An Insurance Company Offers Protected Income of 92%
Trade summary: A bear call spread in Erie Indemnity Company (Nasdaq: ERIE) using June $165 call options for about $11.10 and buy a June $175 call for about $6.30. This trade generates a credit of $4.80, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $520. The risk can be found by subtracting the difference in the strike prices ($1,000 or $10.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($480). This trade offers a potential return of about 92% of the amount risked.
Now, let’s look at the details.
Erie Indemnity Company is a management company, part of the structure of an insurer. This company serves as the attorney-in-fact for the subscribers (policyholders) at the Erie Insurance Exchange.
The Exchange is a reciprocal insurer that writes property and casualty insurance. The company’s function is to perform certain services for the Exchange relating to the sales, underwriting and issuance of policies on behalf of the Exchange.
The sales related services the Company provides include agent compensation, and certain sales and advertising support services. Agent compensation includes scheduled commissions to agents based upon premiums written, as well as additional commissions and bonuses to agents.
The underwriting services the Company provides include underwriting and policy processing expenses. It provides information technology services that supports various functions. The remaining services the Company provides include customer service and administrative costs.
In the most recent quarter, net income for ERIE was $59.3 million, or $1.13 per diluted share, compared to $75.3 million, or $1.44 per diluted share, in the first quarter of 2019.
In part, the decline was due to the news. As the company noted, “On March 11, 2020, the outbreak of the coronavirus was declared a global pandemic.
The impacts of the pandemic and efforts to mitigate the spread of the virus have had significant adverse impacts on economic conditions and financial markets.
We did not experience significant financial impacts on our core businesses of policy issuance and renewal services and administrative services in the first quarter of 2020. However, the financial market volatility did have a significant impact on our first quarter 2020 investment portfolio.”
Operating income before taxes decreased $0.4 million, or 0.5 percent, in the first quarter of 2020 compared to the first quarter of 2019.
Loss from investments before taxes totaled $9.2 million in the first quarter of 2020 compared to income of $9.8 million in the first quarter of 2019. Net realized losses were $10.8 million in the first quarter of 2020 compared to net realized gains of $2.5 million in the first quarter of 2019 driven by decreases in the fair value of equity securities due to significant financial market volatility resulting from the COVID-19 pandemic.
Net impairment losses of $3.1 million in the first quarter of 2020 were also driven by the COVID-19 pandemic’s impact on the financial markets.
Losses from limited partnerships were $3.7 million in the first quarter of 2020 compared to losses of $1.1 million in the first quarter of 2019.
Traders sold the news.
The selling comes as the stock struggled to recover from a bear market that began last year.
Buying shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for ERIE
For ERIE, we could sell a June $165 call for about $11.20 and buy a June $175 call for about $6.30. This trade generates a credit of $4.80, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $480. The credit received when the trade is opened, $480 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $520. The risk can be found by subtracting the difference in the strike prices ($1,000 or $10.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($480).
This trade offers a potential return of about 92% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if ERIE is below $165 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $520 for this trade in ERIE.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.