outearlier, option buyers who lose too much due to time decay are probably buying options that are too far out-of-the-money. Unfortunately,writing a deeply out-of-the-money option, while it will probablyexpire worthless, is not really a very conservative way to approachcovered call writing. The minimal amount of premium brought in bysuch an approach does not provide much in the way of downsideprotection. As with any strategy, covered writing can be operated ina conservative or an aggressive manner; the writing of deeply out-ofthe-money calls is an aggressive approach.A quite conservative covered write can be constructed by sellingan in-the-money call against long stock. In such a case, there is
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AN OVERVIEW OF OPTION STRATEGIES
downside protection all the way down to the striking price of thewritten option, which can be a considerable distance below the current stock price. Of course, the return from such a strategy is notgoing to be huge on the upside, but it is sometimes surprisingly largewhen you consider that the hefty call premium you receive can beused to reduce the cost of buying the stock.Overall, covered writing is usually employed as a moderately bullish strategy, so that one can make money if the stock rises orremains relatively unchanged until expiration. What is sometimes forgotten is that this is not a very good strategy for bear markets, forstocks will normally fall faster than the protection provided by thelimited amount of premium from the written call. Advocates of thestrategy will say that even in a bearish scenario, all you have to do iskeep writing calls at lower strikes and eventually you will collectenough premium to recoup your losses. However, if after a stockfalls quickly, you write a call with a lower strike and then the stockrallies back quickly, you will surely have locked yourself into a loss nomatter how large the premium you took in.In summary, then, covered writing is a strategy designed to dobest when stock prices are stable or moderately rising. If the underlying stock is, or becomes, volatile, this is not an attractive strategybecause you cannot participate in large moves on the upside, but youwill suffer the results of any large move to the downside.
Naked Option WritingWhen an option is written without any offsetting position in theunderlying stock, or without being hedged by a similar long option,that option is considered to be written naked. In general, nakedoption writing is considered to be risky because you can make only alimited amount of money, yet could lose large sums if the underlyingstock or futures contract moved so far that you were forced to buy theoption back for a great deal of money. In general, larger margin andequity requirements are required by most brokerage firms before theywill allow a customer to participate in the sale of naked options as astrategy. Yet, in the next few sections, we see that naked option writing may not be all that risky if approached in a reasonable manner.
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The “investment” required to write a naked option is somewhatdifferent from that required for buying stock or options. You musthave collateral of a sufficient amount to cover your risk in the eyes ofyour broker. Currently, if you are writing naked stock options, youmust have collateral equal to 20 percent of the stock price, plus thepremium of the option, less any out-of-the-money amount.Example: Suppose XYZ were a $100 stock, and you wanted to write oneJuly 110 call naked for a premium of 4 points. You would need to have thefollowing collateral:$2,000–1,000+400________$1,400
(20 percent of the value of 100 shares of XYZ)(the amount by which the call is out-of-the-money)(the premium of the option)
There is a minimum collateral requirement that you must meet,which is 10 percent of the underlying price, no matter how far outof-the-money the option is when initially written. Since the optionpremium is credited to your account when you sell the option, youcan apply it toward your initial collateral requirement.What is collateral? It’s any type of equity in your account that isnot already borrowed against; it could be cash or any marginablesecurity, such as stock, bonds, or government or municipal debtsecurities. Note that you are not charged any interest for the nakedoption collateral requirement, as you would be if you were buyingstocks on margin, for you are not borrowing any money from yourbroker. In fact, if you use government securities as collateral, you areallowed to earn interest on the credit balance that is generated fromthe sale of the naked options. Thus, in the preceding example, the$400 call premium could be invested in a money market fund andallowed to earn interest as long as you had $1,400 worth of equity inyour T-bills.The collateral requirement changes as the underlying stockmoves up and down, to reflect the risk your broker envisions that youhave in the position. For example, if XYZ rose to 120, the July 120call might then be selling at 13. Your requirement would be $2,400
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AN OVERVIEW OF OPTION STRATEGIES
(20 percent of $12,000) plus $1,300 for the option premium, for atotal requirement of $3,700—considerably larger than it was whenthe option was first written.For index options, the calculation is similar, except that only 15percent of the index value is required, as opposed to the 20 percentrequired for stock options. This is because indices are less volatilethan individual stocks.For futures options, if you are using SPAN margin, the requirement is based on the volatility of the underlying futures contract. Thisis a sophisticated and enlightened way of approaching the matterand hopefully one day will be employed for stock options. Thus,SPAN margin might require more collateral for pork belly optionsthan it would for heating oil options, even though both futures mightbe trading at the same price (most of the time, pork bellies are morevolatile than heating oil). If you are not using SPAN margin, then therequirement for writing a naked futures option is usually equal tothe futures margin plus the option premium less one-half the outof-the-money amount, if the option is out-of-the-money.As with naked options, naked index or futures options require aminimum amount of margin. This is normally in the neighborhoodof $200 to $300 per option, so that even an extremely out-ofthe-money option will still require some collateral in order to writeit naked.
Naked Put WritingThe sale of a put, without any accompanying position in the underlying stock, is termed naked put writing. It is a popular strategyamong moderately sophisticated investors. The profit potential is alimited one; if the underlying security rises in price, the put that wassold will expire worthless and you will profit by the amount of theoriginal premium that was collected. The following example and Figure 2.8 define the strategy.Example: Suppose XYZ is selling for 51 and the July 50 put is selling for 2.If you sell the July 50 put naked, your profit potential at expiration would be:
SELLING OPTIONS
StockNaked PutPrice
Price
Profit ($)
30354045505560
2015105000
–1,800–1,300–800–300+200+200+200
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Option
Figure 2.8 shows the shape of the profits and losses associatedwith naked put writing. The profit is limited to the premium collected. On the other hand, if the underlying security falls in price,large risks could materialize. You would be forced to either buy backthe put at a much higher price in that case or accept assignment ofthe stock at expiration. That is, the sale of a put obliges you to buy
Figure 2.8NAKED PUT WRITE
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AN OVERVIEW OF OPTION STRATEGIES
the stock if you are assigned at some later date. The purchase of thisstock could require considerable money.One of the worst put-writing debacles of all time occurred in the crash of1987. In the years and particularly the months leading up to the crash,many investors had been writing naked puts on the “stock market.” In thiscase, the stock market was generally represented by the Standard & Poor’sIndex (OEX), although some other broad-based indices were being used aswell. One of the great attractions was that you only had to have collateral of5 percent (!) of the value of the index at that time.As the stock market inexorably ground its way higher and higherthrough 1986 and 1987, more and more investors became enamored withthe idea of putting up about $3,000 in collateral to collect $100 or $200 inprofits every month, month in and month out. Of course, when the crashcame, OEX fell almost 100 points in two days. Thus, puts that had beensold for $100 were suddenly worth $8,000 to $10,000. To make mattersworse, volatility had increased so dramatically that the puts were even moreexpensive than they normally should have been.Needless to say, many investors were wiped out, some brokerage firmswere wiped out, and lawsuits flew back and forth. In the aftermath, marginrequirements were raised, brokers required more sophistication from theircustomers who wanted to write naked options, and limits were placed onstock market movement.
It is stories like this that make many traders leery of writing nakedoptions. However, before turning the page to look for the next strategy, stop for a minute and look at the preceding profit graph of thenaked put write (Figure 2.8) and compare that profit graph with theone of the covered call write in the preceding section (Figure 2.7).They are the same! The profit and loss potential of a covered callwrite (which is considered to be a conservative strategy) is exactly thesame as the profit and loss potential of a naked put write (whichseems, by the previous example, to be a very risky strategy).What is going on here? Is there some trick? No, there isn’t. Infact, the two strategies do have the same profit and loss potential.The investment required for the two is slightly different, but the dollars of profit and loss are the same. But, you may ask, what about thedisaster scenario in the preceding example? Well, owning stocks during the crash was pretty risky, too, you may remember. In fact, any
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67
time you own stock, you have large risk to the downside—whether ornot you take in some call premium as a hedge—just as you havedownside risk from selling naked puts. In reality, covered call writingprobably isn’t as conservative as some would have you believe, andnaked put selling isn’t as dangerous, either.The conventional wisdom is that covered call writing is the safestform of option trading because it has less risk than owning stock. I’vealways had some trouble with this argument because a stock can fall along way; and even if you sell calls against it several times on the waydown, you can still suffer some rather large losses in bear markets.Moreover, no matter what kind of market you’re in, the sale of a callagainst your stock deprives you of the potential for large gains on theupside, since you are obligated to sell your stock at the striking price.More realistically, it could be said that covered call writing can be aconservative strategy. As with all option strategies, it depends uponhow they’re implemented as to whether they are conservative. Ifyou’re selling “expensive” calls against a stock that is oversold (orcheap by some other measure), then I would agree that that is probably a conservative method of covered call writing. However, if you’reselling out-of-the-money calls against a volatile, overpriced stock, that’snot very conservative because you are taking too much downside risk.Recall that when two strategies’ profit graphs have the sameshape—as do covered call writing and naked put selling—then thetwo strategies are considered to be equivalent.I generally prefer the naked put selling strategy for two reasons:first, you are only dealing with one security’s bid-asked spread ratherthan two, and second, the margin requirement is considerablysmaller. The stock owner receives dividends (if any are paid), but thenaked put seller can use T-bills as his collateral and earn interest thatway. Moreover, the price of the put has the dividend factored in (i.e.,puts are more expensive on high-dividend-paying stocks, all otherthings being equal).
Put Writing Philosophy. The naked put writing strategy is oftenapproached in this manner: if you sell an out-of-the-money put on astock that you like—and wouldn’t mind owning—then you are in a“no-lose” situation. If the stock goes up, you profit by the amount ofthe premium received from selling the put. On the other hand, if the
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AN OVERVIEW OF OPTION STRATEGIES
stock goes down below the striking price of the put you sold, you buythe stock at a low price, which is theoretically good since you don’tmind owning the stock. At that point, you can just hold the stock ormaybe even write some calls against it. This philosophy is quite widespread among naked put sellers. That is, they choose the puts theysell by looking at the qualities of the underlying stock. They are notoverly concerned with whether the puts are “cheap” or “expensive”by statistical measures. In this manner, if you do eventually wind upbeing put the stock, you are buying a stock that you have confidencein and that is fundamentally attractive to you.Unfortunately, the theory and the practice of it are sometimes atodds. It’s all well and good to say that you wouldn’t mind owning astock if it dropped to the striking price of the puts you sold. However, what it if dropped to that level and kept on dropping? Then, it’snot so much fun.When LEAPS options (options with expirations extending out to two years)were introduced, they were generally only listed on some of the biggest andbest stocks. One of the reasons this was done, as opposed to listing them onvolatile highfliers with big option premiums, was to attract put writers whoadhere to the philosophy just described. One of these stocks was IBM,which at the time was selling between 105 and 100. Long-term puts with astriking price of 90 were listed; and many investors sold them naked, figuring that if they had a chance to own IBM at 90, they wouldn’t mind. Well,they all got their chance as the stock began to drop rather precipitously andfell all the way to 45. It didn’t recover right away, either. When the puts gotso deeply in the money, most of them were assigned, even though therewas over a year of life remaining in the puts. Many of those put writers, inthe final analysis, were not really ready to buy IBM and hold it through aplunge like that. Some of them didn’t have the money required to take onthe debit necessary to buy the stock, so they tried to roll their puts to evenlonger-term puts, but those too were assigned. The moral is that even thebest of stocks can go through its own bear market; and, if it does, it will hurtcovered call writers and naked put sellers.
Protecting Your Positions. Regardless of whether you use covered call writing or naked put selling, you have downside risk, as the
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69
previous story shows. Moreover, if you have a whole portfolio utilizing this strategy, you are especially subject to the risk of a marketcorrection (or worse, a bear market). When markets get overextended, you should start thinking about protecting your coveredwrites or naked puts.“How?” you ask. Well, there are several ways, assuming youwant to continue to operate the strategy. One way would be to makeyour portfolio more conservative, utilizing underlying stocks that areless volatile and perhaps “cheap.” Another way would be to buysome (other) puts to protect yourself. The easiest thing to do wouldbe to buy some out-of-the-money OEX LEAPS puts, but they may bequite expensive in terms of implied volatility.A less costly approach would be to buy (deeply) out-of-the-moneyputs on the individual issues that you own or have written naked putson. If you are a covered call writer, you would then have a strategythat the professionals term a collar: long stock, short out-of-themoney call, long out-of-the-money put. If you are a naked put seller,then your resultant position would be a bullish put spread. In eithercase, you have limited your downside risk at the expense of some ofyour option writing profits.Thus, a covered call writer or naked put seller should attempt tolimit his losses; for if he sustains large losses in this limited-profitstrategy, it will take a long time to make them back.
Naked Call WritingThe writing of naked calls is considered to be an extremely riskystrategy, and many brokerage firms require their customers todemonstrate a certain amount of experience and/or sophisticationbefore embarking on the strategy. In reality, it is really not muchmore risky than writing naked puts—and therefore, by equivalence,doing covered writes—for all those strategies can incur large losses ifan unfavorable movement occurs in the underlying. The fact that astock can rise more than 100 percent but can only fall 100 percentmakes the ultimate risk larger with naked calls than with naked puts,but it can be very large in either case. An example of a naked callwrite follows.
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AN OVERVIEW OF OPTION STRATEGIES
Example: Suppose XYZ is selling for 51 and the July 50 call is selling for 3.If you sell the July 50 call naked, your profit potential at expiration would be:StockPrice
OptionPrice
Naked CallProfit ($)
404550556070
00051020
+300+300+300–200–700–1,700
Figure 2.9 shows the shape of the profits and losses associatedwith naked call writing: limited profit potential to the downside andlarge risk if the underlying stock should rise dramatically. Most writers of naked calls are intrigued by the relentless effects of time decayand want to be on the side of a trade that benefits from that decay.This is generally the main impetus for the strategy. It is not primarilyused as a way to profit if you expect the underlying to decline inprice—long puts or synthetic puts and bear spreads would be moreappropriate for that bearish scenario.Writers of naked calls usually sell out-of-the-money calls that, inthe call writer’s opinion, are too expensive; he often feels that thereis not enough time for the stock to climb to the striking price of thewritten call before expiration or that the call is selling for just too highof a price. These are reasonable approaches, but even reasonablemen can lose money.Every option that is worthless at expiration had some value sometime during its life. However, if the option is out-of-the-money (perhaps by a relatively large amount), its value will begin to slip away, until, one day, theoption will have the smallest possible bid: five cents for stock options, andsimilarly tiny amounts for futures options. This bid sometimes lingers for awhile as traders who are short the option—either naked writers or coveredwriters—often attempt to cover their position and move on to the nexttrade. These option writers sometimes are therefore bidding for an option
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71
Figure 2.9NAKED CALL WRITE
that is, by all statistical measures, doomed to be worthless. However, theyare interested in closing out their trade.In the early to mid-1980s there was a tendency among market makersand professional firms to “sell the teenies.” That is, they would look forthese situations where there was a sixteenth bid for options that had no statistical value and sell them. This sale normally took place quite close to expiration—within a week or so. Therefore, there was a very large probabilitythat these professionals would collect the $6.25 for each sale. Moreover,the collateral requirements were quite low: $250 at the most for the publicand much less for market makers. Thus, the annualized rate of return wasover 100 percent for this strategy (and much higher for floor traders).The only problem was that there was the occasional gap up or down bya stock that would turn one of the “worthless” options into something withvalue. However, these were rare and the strategy was highly profitable for along time. As with any profitable strategy, word gets around, and more andmore people start utilizing it. Such was the case with “selling teenies” oncalls of Amax Corp., a metals stocks. It was trading under 30 with only afew days left until expiration. Moreover, the stock had been in a severedowntrend, and there were striking prices all the way up to 50 and above. Itappeared that the calls at all those strikes would expire worthless. Since the
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AN OVERVIEW OF OPTION STRATEGIES
stock had at one time or another traded near each of those higher strikes,there was decent open interest at each one. Consequently, when each oneeventually became bid at a sixteenth, the teenies were sold. Then, theunthinkable happened: an $80 per share bid was made for the companyright before expiration. Small firms went out of business, and even largeones suffered more than they had bargained for.
The resulting havoc pretty much ended “selling teenies” as awidely practiced strategy. However, the practice continues today insimilar form, with the same results upon occasion. Now, option writers are more apt to cover their short options at fractional prices of aquarter or so, because too many times they sold an option at two orthree dollars, only to see it fall to a fractional price and then springback to life once again as the stock reversed direction. This is thereality of the postcrash market, whose volatility still lingers in thememory of every option writer. When these writers cover, there aresurely others out there attempting to use a strategy similar to “sellingteenies,” only now they can get a quarter of a point for that sale.Even with only a week to go, this strategy produces its share ofnaked writing disasters every so often. Thus, naked option writersshould not attempt to sell these extremely low-priced options justbefore expiration. Eventually, the large loss can and probably willwipe out all the “teeny” profits that were made.Many futures traders also sell very low-priced options with a shorttime remaining until expiration. At least with futures, you can’t havea takeover; but that still doesn’t prevent the option owner from exercising if something changes with respect to the fundamentals.
In the spring of 1995, a large client was long a substantial number of callson silver. The striking price of these calls was 550, but silver had drifteddown over the life of the contract and was settling around 535 on the daythat the calls expired. This client, however, was not a speculator, but wasintensely interested in actually owning silver futures (and perhaps, eventually, the metal itself). He owned a very large quantity of calls, and he lookedat what would happen to the futures market if he let those calls expire andinstead bought the same number of silver futures. He realized that his buying pressure would most likely push the price of silver futures back up over
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73
the 550 level and that his average price to buy all the futures he wantedmight actually be higher than 550 by the time he was done. Therefore, heexercised the calls! Traders who were short the 550 calls had obviouslygone home expecting to ring up some realized profits that expiration night.Instead, they found themselves in a nightmare situation as silver gappedopen at 560 and traded even higher the next day. Not only did this gapopening cause panicky short covering by regular futures traders, but, afterassignment, all of the naked options writers were now short futures as welland fed the frenzy even more. This proves that even futures option sellersshould be extremely careful about operating a strategy of selling extremelylow-priced options right before expiration.
Straddle and Combination SellingOne of the ways in which naked option writers attempt to hedgetheir positions is by selling both a naked put and a naked call. Thelosses on one may be more than offset by the profits on the other,for they cannot both lose money at the same time unless volatilityincreases. The put and the call may have the same striking price(which is a straddle), or they may have different striking prices (acombination, or strangle as it is sometimes called). In either case, onestill has unlimited risks—and by selling both the put and the call, therisks exist in either direction, up or down—but there is more profitpotential if the stock is relatively unchanged, which is what stock orfutures prices are most of the time over a short period. Figures 2.10and 2.11 show the short combination and the short straddle.Earlier, the collateral requirements for writing naked optionswere spelled out: 20 percent of the stock price, 15 percent for anindex, and the futures margin for futures option. When you are writing both a naked put and a naked call, the collateral requirement isthe greater of the put requirement or the call requirement; the otherside does not require any additional collateral. In the case of a nakedstraddle, this means that you are forced to collateralize the in-themoney option, while the other one is “free.” In the case of a combination (strangle), the “greater” collateral requirement normally isapplied to whichever option is nearer to the money (if both are outof-the-money). Generally, it seems that combination selling is better
74
AN OVERVIEW OF OPTION STRATEGIESFigure 2.10SHORT COMBINATION
Figure 2.11SHORT STRADDLE
SELLING OPTIONS
75
than straddle selling because there is a better chance that bothoptions could expire worthless; moreover, if one option becomes anin-the-money option, it would generally take a major reversal for theunderlying to swing back far enough to make the other option go inthe-money. Of course, when you are dealing with unlimited risk positions, you are constantly at risk of a volatile and sudden move by theunderlying stock, index, or futures.When puts were first listed, straddle trading was the de rigueur strategy.Even though only 25 stocks had listed puts, there was plenty of interest intrading straddles on them. In particular, since this was 1977 and there wasa bear market of sorts going on, straddle selling was more popular thanstraddle buying. In those days, markets declined slowly instead of all at onceas is the custom now, so that a strategy involving time decay worked well.As profits were built up over time, there was a general feeling that a longterm strategy of straddle selling would be the best approach to the market.Since most stocks wandered in trading ranges most of the time, accordingto computers, if you were to merely diversify and sell straddles in nearly allof the 25 issues available, you would have a nicely hedged portfolio. Ofcourse, there were stopgap measures designed to limit losses should bigmoves occur, but they generally consisted of something like recentering thestraddle at new strikes if the stock moved too far away from the currentstriking price of the straddle. Since IBM was by far the most liquid stock onwhich puts were trading, there were a large number of straddles sold on IBM.The strategy was working rather well up until the second week of April1978. It was on that Friday that a sleepy market awoke and bolted upward20 points (up 3 percent on the Dow) and volume reached the previouslyunheard of levels of 52 million shares! What caused this was a discussion inCongress regarding lowering the capital gains tax; that same piece of newscan still rally the market dramatically even today. What was even more noteworthy for straddle sellers, however, was the fact that IBM shot up over 14points in one week—from 239 to 254. Most straddle sellers had long sincecovered their naked puts or rolled them to lower strikes as IBM had fallenfarther and farther during the spring of 1978. What was left were a lot ofnaked calls that were going to expire worthless, or so the thinking went.Instead, the rally by IBM through several strikes brought ruin to many astraddle seller that day. Similar, but smaller, moves in many other stockspretty much ended the diversified straddle selling approach to trading as apopular strategy.
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AN OVERVIEW OF OPTION STRATEGIES
Of course, someone made money that was being lost by thestraddle sellers—mostly owners of calls. The following story reallydoesn’t apply to straddle selling per se; but since it involves the sameset of events that were just described, it belongs here nevertheless.The bearish market of late 1977 and early 1978 had been rough on manybulls, and one bullish professional trader was about wiped out. He was downto his last few positions—a rather sizable amount of deeply out-of-themoney calls on IBM, plus some calls on Avon, and a few other stocks.When the Aprils expired, he was destined to be out of business, for he hadno further source of funds. So he was just waiting around for April expiration—not exactly anticipating the word from his clearing firm that his trading account was worthless. Then, only a week before April expiration camethe big market rally, exploding the price of IBM dramatically higher. As itturned out, the trader made all his losses back in that one day and in thesubsequent trading the next week.
Today, straddle and combination writers are much more apt tobuy out-of-the-money options to protect themselves against disaster.This strategy is discussed in a later section, entitled “Credit Spreads.”Covered Straddle Writing. In the wake of the 1978 debaclethat naked straddle writers suffered, another approach to straddlewriting became a little more popular; but it has never really capturedthe fancy of large quantities of option traders. It is the covered straddle, in which one buys 100 shares of the underlying stock and alsosells a straddle at the same time. The call from the straddle sale iscovered by the ownership of the stock, so what the trader really hasis a covered call write plus a naked put. This is a fairly bullish positionbecause, if the price of the underlying falls dramatically, he will losemoney on both the long stock and the short put. It has limited upsideprofit potential; although if the stock remains relatively unchanged,the covered straddle writer would capture a fair amount of decayingtime value premium.If you recall our discussion of naked put selling and covered callwriting, you may recall that we said the two strategies are equivalent.So a covered straddle—which is a covered write and a naked put—isequivalent to selling two naked puts. Therefore, it would be more
SPREADS
77
efficient to just sell two naked puts rather than bother with the covered straddle write. It is more efficient not only in terms of collateralrequirements but also from the viewpoint that a covered straddleinvolves three separate securities (underlying, call, and put), while thenaked put involves only one. So, merely selling two naked puts wouldlower commission costs and would also avoid having to deal withthree bid-asked spreads.
SPREADSSpreads are constructed by being both long an option and shortanother option on the same underlying, where both options are callsor both options are puts. Spreads are designed to limit risk, and theyoften limit profit potential as well, although not always. The risk-limiting nature is probably the more important aspect of a spread. If youare normally a naked call seller, you could limit your risk by buyinganother call that is more out-of-the-money than the one you sold. Ifthe underlying rises dramatically, the call that you own will limitlosses; therefore, you no longer have unlimited risk from the optionsale. Of course, buying that call will cost you some of your profit ifboth options expire worthless, but many traders feel that the peaceof mind that the spread provides is worth the small amount of moneythat is spent on the long, protective call.We first describe the strategies in which the spreads are linear,that is, where the same number of options is bought as is sold.
Vertical SpreadsA spread is a vertical spread if both options have the same expirationmonth but different striking prices. There are