A Review Of My Merck Option Trades

| About: Merck & (MRK)

Summary

For the first time I tried a put writing strategy to purchase shares of Merck.

There is a review of option trading and its inherent risks.

Lastly, a review of my Merck options trades are chronicled and the results are summarized.

A Review of My Merck (NYSE:MRK) Option Trades

In September 2015 I became interested in purchasing shares of Merck & Co as I wanted to invest in the healthcare sector, particularly a pharmaceutical company, for reasons outlined in a previous article. As Chart 1 shows MRK was trading in the low $50s at that time and I decided that I would try to purchase my shares for $50. On September 18, 2015 MRK closed at $51.24. I could have simply placed a limit order with my broker, TDAmeritrade, in order to buy my shares but for the first time in my investment career I decided I would change strategies and sell a put option in order to purchase my shares. I thought that this change in strategy would allow me to purchase shares at my target price and receive income in the process. This article will detail the risks involved with writing options and this article will also detail the results of my option writing on MRK shares since September 2015.

Chart 1 - Merck Weekly Price Chart

Click to enlarge

The Inherent Risks of Buying and Selling Options

Over the years I have purchased many options. Most of them have been call options and far fewer have been put options, but I always have been a buyer of calls and puts. Having bought numerous options over the years, but mostly losing money on those call options, I thought I would try selling them as I have often heard that the only people who consistently win in the options markets are those selling the option. For an excellent primer on options the reader can look here or read any of the numerous books on options by Lawrence McMillan.

The risks of buying and selling options are many. The option buyer has to be right on the direction of the move in price, the amount of the price movement, and the timeliness of the move to make money on the option purchase. This is the problem I frequently ran into on my call option purchases. I would buy the call option, but the stock would either remain stagnant or worse decline. This caused my option premium to decay and therefore I would lose money on my option purchase. This is why it is often said that the seller of the option is the one who consistently makes the money in an option contract.

However, the seller has risks also. When you sell the put option you are obligated to buy the shares of the underlying at the strike price. If the strike price is $50 but the stock falls to $40 a share the seller has to pay $50 a share for the stock and is automatically down $10 a share in the trade. Conversely, the seller of the call option has to sell the shares at the strike price. If the shares are selling for $60 in the market at the expiration date, but the strike price is for $50 then the call option seller has left $10 a share on the table. However, the option premiums received by the seller are kept regardless of the outcome of the transaction.

It is because of these risks that put option sellers are frequently reminded to only write puts on stocks you truly want to own. This is because you may end up buying the shares for a price that is higher than the current market price of the shares. I was aware of these risks and was willing to write a put on MRK because I was comfortable owning shares in MRK.

A Review of My Option Writing on MRK

Now that the basics of options have been reviewed I will get into the results of my trades. Table 1 shows my transactions so far with my MRK trades. Thinking that I would be comfortable buying MRK at $50 per share I could have just put in a limit order to buy 100 shares at $50. However, as I mention previously, I thought I would instead write a put option at a $50 strike price. By doing so I received $115 minus commissions as outlined in Table 1. After selling my initial put option MRK rallied and closed above $50 when the option expired on the third Friday of October 2015. This allowed me to keep the premium but I still did not own MRK. I repeated this trade with an expiration in November. I received the same premium and had the same result. In order to receive a higher premium I then had to increase the price in which I agreed to buy MRK. This was the trade on 23 November 2015. However, this time MRK closed below $53.50 on 28 December 2015 and I was obligated to purchase the shares for $53.50. This was done automatically by my broker, TDAmeritrade. Now that I owned MRK, I switched strategies and became a writer of call options. This meant that I would have to sell my shares if the stock closed above the strike price at the expiration date. On 28 December 2015 I received $46 minus commissions obligating me to sell MRK at $57.50 any time before the third Friday of April 2016. For me, if I had MRK called away at $57.50 I would make $3 per share minus commissions and get to keep my option premiums. As can be seen in Chart 1 the stock declined and the option began to decrease in price or decay as the probability of the stock closing above the strike price became less likely. As such I was able to buy the option back and remove my obligation to sell the stock. I did this because TDAmeritrade offered to allow me to execute this trade without a commission but with a small exchange fee since the option was priced at or below $5. Once this trade was closed out, I wrote another call option for April. This option is still in effect and is actually a weekly option that expires on 8 April 2016, but it obligates me to sell my shares for $54, which is only slightly above my purchase price.

Table 1 - MRK Trades September 2015 to Present Day

Date

Trade

Proceeds

Costs

Commission

Net Income

21 Sep 15

Sold 1 Oct 2015 50 Put

115.00

-10.79

104.21

20 Oct 15

Sold 1 Nov 2015 50 Put

115.00

-10.79

104.21

23 Nov 15

Sold 1 Dec 2015 53.50 Put

112.00

-10.79

101.21

28 Dec 15

Assigned 100 shares of MRK

-5350.00

-19.99

-5369.99

28 Dec 15

Sold 1 Apr 2016 57.50 Call

46.00

-10.79

35.21

22 Feb 16

Bought 1 Apr 2016 57.50 Call

-4.00

-0.03

-4.03

3 Mar 2016

Sold 1 Apr 2016 54 Call

30.00

-10.79

19.22

Total Cost

-5005.93

Total Profit

364.06

Click to enlarge

Summary

As can be seen I have sold 3 put options before I was assigned MRK at $53.50 in December 2015. Once that happened, I immediately wrote call options above my stock cost basis of $53.50 on MRK. I figured that the worst thing that could happen would be to have my stock called away at a higher price than what I paid for it. If MRK did not reach the strike price on the option I would collect the dividend and still own what I consider to be a quality company with a strong drug pipeline. Also not that the ex-dividend date for MRK is 11 March 2016, so I will receive $0.46 per share on 7 April 2016, further reducing my cost basis.

So far I am very happy with my results. MRK has proven to be a good stock for this strategy as it has not fluctuated wildly. This has allowed me to receive option premium which has reduced my overall cost basis on the shares I own. While MRK currently is slightly below my assigned cost of $53.50 I have received $360.03 in option premiums. Additionally I have dividend income of $46.00 coming my way in two weeks. If my MRK shares are not called away on the expiration date of 8 April 16, I will look to write another call. My goal on future call writing is to write calls with the strike price above $53.50. I have to remember to plan my trades and trade my plan.

Disclosure: I am/we are long MRK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short 1 April 8, 2016 Merck 54 Call