Contents
Summary
- I am of the opinion PAYX shares are richly valued.
- You can potentially profit from a drop in PAYX’s share price through the use of options even if you do not own the underlying shares.
- Option strategies have varying levels of risk. This article presents two bearish strategies of differing degrees of risk.
Introduction
I have had a few readers recently enquire about option trading and provide this article to explain a recent option trade.
In my recent Paychex, Inc. (PAYX) article I concluded that PAYX was richly valued. In the ‘Option Strategy’ segment of that article I concluded that:
‘In preparing for this article I looked at short-term out-of-the-money calls. PAYX’s option premiums are razor thin, and therefore, I am not prepared to employ this conservative option strategy.’
I very recently met Andrew, a reader of this blog, who has extensively and successfully employed the use of options. He understands my conservative nature and suggested I entertain more than just the short-term out-of-the-money covered call strategy I have been employing.
NOTE: The option strategy Andrew has employed cannot be executed through a tax efficient account. Secondly, you will see there is a potential downside to the strategy he has employed. Andrew has, therefore, proposed an alternate more conservative option strategy which will reduce your profit potential and slightly raise your breakeven point but will greatly reduce your risk of loss should PAYX’s share price rise as opposed to fall.
Naked Call
Andrew is prepared to accept my view that PAYX is overvalued. His judgment is that the price may decline during the next six months, especially if there is a market correction during that timeframe.
He does not own PAYX shares but through the use of an in-the-money naked call option strategy he has positioned himself to take advantage of this potential pullback; an attractive feature of options is that you do not need to own the underlying shares in order to potentially generate a profit.
On April 4, 2019, Andrew wrote a September 20, 2019 call with a $75 strike price; PAYX was trading at ~$80.40.
Through this trade, Andrew has given someone the right to purchase PAYX shares from him at $75 anytime before expiry (most North American options are exercised shortly before expiry). In exchange, Andrew has received ~$7.10/share and each option contract is for 100 shares.
Let’s look at the following scenarios to see the potential outcome.
Andrew could let the options expire and would BREAKEVEN at ~$82.10 ($82.10 – ($75 + $7.10 option premium collected). NOTE - nominal trading fees are excluded from this example.
In this scenario Andrew MAXIMIZES his profits.
Nobody in their right mind would exercise the right to buy shares at $75 if they can purchase shares on the open market for a lower price. As a result, Andrew keeps the $7.10 premium he collected when he wrote the option and that is the end of this trade.
If PAYX’s share price were to tumble well below $75/share prior to September 20, 2019, the option contracts could end up trading for a fraction of the $7.10 premium Andrew collected. He could, therefore, close out his position well before expiry, pocket the difference between the $7.10/share he collected and whatever the value of the option is at the time he decides to close his position, and be done with this trade.
He would not generate as much profit as he would if he were to just allow the option contracts to expire. He might, however, elect to close out his position if he subsequently determines there is a reasonable probability that PAYX’s share price could trade above the $75 strike price before expiry.
Let’s suppose PAYX shares pullback but only to ~$78 shortly before the September 20, 2019 expiry. Andrew would need to deliver PAYX shares to the holder of the option who has the right to purchase shares at $75/share.
Andrew will close out his position at a cost of ~$3/share plus a small amount for time value….let’s say a total of $3.30/share. He, however, collected $7.10 when he wrote the option contract so he is ahead $3.80/share ($7.10 - $3.30).
The closer the price is to the $75 strike price - the greater the profit.
The closer the price is to the $82.10 breakeven price - the lower the profit.
As you can deduce, the worst case scenario is where PAYX trades well above the $82.10 breakeven price.
Let’s suppose PAYX shares were to experience a sudden surge in value (ie. perhaps a takeover offer with a hefty premium) and reached $100/share.
The holder of the option could decide to exercise their right to acquire shares at $75. Now Andrew is in a predicament where he must acquire shares on the open market at $100 but he will only receive $75 under the terms of the option contract. In this scenario, Andrew will suffer a loss of $17.90/share ($25/share loss - $7.10/share option premium).
While the above noted scenario is possible, the probability is low. It is more likely that PAYX’s shares will slowly rise in value which would provide sufficient time for Andrew to reassess his option strategy.
If PAYX’s share price creeps up to $88 prior to expiry then Andrew may decide that he wishes to close out his position. If he closes his position in August, Andrew will need to lay out $13/share ($88 - $75 strike price) plus whatever the market deems to be the value for the remaining outstanding days until the September 20, 2019 contract expiry date; the time value of the option diminishes as we approach the contract’s expiry date.
We must remember, however, that Andrew collected ~$7.10/share when he wrote the option contract. His loss, therefore, will be $13/share + the time value/share minus the ~$7.10/share option premium. The loss could, therefore, be ~$8/share.
I lay out this terrible scenario since I want you to know there are risks with option trading (just like there are risks with equity trading).
Alternate Trade
In order to reduce your risk of loss in the event PAYX’s share price rises you may wish to consider pairing the sale of your in-the-money call with the purchase of an out-of-the-money $87.50 September 20, 2019 call.
As I compose this article, this option last traded hands at $0.80 meaning you would have to lay out $80/contract.
Your BREAKEVEN point is now reduced to ~$81.30 ($75 + $7.10 - $0.80) option premium collected (nominal trading fees are excluded from this example).
If PAYX shares trade below $75/share you maximize your profit at $6.30.
If PAYX shares trade between $75 and ~$81.30, the outcome is similar to that under the Naked Call scenario but the profit is reduced by $0.80/share since this is what you paid to acquire the out-of-the-money call.
- The closer the price is to the $75 strike price - the greater the profit.
- The closer the price is to the $81.30 breakeven price - the lower the profit.
If PAYX shares trade between $81.30 and $87.50 you would not exercise your right to acquire shares at $87.50 since you could acquire shares on the open market for a lower price.
Suppose shares are trading at $86 come expiry and you have not closed out your positions. You would need to sell PAYX shares at $75/share but you would need to buy them on the open market at $86 meaning you are sustaining an $11/share loss. You, however, netted $6.30 from your two option trades so your loss is capped at $4.70/share.
If PAYX shares were to skyrocket to $100 at expiry, you would exercise your right to buy PAYX shares at $87.50 since you bought a call.
As noted earlier, under the naked put option you would suffer a loss of $17.90/share.
By employing the alternate bearish option strategy wherein you pair the put and the call, you:
- have to sell the shares at $75 and you collected $7.10 when you sold the call so your inflows will total $82.10.
- have to buy at shares at $87.50 and you spent $0.80 for the right to acquire shares at $87.50 so you have laid out $88.30.
Your loss is, therefore, $6.20.
This is certainly not a great outcome but at least you have not exposed yourself to unlimited risk.
Final Thoughts
The option strategy Andrew has employed is because he does not own the underlying shares but wants the opportunity to benefit from a reasonable likelihood that PAYX’s share price will pullback from the current price between now and the September 20, 2019 expiry.
There are various possible outcomes to this trade for which I have provided an explanation. While Andrew stands to maximize his profit with a drop in PAYX’s share price it is interesting to note that this trade has the potential to have a profitable outcome even if PAYX’s share price increases slightly from the current share price!
Andrew's option trade exposes him to unlimited risk which he will very likely address at a later date. Since the strategy he has employed might not appeal to all readers, the alternate less risky bearish option strategy presented might be more appealling. To recap, this strategy calls for selling an in-the-money call and purchasing an out-of the money call with an identical strike price and expiry date.
The account in which I hold PAYX shares is in the process of being amended to permit option trading. Unless something dramatic occurs to PAYX's share price before the account is set up to permit option trading, my intent is to write in-the-money COVERED calls; this is an even more conservative bearish option strategy than the alternate strategy presented in this article. I will write an article disclosing my trade once it has been placed.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long PAYX.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
