Covered Call With Protection For InterOil

| About: InterOil Corporation (IOC)
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Investment opportunities for stocks often present themselves as having attractive potential returns, but the risks associated with the investment may not be tolerable. For these situations, a married put strategy may be considered, as the married put strategy uses a put option in order to limit exposure. As an example, an investment in InterOil Corporation (NYSE:IOC) will be considered.

InterOil is an oil and gas exploration company operating in Papua New Guinea. Revenue is about $1 Billion, but the company competes with much larger companies like BP (NYSE:BP), Exxon Mobile (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP). InterOil has little in earnings but there is significant interest in the company's potential. Oil exploration can be a hit or miss situation. The larger companies have a large base to help amortize the misses, but InterOil can be negatively impacted by a single failure and the company's stock price can fluctuate wildly with perceived fortunes or misfortunes. InterOil not only faces competition from the oil industry titans, but also faces political uncertainty, as a military mutiny in Papau New Guinea was of recent concern. The mutiny appears to have been quashed, but the company's focus on Paupau New Guinea is something to consider before investing in the company.

In InterOil's third quarter 2011 earnings conference call on November 15, 2011, the company indicated they are working with three investment bankers in order to secure a partnership with an internationally recognized Liquid Natural Gas (LNG) related company. Interest from LNG purchasers has increased as a result of the company's search for a LNG partner.

The company's stock price has fluctuated significantly over the last two years with the price taking a significant dip in the 2011 September-October time frame as shown below:

(Click to enlarge)

Finding the trade:

Consideration will be given for establishing a married position for InterOil position which protects from unpleasant surprises. A large number of available combinations of married put positions are available for consideration, the issue at this point is to find a position or positions meeting an investor's investment criteria. Using PowerOptions tool for calculating the Put-to-The call premium ratio which estimates the number of call writes needed to pay for put option insurance may be used for analysis, the following call premium ratio table aids in determining a position:

(Click to enlarge)

In the table above, the lowest payback for insurance was determined to be at the $70 strike price with a Put/Call Premium Ratio of 2.93.

As a result of the put/call radio analysis, the following married put position was entered:

Buy IOC 100 shares: $67.89
BTO 1 IOC 2013 Jan 70 Put: +$19.90
Total Invested: $87.79
Guaranteed Return: - $70.00
Total amount at Risk $17.79 or 20.3%

The total amount of risk for the married put position was $17.79 or 20.3% which is a considerable amount of risk, especially for a company with a stock price as volatile as InterOil. In order to reduce the risk, a call option was sold in order to aid in paying for the put option insurance as shown below:

Sell-to-Open 1 IOC 2012 Mar 70 Call: $6.90

Following the sale of the call option and collecting the $6.90 premium the risk is now lowered to $10.89 or 12.4% as shown below:

Total Risk after the Married Put: $17.79
Income from the Call: -$ 6.90
New Risk: $10.89 or 12.4%

A profit / loss graph of the married put + call write (Collar) is shown below:

(Click to enlarge)

Successfully implementing two additional sales of call options, similar to the one above, may enable covering the cost of the put option insurance. With 385 days until expiration of the put option, there is a good chance of implementing several more call option transactions.

Risks of the trade:

A risk to be aware of with this trade, as shown in the above graph, is the potential for a loss if the stock price moves significantly up or down.

On the downside the position is protected by both the call and the put. The new risk as shown above is 10.89 points or 12.4%, even if the price of the InterOil stock goes to zero.

On the upside, the risk comes from the loss in value of both the call and the put if InterOil's stock price transitions above $70 per share. Generally, the call option is rolled up to a new call option in the event the price exceeds $70 per share in order to avoid the early call or loss of value. In this scenario, he put option will continue to lose value, but the stock will gain in value faster than the decline of the put option's value. It is very important to roll the call once the call strike price is exceeded in order to mitigate a loss. One of the largest risks is in the event that InterOil is purchased by another company at a high price. In this case, the put option will rapidly decline and the call option will rise to cancel the advance in the stock's price. Collars in general have the problem associated with a company's acquisition due to the obligation to deliver the stock at the lower call strike price. The call option can be a limiting factor for profit if it is not rolled in synchronization with the stock's price advance.

The expectation:

As the graph above indicates, the maximum profit at options expiration results when the price of the stock is at the $70 strike price of the call option. The maximum profit of 8% may be realized in 46 days. For an increasing stock price, the call option would be rolled as necessary. Rolling up the call strike price and rolling out to the next month in the series generally results in a net credit. Rolling the call option as the stock price increases, negatively impacts the potential return. As an example, if the stock's price were to move significantly up, about half of the price advance would be lost in the rolling process.

Disclosure: I am long IOC.