3433-vol. 6 issue 2-3.pmd - iarfc

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124 Journal of Personal Finance Table 5 Bull Call Spread vs. Stock Investment: Monthly Return January 2004 – December 2006 Bull Call Spread a Stock Investment Dow Jones Average Standard Sharpe Average Standard Sharpe Companies Return Deviation Ratio b Return Deviation Ratio Alcoa -13.16% 46.52% -0.37 0.58% 6.49% 0.04 AIG -16.40% 69.46% -0.30 0.06% 5.64% -0.05 Altria Group -5.36% 38.56% -0.25 -1.09% 5.35% -0.27 AT&T 5.12% 112.79% 0.01 -0.90% 17.09% -0.07 Boeing 4.48% 50.63% 0.01 -2.03% 4.48% -0.53 Citigroup -14.81% 56.94% -0.33 -0.26% 4.06% -0.15 Caterpillar -6.85% 47.86% -0.24 1.45% 14.51% 0.08 Coca-Cola -22.65% 42.86% -0.63 0.15% 4.35% -0.05 DuPont -23.06% 52.45% -0.52 -0.18% 4.94% -0.11 Exxon Mobil 0.43% 51.85% -0.07 -1.64% 5.38% -0.37 General Electric -14.61% 54.33% -0.35 -0.24% 3.24% -0.18 General Motors -22.35% 50.72% -0.52 1.95% 10.95% 0.15 Hewlett-Packard -10.64% 45.84% -0.32 -1.37% 6.28% -0.27 Home Depot -2.72% 80.30% -0.09 -0.23% 5.12% -0.12 Honeywell -23.32% 44.26% -0.62 -0.56% 4.16% -0.22 IBM -13.78% 37.15% -0.48 0.20% 5.50% -0.03 Intel -17.20% 41.91% -0.51 1.44% 7.42% 0.15 Johnson & Johnson -5.12% 41.94% -0.22 -0.56% 2.89% -0.31 McDonald’s -3.37% 43.29% -0.17 -1.42% 4.93% -0.36 Merck -12.97% 68.18% -0.25 0.61% 8.94% 2.88 Microsoft -16.62% 43.68% -0.48 -0.10% 4.99% -0.09 MMM -36.69% 75.62% -0.54 0.18% 5.36% -0.03 Pfizer -21.36% 58.06% -0.44 1.15% 5.70% 0.14 Procter & Gamble -5.42% 36.39% -0.26 2.21% 17.09% 0.11 Verizon -13.92% 51.20% -0.35 0.08% 3.66% -0.07 Wal-Mart -24.31% 48.57% -0.59 0.54% 4.55% 0.04 a This spread involves buying one contract of the call option that has the strike price right below the stock price, and selling one contract of the call option that has the strike price right above the stock price. b The Sharpe ratio is computed by dividing the mean return on the spread less the mean return on Treasury bills by the standard deviation of return on the spread. ©2008, IARFC All rights of reproduction in any form reserved.
Volume 6, Issue 2 & 3 125 Conclusion This study demonstrates that a bull call spread is hardly profitable for ordinary investors. Given the sizable bid-ask spread of calls, it is hard to make any profits from this spread position. Compared to the bid-ask spread of a stock, the bid-ask spread of an option is enormous, which makes a bull call spread unprofitable. The results in the paper confirm that options trading is truly risky. When someone claims that options trading is easy to use to make money, it is definitely important to consider this claim with suspicion. Also, it will be unethical if those companies, particularly software sellers, do not accurately reveal the whole picture of options strategies to potential buyers. This paper does not claim that it is impossible to use a bull call spread to make money. Instead it asserts that it is extremely difficult for ordinary, non-professional investors to take advantage of it. Professional options traders may skillfully implement the strategy by picking correct stock options, timing the market, taking follow-up actions, or using program trading. Those professional investors may even take advantage of lower bid-ask spreads, compared to non-professional investors. Given the results, however, it would be safe to conclude that options trading is too risky for ordinary investors to adopt for their investment. The high level of risk involved with options trading is not worth taking, considering the risk-return tradeoff. The results suggest that even a relatively easy-toimplement strategy, such as a bull call spread, is hardly profitable. One implication for financial planners is that they have to explain the enormous risk involved with such options strategies when their clients express their interest. In fact, it would not be a bad idea at all to discourage their clients to put their hard-earned money into such barely-rewarding trading frameworks. This paper clearly makes the point. Endnotes Research & Theory 1 The first listed option contracts were offered by the Chicago Board Options Exchange in 1973 and were traded on common stock. 2 Even a simple covered call strategy using out-of-the-money calls is known to bring significant benefits to investors in terms of risk and reward. It is reported that covered call writing reduces the volatility of returns significantly, but does not significantly lower returns. See Han and Dadlani (2006) for covered call writing. 3 For a variety of follow-up actions, see McMillan (2002).
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