A Fundamental Approach to Using Call Options to Enhance Returns

In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal
— Warren Buffett

Please refer to Important Disclosure Information at the end of this research note.

Kids don’t try this at home!

Call options are derivatives that give the holder the right but not the obligation to buy the underlying shares by a fixed future date at a price agreed upon today.

If you’re unfamiliar with the concept stop reading now (or re-read the Disclosure section below)!

For the fundamental investor who already owns a relatively full position in a security, call options can be an attractive way to enhance returns without tying up more capital.

Here’s an example

Microsoft shares closed at $49.69 on 2/11/2016. Here’s how I would think about the $35 January 2018 calls:

As I write this, the January 2018 $35 strikes have an ‘Ask’ of $16.55.

A $35 strike is currently “in the money” by $14.69 ($49.69 - $35), which is effectively your equity at a 3.4x leverage ratio.

You’re also borrowing $35 at a 6.5% interest rate (including foregone dividends) which seems somewhat high, but let’s keep going.

By buying the call, you’re also getting a put option: the right to sell shares at $35. So if Microsoft closed below $35 you have the right to ‘sell’ MSFT shares at $35 to cover your loan, effectively making this a non-recourse loan.

Let’s review our Risk/Reward

If MSFT shares closed 20% higher or around $60 by January 2018, you stand to make 20% if you own the shares and almost 50% if you purchased the calls. That’s a nice reward but not spectacular.

You break even on your investment if shares close at $51.5 or about $2 higher than the current price. That’s a somewhat low risk outcome unless the world falls apart.

You're able to make this levered bet by taking a 6.5% non-recourse loan which is risky but not as risky as taking a margin loan. 

Now if MSFT closes below $35, then you lose all your capital.

Which is better the calls or the shares?

The greatest risk to buying the options is you could be right in your fundamental analysis but wrong on timing leading to a permanent loss of capital.  

For example, in our MSFT example, if the shares are below $35 by January 2018 and then jump to $60 in February 2018 you lose your entire investment if you use calls even though you were right in your fundamental thesis.  

We try to mitigate this risk by only looking at long-dated options like the 2018 calls and not near-term options that expire in less than a year, giving us some time for our fundamental thesis to play out.

As long as the shares close 6% or higher you do better with the calls. Below that you’re much better off owning the shares. In fact if the shares close 10% lower or around $45, you lose 40% of your capital, if you own the calls.

In Conclusion

The job of the fundamental analyst is doing the due diligence to help assign probabilities to various outcomes.

When owning the shares presents an attractive risk/reward, its worth looking at long-dated call options as a way to enhance returns without taking on too much risk.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice.  A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.