Okay, so here’s a real-world example (since I just ran out of books to read, I haven’t got anything better to do). We’ll take the numbers as they are today although I would probably wait a bit for this trade to get closer to parity.
Take AAV Feb ’08 options. AAV closed at $12.08; puts are going for .30 and calls are going for .60 (actually .55 but let’s not make this too complicated). If you sell the calls and buy the puts, your cost basis in AAV is roughly $11.80 (again rounded).
Now my head starts to spin because I got up really early, so correct my math if it’s wrong. It’s all rounded, so don’t get too picky with the numbers.
Say you buy 1000 AAV and another 1000 on margin. Your yield is roughly 30%, minus the cost of money, so 23%.
Worst case: If AAV goes down to $10 and the dividend gets cut to $0, you have a fat 29% loss. But if the dividend was suddenly cut to $0, you’d end up with a $6 or $7 stock anyway. With 100% leverage and without protection (a hugely bad idea, but this is just a thought experiment) you’d have an 81% loss if it declined to $7. Without the collar or any leverage, you’d have a 41% loss.
If AAV goes down below $10, and the dividend remains intact, you end up with a 6% loss over a year. This is the most likely downside scenario, in my opinion, although I think it is relatively unlikely because Canroys in general are slightly undervalued.
If AAV goes up to $12.50 just before the next dividend (which is paid monthly), it gets called away. You get .70 (call premium + increase in stock value to $12.50), or just about 6%. Not bad if you annualize it.
If AAV sits n’ spins, you get your 23%.
Feel free to smack me around if I’m wrong. As I’ve said before, I know biotech but I’m relatively new to other areas.
None of this should be taken as a suggestion to use that much leverage, of course.
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