strike of the long call and the 95 strike of the unprotected shortcall). However, your overall cash credit is $825 on these positions, soyou would still have a net of $325 to cover transaction costs.Remember, this is worst case; it assumes no rolling forward, and it alsoassumes that the stock’s price rises above $95 per share prior to expiration. In addition, exercise would represent capital gains—assumingyour basis of $80 per share—or a profit of $3,500 ($2,000 on two exercised 90 calls and $1,500 on one exercised call at 95). The overall outcome for exercise of all these positions, without counting dividendincome, transaction costs, or taxes, would be as follows:
Capital gain, 200 shares with basisof $80, exercised at $90
$2,000
Capital gain, 100 shares with basisof $80, exercised at $95
1,500
Loss, uncovered 95 call versus longcall at 100
–500
Net premium income received
825
Total gain before costs and taxes
$3,825
This worst-case analysis assumes rapid increase in the stock’s price, necessitating the purchase of an “insurance call” at the top of the transaction.However, splitting the ratio between different expiration dates and strikeprices provides a degree of protection in most situations. It may not benecessary to assume worst-case outcome and still remain within your riskprofile range. You may consider this worst case because stock was calledaway, so the ratio write is appropriate based on the same rules for anyform of covered calls: You have to be willing to accept exercise as one of
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the possible outcomes. In the example, using the single long call at the topof the transaction eliminates the ratio-write risk entirely, while leavingyou exposed to the net covered call exposure.
Ratio Writes for Rescue Strategies and HigherCurrent ReturnsThe ratio write is not only a useful rescue strategy for depressed stock;it may also serve as a powerful tool for creating higher returns fromoptions with minimal risk, even when the price of the stock is belowyour original basis. However, to ensure the safety of your position, thesplit of expiration dates and strike prices is recommended.
Rescue Strategy Using PutsYou can create a rescue strategy with short puts in place of the purchaseof additional shares. Given the previous example, refer to step 3: anadditional 200 shares are purchase at $70 per share. Remembering thatshort puts can be used as a form of contingent purchase, an alternaterescue strategy can be employed to reduce average price and createadditional downside protection through put premium income.The rescue strategy is modified in this example. Let’s say that you soldthree 65 puts in this situation. This means that if the market value ofthe stock were to fall below $65 per share, you would risk exercise. Let’salso assume that you could get about 5 points for each put, whichwould reduce your basis in the additional 200 shares down to $60 pershare. Your average price on all 300 shares would then be $63.43($70.30 on 100 shares plus net $60 on an additional 200 shares).
The Risk of Continued Price DeclinesThe difference in this variety of the rescue is that the net basis remainsabout the same, but there is a further chance for price decline. This is whyyou should employ such a strategy only when acquisition of more shares
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is desirable based on your fundamental analysis of the stock. If the additional two puts were exercised, you would revert to the original rescuestrategy and write covered calls. However, using short puts allows you tocreate the lower net basis without necessarily having to acquire moreshares. If the short puts expire, you create a reduced basis in the 100shares by virtue of put premium. In that instance, you began with a basisof $70.30 and received $1,000 for the two puts. If the puts expired worthless, then your net basis in 100 shares would be $65.30. Stock would beabove $65 per share at that point (we know this because the puts wouldnot be exercised as long as stock value was at or above strike price).The net outcome of this situation is that you have 100 shares at $65.30net basis. The stock resides somewhere at or above that level, and youare free to sell, hold, or use as cover for additional option strategies. Ifwe compare this outcome to the one summarized in Figure 6–2, profitcan be substantial. That rescue assumed that the 65 calls were exercised,so market value would be higher than $65 per share. In the expired putversion of the rescue strategy, you end up owning 100 shares with a netbasis of $65.30, which is 10 points below the call strike price.The advantage of having 300 shares is clear: profits would be threetimes those of the 100-share rescue. However, using short puts may bemore conservative because you would not be required to buy sharesunless prices decline below strike price. Given that average share pricesare continually reduced through averaging down, the questionbecomes, Are you willing to buy more shares as market prices decline?As long as you believe that the stock’s long-term value remains strong,this may be desirable; or you may conclude that, as strong an investment as it is, there is simply too much volatility. You would prefer, then,to create a situation in which the net basis is lower than current marketvalue so you can sell shares at a profit.Both varieties of the rescue strategy achieve this goal. Remember, thisexample began with an illustration of a stock that fell from the mid-80sdown to $70 per share or lower. So, if you can reduce your basis to create a profitable outcome, the rescue strategies are valuable ways to manage your portfolio. The decision to use calls or puts depends on yourattitude toward the company, available resources, and your willingnessto wait out the stock’s market trends.
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Covered Calls for Contingent SaleLooking beyond contingent purchase, we also have to consider contingentsale strategies. The most conservative form of contingent sale is thecovered call write. When you own 100 shares and you sell a call, youinvite the possibility of exercise. One strategy—writing deep in-themoney calls to create exercise intentionally—makes sense, but only ifyou first consider the tax implications.For example, using the previous example of Federal Express, with thestock at 87.78, current-month calls (based on October 2004) are available for 12.70 (November 75) or 7.90 (November 80). These are virtually all intrinsic value, so if you want to create exercise, it makes littledifference which one you pick. Strike prices are approximately 5 pointsapart, but so are option premium levels. Every point of movement instock price will be matched point-for-point in changes in option premium, so short-term changes in the stock could create immediate profit opportunities as an alternative to exercise.
Picking the Right Conditions for Forced ExerciseThe strategy of creating a forced exercise as a form of contingent salemakes sense under two conditions. First, your original basis in the stockshould be low enough that the exercise price would create a profit. Forexample, if you purchased the stock at $72 per share, selling the 75 callwould combine a 3-point capital gain plus a 12.70-point profit on thecall, with total return before trading costs and taxes of $1,570.The second condition is an awareness of the tax rules. When you sell inthe-money covered calls, you may lose long-term status for taxing ofcapital gains. In the event of exercise, the entire transaction could betaxed at the short-term rate. For example, if you owned Federal Expressfor many years and your original basis was $20 per share, selling at astrike price of 75 would be a 55-point gain. The difference in long-termand short-term rates could be substantial, perhaps even offsetting theoption premium with increased tax liability. However, if you have a significant capital loss carryover, current-year short-term gains will beabsorbed by the carryover loss. In fact, creating current-year gains may
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be a smart tax move, because annual loss limitations are only $3,000,and it could take many years to completely use up a capital loss carryover. For some unfortunate ex-stockholders of Enron, WorldCom, orany number of dotcom companies, the carryover loss may never beentirely absorbed unless future gains are realized to offset those lossesfrom year to year.One of the great advantages to covered call writing is the ability to usewell-selected stock as cover for a string of covered call profits. Thisstrategy—based on the fundamental value of the stocks in your portfolio—enables you to keep stock in most circumstances, while enhancingcurrent income. This can work over many years if you write out-of-themoney calls, use high-dividend stocks, reinvest your short-termincome, and avoid exercise. If stock is worth holding onto for the longterm, it is worth avoiding exercise through a series of rolls forward andup. The forward roll increases the time value, while roll-up increasesthe strike price so that if exercise does occur later, you will increase yourstock profit by that point spread as well.The possible alternatives to outright stock purchase demonstrate howyou can use options to leverage your capital, employ conservative techniques to offset time value risks, and put rescue strategies into effectwhen a stock’s price moves downward. The covered long-LEAPS-callstrategy even employs shorter expiring short calls to balance out longposition time value. All of these strategies make it possible to deal withvolatile market conditions, improve your portfolio diversification, andlock in prices on a wide range of stocks that you might want to buy inthe near future.The next chapter expands on these concepts to show how options can beused to offset paper losses and to maximize conditions in down markets.
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7OPTION STRATEGIESIN DOWN MARKETSSome options moves qualify as conservative strategies—as longas the purpose is to manage the portfolio rather than to simplyspeculate. You can use long puts or calls to manage pricechange, and short puts—with their limited risk—present greatopportunities as long as they are used solely when you would behappy to acquire more shares of the underlying stock. Thischapter provides a conservative context to these ideas, explainshow to evaluate your stock positions when prices have fallen,and examines options strategies to reduce market risk.
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T
he chronic problem every investor faces is the inevitability ofcycles. The stock market experiences these cycles in a variety ofways. The severity and duration of a cycle determines the successof your program, if only because timing is so crucial. Even though youinvest with the long term in mind, you prefer to adhere to the advice tobuy low and sell high—instead of the other way around. Chapter 6,“Alternatives to Stock Purchase,” showed how to devise a rescue strategywhen stocks move in an unexpected direction as part of a contingentpurchase plan. In this chapter, we offer a variety of additional optionstrategies worth considering.
Thinking Outside the Market BoxWhat characterizes the “crowd mentality” of the market? Fear andgreed often have more to do with decision making than does prudentor analytical, strategic thinking. While an academic approach—usuallytaken by someone with no money at risk—may dictate against fear andgreed, it is far more difficult to ignore those emotional responses tomarket trends when you have capital at risk.Knowing this, how can you proceed? How can you manage and resistfear and greed to avoid making the common mistakes? Investors oftendescribe themselves as conservative, but they act irrationally when sudden and unexpected trends emerge. They may also say they base decisions on the fundamentals, but they watch index movements,short-term price trends, and other newsy but not especially useful formsof information. Valid fundamental data is less exciting than current-dayprice movement and far more difficult to convey in a 10-second television or radio news bite. As a consequence, the vast majority of news thatinvestors receive through television and radio is useless. The print mediaare more useful to the extent that stories go into greater depth and maybe more analytical. Coverage by the leading financial newspapers and
162
magazines is superior to television and radio media, primarily becausethe venue is more suited to the kind of fundamental and analyticalinformation investors need.
Remembering the FundamentalsThe success of your conservative approach to investing is based partially on the quality of research and information you have available. Youmay use one or more of the dozens of free Internet Web sites and subscription services; print services, including newspapers and magazines;and stock market services. The amount of time and money you arewilling to spend determines how information-based your decisions are;ultimately, going directly to a company’s Web site and reviewing quarterly and annual financial statements is a fine starting point. Thisassumes that you can glean information from the financial informationprovided by corporations and their auditing firms. To a large extent, aslong as you understand how to interpret the important indicators, youcan make sound decisions.A sensible way to narrow your field of investigation is to identify a fewhigh-quality fundamental indicators and then investigate companiesmeeting your criteria. This is preferable to listening to analysts and WallStreet personalities, and then buying stocks they recommend, oftenwithout fundamental reasons for doing so.If you want to act as a contrarian in the way you pick stocks, you haveto first ask yourself if the market efficient. If so, does the majority tendto make sensible market decisions? In fact, the majority often does notmake good decisions, so a contrarian approach to stock selection makessense. It may be the ultimate contrarian approach to define yourself asa conservative investor and at the same time use options to managemarket price swings.The long-term conservative point of view is that taking a long stockposition in well-chosen companies is the primary, and perhaps theonly, method for investing success. However, this approach may not beconservative at all. If you entrust your portfolio to short-term pricegyrations, you are at the mercy of a chaotic and ever-changing market.It makes more sense to view your portfolio in two segments. First, theChapter 7 Options Strategies in Down Markets
163
foundation of your conservative portfolio will always be defined withwell-selected companies whose long-term value ultimately dictateswhere their stock prices will head. Attributes of such companies includeconsistent growth in dividend payments, strong and consistent capitalization, and competitive growth in revenues accompanied by consistentearnings. Second, you can manage market gyrations with the selectiveuse of options, which is prudent and conservative as long as the purpose in using options is not speculative and as long as option richnessdoes not dictate which stocks you hold or buy. Options are a secondarytool to help you manage market volatility, increase short-term profits,protect paper profits, and devise rescue strategies when your portfolioexperiences paper losses. All of these goals are conservative.
Conservative Versus Speculative: Rememberingthe DifferenceTiming is crucial in the use of options. A speculator is likely to devisestrategies and select options based primarily on implied volatility and aperception of how stocks will react in the short term. However, becausespeculators leverage their capital in high-risk scenarios, they do notappreciate the long-term goals that you develop as your first priority.The use of options in the two instances—speculative and conservative—are vastly different. You use options successfully if you time strategies totake advantage of short-term price changes in stocks you own, to protectpaper profits, or to average prices when your stock values have declinedbut you continue to believe those companies are quality investments.Options can help you to overcome the short-term timing problem,enabling you to acquire more shares when prices are low. When pricesare high, options are effective at protecting paper profits without having to sell shares. Using long puts, you can offset price decline by sellingputs at a profit or by exercising them to actually sell shares at the market top. If you use covered calls, you can actually cash out your paperprofits without selling stock. Such examples of options used to timeprice changes in your stock make the point that many conservativestrategies can help you to build wealth in your portfolio while resistingthe temptation to think conservatively but act speculatively.
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The Long Put: The Overlooked OptionThe tendency to favor long calls over long puts—a common phenomenon among speculators—arises from the tendency for investors to beoptimistic. Realistically, we know that market values rise and fall, butthose who speculate in long options invariably believe that a stock’sprice will begin rising immediately after they buy a call. It is relativelyrare for speculators to consider buying puts in the belief that the stockwill fall in value.This generalization applies to most, but not all, speculators. However,because so much emphasis is placed on calls, long puts often are overlooked and at times undervalued as a result. Your conservative risk profile may present situations in which buying long puts not only makessense, but conforms to your standards as well.
When the Stock’s Price RisesThere are two scenarios worth considering. First, and most likely, is one inwhich a stock’s price rises quickly. The temptation is to sell shares at themarket top and take profits. This is a dilemma. You want to keep shares forthe long term, but you also want to protect paper profits. If you don’t wantto sell shares, buying long puts is a sensible alternative. You do not need tospend a lot of money on long puts either. If you expect a correction within 2 to 2 months, you can probably find an out-of-the-money put for arelatively small premium with a 2- to 3-month expiration.For example, assume that you purchased shares of various stocks andthey have appreciated. We use the 10 stocks in our model portfolio tosummarize available puts expiring in 27 months, as shown in Table 7–1.In each case, the examples cover a range of current price strike pricesfrom the closest increment to the stock’s price, and two strike pricesbelow that price. For example, Pepsi Cola is currently worth $48.48 pershare, so we looked for puts with strike prices of 45, 40, and 35. If thePepsi market value declines below those strike price levels between thecurrent (October) date and expiration (27 months later), we can eithersell the puts at a profit or exercise them. If we sell at a profit, we offsetlost paper profits with a current option profit. If we exercise, we sell
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Table 7–1 Long Puts to Protect Paper ProfitsName ofCompany*
Symbol
CurrentPrice
Clorox
CLX
$55.91
Strike prices 55/50/45Coca-Cola
KO
XOM
FNM
FDX
GD
JCP
PEP
WM
XRX
Strike prices 12.50/10/7.50
1.20
—
3.30
1.80
0.90
—
6.60
—
8.60
6.70
5.10
11.10
7.20
4.20
—
2.35
—
3.00
1.70
0.85
3.80
2.05
—
1.45
0.75
0.35
$38.43
Strike prices 35/30/25Xerox
—
$48.48
Strike prices 45/40/35WashingtonMutual
2.40
$38.20
Strike prices 35/30/25Pepsi Cola
3.80
$100.01
Strike prices 100/90/80J.C. Penney
5.80
$87.78
Strike prices 85/80/75GeneralDynamics
3
$67.65
Strike prices 65/60/55FederalExpress
2
$48.70
Strike prices 45/40/35Fannie Mae
1
$38.90
Strike prices 35/30/25Exxon Mobil
27-Month Put Premium
$14.32
* Stock prices and option premium values based on closing prices as ofOctober 22, 2004. Source: Chicago Board of Exchange (CBOE).
Pepsi shares at the strike price. For example, if we purchase one 45 putper 100 shares and the stock falls to $39 per share, we can exercisebefore the expiration deadline and sell shares at $45 per share, the putstrike price. That would produce a pretransaction cost profit of $3 per
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
share (6 points between market and strike values minus the cost of $3per share).As you can see, low-cost puts can be used to produce protect profits.You can employ long puts to protect paper profits and to provideyourself the choice between exercising and selling those puts if andwhen prices retreat. You can protect against price decline in the case ofPepsi stock below $45 per share for premium cost of $300 (or below$40 per share, at a cost of $170 per put; or below $35 per share, foronly $85 per put).If you have bought shares of stocks that tend to rise and fall on averagewith marketwide direction, a rapid price increase could create an overbought position in many, if not all, of your portfolio issues. So, the useof puts to protect paper profits is a prudent method for dealing withshort-term price trends. Because the assumed market trend is shortterm, a 27-month protection period is a very long period in terms ofmarket price trends. Rapid price spikes tend to correct within a veryshort timeframe, so if you have read the market correctly, this strategy—even given its limited life span—is both realistic and conservative.Shorter term options provide protection for shorter time periods, oftenwith advantageous pricing. For example, compare the prices for Pepsi45 puts at various expirations:1
Months toExpiration
PremiumCost
27
$300
15
210
6
100
3
50
2
25
1
20
1 Based on closing bid prices, October 22, 2004; source: CBOE delayed quotes, www.cboe.com.
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You can see from this comparison that, depending on the amount oftime you want to have the protection, the premium cost varies considerably. You can buy 27 months of downside protection for $300 or 2months for only $25 (before transaction costs).Balancing time and cost enables you to identify a practical means formanaging short-term price fluctuation in your long stock positions.The alternative is to ignore short-term price gyrations and simply holdstocks for long-term appreciation. This is also a conservative approach.Because short-term price movement is often irrational and not causedby any fundamental changes in the companies themselves, you caneither avoid management of short-term price changes or use options toexploit price spikes and to create the opportunity for additional profitswithout substantial capital risk.The strategy of buying puts to insure paper profits (or even to providea safe floor for your purchase price of shares) is a system for managingshort-term volatility while continuing to execute the long-term conservative policies you have established in your portfolio. This is not merespeculation; it is a method for protecting current value at a relativelysmall cost, just as is purchasing fire and casualty insurance on yourhome even though the chances of a loss are slim. In the case of yourportfolio, it is doubtful that properly selected stocks will experiencelarge price declines, but when market prices rise too quickly, a shortterm correction presents an opportunity to protect profits for relativelysmall cost.
When the Stock’s Price FallsIn the second scenario, long puts are used when market prices fall rapidly. In this situation, you may recognize a buying opportunity on anintellectual level, but you also fear further declines. So, you use longputs to provide an immediate floor for stocks in your portfolio. In casesof extreme short-term volatility, you can combine long puts with longcalls. Long puts protect your capital value in case of a further decline; atthe same time, a price rebound would make the long calls profitable.The two scenarios for using long puts—when your stock prices eitherrise or fall rapidly—are based on the premise that you want to protect
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the long value of shares you own. This qualifies both strategic uses oflong puts as conservative in nature. Speculators have no interest in protecting long stock value; in fact, the true speculator does not even ownstock unless it serves as vehicle for executing some related strategy, suchas covered call writing. Were you to play market price swings, youwould be defined as a speculator. However, the strategies described hereare designed to serve as insurance for your paper profits, reduction offurther losses, or an opportunity to take paper profits if and when theymaterialize. The thoughtful selection of long puts makes sense in theseextreme market positions. It can also make sense to buy puts for insurance. For example, if you buy shares and you want to guarantee that themarket value will not fall below your net basis, using puts as insurancemakes sense even when market prices are not especially volatile. It isconservative to insure long positions. A basic assumption is that yourstocks will rise in value. Realistically, you also know that you could bewrong, at least in the short or intermediate term.
Short Puts: A Variety of StrategiesIn a down market, you face the dilemma well known to all investors.You want to take advantage of buying opportunities, but you’re not surewhere the market is going. The conservative point of view should be torecognize down markets as the chance to pick up more shares of yourfavorite stocks. This not only represents a bargain; it is also a way to create new paper profits. When you buy cheap shares, you lower youroverall basis in a stock, and that improves long-term as well as currentincome potential.Given the fear factor in down markets, you may hesitate to put a lot ofcapital into shares. What if the market continues to fall? What if it takesmonths instead of days to recover? Anyone can look back over pastpricing patterns and identify the obvious timing of purchases, but it isfar more difficult to do in advance. This is where short puts are especially valuable. There is always the possibility that stock prices will falland not recover. This danger exists whether you use options or not; it isa well-known investment risk. The value of using options is that strategies may exploit temporary price declines. When prices fall and remain
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down, options reduce the losses (if you use short options) or providethe opportunity for recovery with limited additional cost (if you uselong options). For many conservative investors facing possible losses,using options in short strategies is more appealing than going long,because at the very least, it involves receiving payment instead ofspending more capital.When you sell puts, you receive the premium payment. If the stock’smarket value falls below strike price, the put is exercised. You can avoidexercise by rolling forward and down; or you can accept exercise andhave 100 shares put to you. However, in down markets, selling puts canbe a valuable method for acquiring additional shares of stocks at areduced price, thus reducing your basis in stock through the profits youearn from selling puts.
Conservative Ground Rules for Short PutsFollowing are seven conservative ground rules for selling puts in downmarkets:1. Sell puts on stocks you already own. Conservative standards statethat you will buy and hold stock that meets your fundamentalcriteria. If those criteria continue to hold even when the stock’smarket value falls, then you may view selling puts as a sensibleand conservative strategy. This gives you the potential to pickup more shares and lower your average basis as well as toincrease current income.2. Select strike prices based on support level. The stocks you selectfor writing puts, like all stocks, are likely to trade in a predictable price range. Conservative stocks normally have a fairlynarrow trading range and strong support. But when marketwide price declines occur, your conservative stocks mayspike downward temporarily.3. Sell puts that provide a minimal rate of return. What rate of returnwill you earn on short puts if exercised? As a general rule (and nota universal one) you may want to look for puts that represent a 10percent return on strike price. Identifying percentage helps you to
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avoid a common problem: choosing a higher dollar amount without comparing rates of return. For example, let’s say that you havetwo stocks on which you want to write puts, but you’ve decided togo with only one. Current market value of one stock is $40 andthe other is $65. The $65 stock has options available at 5, and the$40 stock has puts at 4. The $500 premium on the first stock ishigher than the $400 premium on the second. However, on a percentage basis, you would be wiser to pick the second stock andtake the 10 percent return. This is a better return than the 7.7 percent return on the $65 stock. (This comparison assumes the sametime to go until expiration, because annualized returns can alsochange the comparative picture.)4. Coordinate strike price and current market value. In picking shortputs, you want to gain the best possible premium, but you alsowant to avoid exercise. The farther out of the money, the betteryou avoid exercise, but the lower the premium will be. So, youmay look for puts with strike prices between 3 and 7 pointslower than current market value. Why this range? It is the mostlikely range for creating premium profits. If the strike price isany closer to the current market value, a relatively small declinein the stock will put you in the money and could lead to exercise. If strike price is farther out, you are less likely to generateadequate premium to justify the short position exposure.5. Pick expiration time based on your market perceptions. How longshould you leave yourself exposed in the short position? Thelonger until expiration, the greater the time value; the shorterthat time, the lower the risk. The key is to compare those putsoffering the desired 10 percent return with proximity betweenstrike price and current market value. How long an exposureperiod is required? Is it worthwhile? How long do you estimateit will take for the market to rebound? The decision has to bebased on your willingness to remain at risk.6. Pick exit levels and/or roll levels when you initiate the transaction.You may set a rule for yourself. For example, you may decidethat once the stock’s market value declines to within one pointof the strike price, you will roll forward and down to avoid
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exercise. You may also decide that if and when the put’s premium value declines to one-half its original value, you will closethe position and take a profit, perhaps then replacing the shortput with another. For example, if the stock’s price rose whilethe short position was open, you may be able to sell a put witha higher strike price, generating additional premium profits.7. Plan out secondary strategies in the event of exercise. What if theprice of the stock falls below the strike price, and before youhave the opportunity to roll out of the position, the put is exercised? In that case, you need a rescue strategy. One conservativechoice would be to do nothing. If the put exercise reduces youroverall basis, you will have more shares at a lower overall cost.Remember, as long as the fundamental value of the company isstrong, this is a short-term situation and not a problem. In fact,it is a long-term advantage because your average price of shareshas been reduced. Another secondary strategy may involveeither selling additional puts or reverting to a covered call strategy. With more shares, you can write more covered calls. Thebasic rule is that if exercised, the covered call position mustproduce an overall net profit in the stock (after calculating thenet basis due to average costs and further reduced by short-putand short-call premium). In that case, writing out-of-themoney calls (which are 100 percent time value) further reducesyour