Is Statoil A Good Holding For Writing Covered Calls?

Aug.20.12 | About: Statoil ASA (STO)

A few weeks ago, fellow Seeking Alpha contributor Mathieu Malecot published an article suggesting that Statoil (NYSE:STO) is an excellent stock to write options against. As one of my favorite ways to increase my portfolio's total return is through the use of covered options plays, I wanted to investigate this idea further.

In his article, Mr. Malecot accurately points out that Statoil's ADRs have been stuck in a trading range of roughly $20 to $29 per ADR share for the past year. In fact, this has gone on for longer than a year. Here is Statoil's trailing two-year price chart:

STO Chart

STO data by YCharts

As this chart shows, Statoil has been stuck in this trading range for the past two years, only once breaking out of it to the downside. This was only for an approximately two-week long period of time in late August to early September of 2010. This trading range has persisted despite the company's considerable exploration successes over the same period of time.

Generally speaking, more volatility in the underlying stock leads to higher potential returns for option investors. It also leads to higher risk. In this case, Statoil's range-bound quality is not a bad thing. This is because my intentions are to write covered calls against it. I also want to avoid, if at all possible, having any holdings called away. I realize and accept that this strategy is not the absolute most profitable covered call strategy around; however, my objective is simply to maximize the amount of money that I can make off of the Statoil shares that I already own.

The first thing that an investor will need to determine is the desired timeframe of this position. At the time of writing, call options against Statoil's ADRs with expiration dates of September 2012, October 2012, January 2013, and April 2013. Typically, options with later maturities have higher time values (so the premium that is collected when selling the option will be greater). Of course, choosing shorter-term options gives the ability to sell more per year, assuming the options are held until expiration as I typically try to do.

So, how profitable is it to write covered calls against Statoil ADRs? The answer to this is perhaps best illustrated through examples. For our examples, we will assume a hypothetical investor who purchases 1,000 shares of Statoil with the intent of writing covered calls against this position. We will also assume that these shares were purchased at today's closing price of $25.17. Thus, the total cost of entering this position is $25,170.

We will determine the potential profitability by running two different scenarios. In the first one, our hypothetical investor will sell call options with a maturity date of October 2012. In the second one, our investor will sell the January 2013 call options against this position. This should demonstrate the results of using different option periods.

Example 1

Here are the prices of the Statoil October 2012 options at the time of writing:

Click to enlarge

Source: Yahoo! Finance

As this chart shows, there are options available that are both in the money and out of the money for this expiration date. Out of these, three are available that are outside of Statoil's defined trading range. These are the $30, $32.50, and $35-strike call options. Since our investor's goal is to maximize profit while also minimizing the chance that the option will be called away, the $27.50 option will be selected. While the other options are outside of Statoil's two year-long trading range, the absence of a bid price essentially states that the other out of the money options are not going to be sellable. Our investor thus sells ten 10 $27.50 call options, receiving $170 in premium.

There are three possible outcomes that can occur on the option expiration date depending on the stock price.

Scenario 1: Statoil stock above today's price but below the $27.50 strike price of the option contracts

In this scenario, the option will expire worthless and the investor will keep the $170 option premium that was received. The investor will also keep the 1,000 shares of Statoil stock. The total profit from this trade would thus be $170 minus transaction costs and taxes. The investor would also profit off of the gains in the stock price but as the underlying stock is not being sold, it is an unrealized gain and is not being included as profit in this analysis. Transaction costs and taxes will also vary and so therefore are also being excluded.

Therefore, the total profit here is $170 on an initial investment of $25,170 over a period of 31 days. This works out to an annualized return of 8.243%.

Scenario 2: Statoil stock above $27.50 at expiration

In this scenario, the option will be exercised and the investor's stock will be called away. The investor will receive $27,500 for the stock. The investor will also retain the $170 option premium received when the options were sold. The total profit here before taxes and transaction costs would be the $170 option premium and the realized gain of $2,330 on the stock. This is a total return of 9.93% over a period of 31 days which works out to a 204.867% annualized return.

Scenario 3: Statoil stock below the purchase price of $25.17 at expiration

In this scenario, the option will also expire worthless. The investor may also suffer an unrealized loss. In this case, the option premium (which is still kept by the investor) will help to reduce the loss. It has the effect of reducing the cost basis by the quoted option price ($0.17 in this case). Therefore, the investor's results will depend on how far the stock has fallen below the break-even point of $25.00. The investor will also keep the 1,000 shares of Statoil and so a rally in the stock price can easily push this back to a gain simply by our investor being patient.

Example 2

Here are the prices for the Statoil January 2013 call options at the time of writing:

Click to enlarge

Source: Yahoo! Finance

As you can see, there are call options available with a January 2013 expiration date that lie outside of Statoil's trading range (and have a bid price). Selling one of these, for example, the $30-strike option, would reduce the risk of the stock being called away. If our hypothetical investor wrote the $30 strike call options then the returns would be much less than in the previous example. For the sake of consistency though, we will assume that the investor sells the $27.50-strike call options. This will result in an immediate receipt of $700 in premium.

The three potential outcomes are the same. The only thing that is different are the numbers.

Scenario 1: Statoil stock above today's price but below the $27.50 strike price of the option contracts

In this scenario, the option will expire worthless and the investor will keep the $700 option premium that was received. The investor will also keep the 1,000 shares of Statoil stock. The total profit from this trade would thus be $700 minus transaction costs and taxes. The investor would also profit off of the gains in the stock price but as the underlying stock is not being sold, it is an unrealized gain and is not being included as profit in this analysis. Transaction costs and taxes will also vary and so therefore are also being excluded.

Therefore, the total profit here is $700 on an initial investment of $25,170 over a period of 152 days. This works out to an annualized return of 6.809%.

Scenario 2: Statoil stock above $27.50 at expiration

In this scenario, the option will be exercised and the investor's stock will be called away. The investor will receive $27,500 for the stock. The investor will also retain the $700 option premium received when the options were sold. The total profit here before taxes and transaction costs would be the $700 option premium and the realized gain of $2,330 on the stock. This is a total return of 12.04% over a period of 152 days which works out to 31.389% annualized.

Scenario 3: Statoil stock below the purchase price of $25.17 at expiration

In this scenario, the option will also expire worthless. The investor may also suffer an unrealized loss. In this case, the option premium (which is still kept by the investor) will help to reduce the loss. It has the effect of reducing the cost basis by the quoted option price ($0.15 in this case). Therefore, the investor's results will depend on how far the stock has fallen below the break-even point of $24.47. The investor will also keep the 1,000 shares of Statoil and so a rally in the stock price can easily push this back to a gain simply by our investor being patient.

Overall, Statoil does indeed appear to be an excellent candidate for long-term investors who wish to increase their portfolio returns by writing covered call options against the stocks that they own. In this case, the shorter-term options look to be giving higher annualized returns, but of course that will also result in higher transaction costs which may eliminate that advantage depending on your situation.

Disclosure: I am long STO.