and holding JCI stock over this period. He would have made 5.17 + 0.29 = 5.46 per share instead of 1.19 per share. That's frustrating. But the beauty of the covered call transaction is that he would have made the same 1.19 per share if JCI had closed at 31 or higher.

He left himself plenty of room to make his max profit by using an in-the-money covered call. And he wouldn't have lost any money until JCI dropped below 29.81 (30.10 - 0.29 dividend), whereas the buy and hold investor would have a loss at any closing value less than 33.71 (34 - 0.29 dividend). On a risk adjusted basis, we prefer the covered call trade.

A Less Fortunate Bet On DAL

A less fortunate (and large) option trade crossed the wire a few weeks ago. In late March someone bought to open 30,000 May 50 calls on DAL for $1.85 each, thus investing $5.5 million to control 3 million shares of Delta Airlines. DAL was trading around $49 at the time. This is not a covered call trade, it is merely a large directional bet that DAL will close above $51.85 (strike + cost of call option) before May 20 (expiration):

Action Price
Buy May 20 50-strike calls $1.85
Break Even on May 20 $51.85

Today, about 3 weeks later and with a month to go until expiration, DAL is down about $1.50 from where the trade was placed, closing yesterday at $47.50. The May call options have had significant time decay (and earnings risk decay, since earnings came out 2 days ago) and closed yesterday at $0.66. This investor has lost (on paper) about 64% of his investment, or about $3.5 million.

There is still a month to go until expiration, but this investor needs DAL to rise by 9.2% before May 20 in order to break even. We're guessing the investor thought the earnings news on Apr 14 would be better than it was, perhaps due to the reduced price of oil in the most recent quarter. Although an intuitive argument, DAL earnings failed to impress. Just goes to show that the big boys get it wrong sometimes, too.

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