one in which the stock has demonstrated a consistent, steadygrowth in market price within a relatively narrow trading range.While exercise of either side of this transaction would be welcomed, the best outcome allows you to manage the positions toavoid exercise, and then repeat the position later.7. Premium income from both positions is attractive. In order tojustify any option position, the premium levels have to be right.In this strategy, you write two short positions. Longer exposureincreases the chance of exercise on either side of the transactions, but rolling techniques can help you to avoid exercise longenough that the positions can both be closed at a profit.8. The proximity of strike prices to current market value is ideal.The current market value of stock should ideally reside exactlyhalfway between the strike prices of the call and the put, orwithin one dollar of the halfway mark. For example, if yourstrike prices are 45 and 55, the ideal market price of the underlying stock us $50 per share. (For the purposes of illustration,we limit the examples that follow to strike prices at least 5points out of the money.)9. A fundamental analysis of the underlying stock has passed yourreview. It is always essential to evaluate the stock before deciding to buy shares or to continue holding shares you alreadyown. This strategy makes sense only if it also makes sense toown the stock, based on your conservative profile.10. You have evaluated all possible outcomes, and you are satisfiedthat this strategy is worth entering. Consider all possible outcomes, including the net portfolio value when the stockdeclines below the put’s strike price and you end up with apaper loss. Your analysis should be comparative based on youroutcome if you simply continue holding shares of the stockwithout writing options.
Examples of the Strategy in PracticeThis combination strategy requires several steps.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Pick Your PortfolioWe use our model portfolio of 10 stocks. Using the same stocks in previous chapter examples, we show how the combination strategy worksin various situations.
Pick Expiration DatesWe make the comparisons among our model portfolio stocks assuming that expirations will occur in 15-month or 27-month periods. Inpractice, you can alter the expiration dates between call and put. Thereis no specific reason why identical expirations are necessary for thisstrategy unless you are working from an assumed target date for finalclosure of the strategy.
Review Trading Range TrendsThe next step is to review the trading ranges for these stocks. We discover the following moderate-level volatility over the past 12 months:1Stock
Trading Range
Clorox
$45–55
Coca-Cola
35–55
Exxon Mobil
35–50
Fannie Mae
60–80
Federal Express
65–95
General Dynamics
85–100
J.C. Penney
25–40
Pepsi Cola
45–55
Washington Mutual
35–45
Xerox
12–17
1 Price ranges over 52 weeks, rounded to closest 5-point increment.
Source: http://www.schwab.com.
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207
Look for Available Options and Strike PricesNext, we check available options on all of the issues. We look at the 15month and 27-month LEAPS calls and puts for each option and selectthose that are out of the money in each instance. For most of the stocks,we limit our analysis to options at least 5 points out of the money.(Exceptions are the two stocks with the highest and lowest price ranges:for General Dynamics, we looked for options out of the money 10points in either direction, and for Xerox, we reviewed options a minimum of 2.5 points out of the money.)In examining the available options, we discover a range of calls andputs meeting our criteria, summarized in Table 8–1The information in Table 8–1 is difficult to judge comparatively forseveral reasons. First, it is not annualized, but we are dealing withsignificantly different expiration terms, price ranges, and distancesbetween current market value and strike price. For example, FannieMae and J.C. Penney strike price spreads are 20 points apart, andXerox has a spread of only 7.5 points. To a degree, variation in thepoint spread is a factor of stock price level; we also have extendedsome of these examples to achieve the desired minimum 5-point difference between market value and strike price (the exception to thisis Xerox). In choosing between the 15-month and 27-month alternatives, we cannot make a valid judgment until we annualize thereturns and then review them side by side. Table 8–2 shows combined short call and put for each strike selection and also annualizeseach return.This summary allows you to look at potential returns side by sidebetween stocks and between expiration dates. Even so, this analysisis only accurate on the assumption that all options expire worthless. The return will be quite different if one or both options areexercised. For example, if the Coca-Cola 45 call is exercised, thespread between strike price and current market value will be sixpoints; but if the General Dynamics call is exercised, the spread willbe 10 points.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 8–1 Stocks for Combined Call and Put Short StrategyName ofCompany*
Symbol
CurrentPrice
Clorox
CLX
$55.91
60 call/50 putCoca-Cola
KO
XOM
FNM
FDX
GD
JCP
PEP
WM
$5.10
$3.80
$1.05
$0.50
$2.15
$1.20
$1.45
$1.10
$2.70
$1.80
$2.85
$4.90
$4.80
$6.60
$5.90
$4.50
$10.10
$6.70
$5.60
$4.60
$9.60
$7.20
—
$1.45
$2.50
$2.35
$1.20
$0.95
$2.30
$1.70
$1.10
$1.30
$1.65
$2.05
$0.80
$0.50
$1.60
$0.75
$38.43
45 call/30 putXerox
$2.15
$48.48
55 call/40 putWashingtonMutual
$2.85
$38.20
50 call/ 30 putPepsi Cola
Put
$100.01
110 call/90 putJ. C. Penney
Call
$87.78
95 call/80 putGeneralDynamics
Put
$67.65
80 call/60 putFederal Express
Call
$48.70
55 call/40 putFannie Mae
27-MonthOptions
$38.90
45 call/30 putExxon Mobil
15-MonthOptions
XRX
$14.32
17.50 call/10 put
* Stock prices and option premium values based on closing prices as of October, 2004.Source: Chicago Board of Exchange (CBOE).
Chapter 8 Combination Conservative Techniques
209
Table 8–2 Annualized Return, Combined Call and Put Short Strategy
Stock andExpiration*
(A)CombinedPremium
Clorox15-month27-month
$5.008.90
Coca-Cola15-month27-month
$1.553.35
Exxon Mobil15-month27-monthFannie Mae15-month27-monthFederalExpress15-month27-monthGeneralDynamics15-month27-monthJ.C. Penney15-month27-month
(B)CurrentStockPrice
(C)SimpleReturn
(D)Months toExpiration
AnnualizedReturn**
9.8%15.9
1527
7.8%7.1
4.0%8.6
1527
3.2%3.8
5.2%9.2
1527
4.2%4.1
11.5%16.9
1527
9.2%7.5
11.8%19.1
1527
9.4%8.5
10.2%16.8
1527
8.2%7.5
—%12.7
1527
—%5.6
4.4%8.3
1527
3.5%3.7
6.2%9.6
1527
5.0%4.3
9.1%16.4
1527
7.3%7.3
$55.91
$38.90
$48.70$2.554.50$67.65$7.7511.40$87.78$10.4016.80$100.01$10.2016.80$38.20$—4.85
Pepsi Cola15-month27-monthWashingtonMutual15-month27-month
$48.48
$2.403.70
Xerox15-month27-month
$1.302.35
$2.154.00$38.43
$14.32
* Stock prices and option premium values based on closing prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).** The calculation to annualize involves the following two steps:Divide total premium (Col. A) by stock value (Col. B) to arrive at simple return (Col. C).Annualize with the following formula to reflect return on a 12-month basis:[col. C ÷ col. D ]  12
210
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Compare YieldsThe final step before making a decision is to develop a valid comparison. If calls are exercised, you gain points between current market valueand strike price. The exercised rate of annualized return is calculatedbased on current market value; also consider your original basis in eachstock as part of the process to determine whether, in your opinion, thiscombined strategy is worth the exposure.The return will also be different if either option or both options declinein value and are closed or if you replace them by rolling forward and up(calls) or forward and down (puts). These variables point out the difficulty in making accurate comparisons between stocks and betweenoutcomes. However, if we make a few generalizations, we can comparethe outcomes as reflect in Table 8–2.The last column shows that, in fact, the two best outcomes are found inthe 15-month positions for Fannie Mae and Federal Express. This comparison demonstrates the complexity of return analysis. We use the basicassumptions involving the same time to expiration in order to makethese analyses as comparative as possible. This comparison also does nottake dividend yield into account, although some methods do includedividends. For example, the Chicago Board of Exchange includes dividend yield. It can make a considerable difference. Fannie Mae paid anannual dividend of 3.1 percent, and Federal Express was at 0.3 percenton the date of this analysis. So, if we add in the annualized dividendyield to these returns, the comparison takes on a different result:AnnualizedPremiumYield
DividendYield
DividendTotal
Fannie Mae (15month)
9.2%
3.1%
12.3%
Federal Express(15-month)
9.4
0.3
9.7
Stock
Both of these stocks will yield high returns on an annualized basis,using the combined short-option strategy. However, Fannie Mae isChapter 8 Combination Conservative Techniques
211
more desirable when dividend yield is added into the total. Anotherreason this stock is more desirable than most of the others is the pointspread between current market value and strike prices of the short calland put. The range is a full 20 points (higher than all of the other stocksexcept General Dynamics and J.C. Penney) and by far the highest yieldwith dividend yield included.
Select Stocks for the Short Combination StrategyThe final step is to pick the stock you will use for this strategy.Assuming that you have been following all of the model portfoliostocks but do not yet own any, you could easily narrow down yourchoice to Fannie Mae or Federal Express—assuming that all else isequal in the fundamentals of all of these stocks.Suppose you buy 100 shares of Fannie Mae at $67.65 and, at the sametime, write a 15-month 80 call and a 15-month 60 put:Buy 100 shares of FNM @ $67.65
$6,765
Sell one 15-month 80 call
–285
Sell one 15-month 60 put
–490
Net basis before trading costs
$5,990
The strategy, based on current value of stock at the price of $67.65 pershare, is illustrated in Figure 8–2.The profit zone is the difference between the strike prices plus the number of points received for selling the short puts. This zone is quite wide.It does not include dividend income (assuming that dividend yieldcomparisons were useful in comparing potential outcomes but are nota part of the option-specific returns). There would no loss zone on theupside. In the event the call was exercised, shares would be called awayat the strike price of $80 per share, producing a capital gain of $12.35per share, or 18.3 percent (if this occurred on the last day before expiration, annualized capital gain would be 14.6 percent). In the event theput was exercised, your basis would be the put’s strike price averaged
212
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Fannie Mae (FNM) *
MARKET
PRICES
OF
strike price, short call
profit zoneoriginal purchase pric e of stock
strike price, short put
75
7.
STOCK
ts
in
po
8584838281P 8079R 7877I76C 7574E 73727170P 6968E 67R 6665646362S61H 6059A 58R 5756E 555453525150
limited loss zone1 5 - M O N T H T I M ET O
E X P I R A T I O N
* Based on closing prices as of October 22, 2004; source: www.cboe.com
Figure 8–2 Profit and loss zones, short-option combination.
with your original basis. If you bought shares at $67.65 and then hadthe put exercised for an additional 100 shares, average basis would be$63.83 per share. If both options were exercised, you would end up with100 shares of stock. The original 100 shares would have been calledaway when the call was exercised at $80 per share, and another 100shares were put to you when the put was exercised at $60 per share.In this transaction, the combined call and put premium reduces yourbasis in the stock to $59.90 per share. The profit zone in the illustrationextends downward to the price of $52.25, reflecting the strike price of60 minus 7.75 points for total short option premium.
Chapter 8 Combination Conservative Techniques
213
As long as you would be happy to accept exercise of either option, thepossible outcomes of this transaction are all positive. In the case of theput, the assumption would be that the strike represents a fair purchaseprice in your opinion. Based on the Fannie Mae 12-month tradingrange from about $60 to $80, this does seem to be a fair conclusion.Your net cost of $52.25 upon exercise of the put is below the 12-monthtrading range.
Outcome ScenariosEven after identifying a desirable yield, it still makes sense to go throughthe various possibilities to make sure that you understand what couldoccur and what actions, if any, you would want to take in response.
Planning Ahead for Each Outcome ScenarioYou must consider what actions, if any, you would take in the followingscenarios:1. The trading range of the stock remains in between the strikeprices. If the stock’s trading range remains below the callstrike price and above the put strike price, neither will beexercised. This condition occurs in one of two instances.First, the price of stock simply does not move in either direction more than the example’s 20-point range. In this case,you can wait for expiration or, when the value of eitheroption or both options has declined to near zero, you canenter a closing purchase transaction and cancel the shortpositions. Once this is done, you are free to sell more optionsunder the same strategy. Second, when the stock’s priceapproaches one strike level or the other, you may roll forwardto avoid exercise. This extends your period of exposure, butalso extends the future strike price (upward for calls anddownward for puts). So, if the call were eventually exercised,it would be at a higher price (in the case of the call) or alower price (in the case of the put).
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
You are free to close or roll either of the short positions withoutchanging the risk profile in the remaining segments of the position. This is only true, however, as long as you own 100 sharesfor each short call written. The risk profile provides great flexibility. As the trading range of the stock begins moving in onedirection or the other, you can roll forward, close the position,or alter expiration dates and strike prices. The decisions abouthow you deal with the short call or the short put are independent of one another. They work well together due to the highreturns you can earn consistently without increases in marketrisk; that does not mean you are limited in terms of strikeprices or expiration dates.2. Both options are exercised. If price in the underlying stockmoves enough points in the money on both sides, you couldexperience exercise of both options. This would require notonly movement into the money, but early exercise on both sidesas well, and You would end up where you were before enteringthe transaction. Upon exercise of the call, your 100 shares aresold; and upon exercise of the put, you receive 100 shares at thestrike price. Because the space between strike prices is 20points, this outcome produces a 20-point gain in option exercise, plus the premium income. In the example, the total $775premium is yours to keep no matter what; but if you were tosell 100 shares at $80 and acquire 100 shares at $60, you wouldhave an additional $2,000 capital gain. However, because youend up with a net 100 shares and no open short positions, thisoutcome is highly desirable. Once it has occurred, you can onceagain write a short call and a short put.When both options are exercised, the most desirable sequencewould be for the put to be exercised first, and then the call. Theoutcome then creates a situation in which you own appreciatedstock. For example, if your original basis were $6,765 (the market value at the time the short positions were entered), it wouldbe desirable to have stock purchased at $60 per share.This outcome is the same as if you simply bought 100 shares ofstock and set a goal to buy an additional 100 shares if the
Chapter 8 Combination Conservative Techniques
215
stock’s price falls to $60 and to sell shares if the stock’s pricerises to $80. The difference with the option short combinationis that you express the same goals but earn a higher profit andextend the profit zone at the same time. You do not depend onprice movement to reach the profit goal: the strategy producesa profit through call and strike premium, no matter whichdirection the price moves.3. The call is exercised but the put is not. In this situation, yourstock is called away at $80 per share (based on the precedingexample), but you are not required to repurchase those shares.The short put either expires worthless or is closed through purchase. The outcome is desirable because your gain consists of$1,235 on the stock plus $775 on option premium. The downside of this outcome is lost opportunity. When your stock iscalled away, it is because that stock has appreciated in value, soyou end up earning a profit, but you no longer own the stock.If you can consistently produce high returns—and with thisstrategy, you can—then the lost opportunity may be viewed asa worthwhile trade-off.4. The put is exercised but the call is not. If the put is exercised,you acquire an additional 100 shares. Because the originalbasis is $67.65 per share, the new combined basis of 200 sharesis $63.83 before considering option premium. When youdeduct the $775 option premium, the basis is further adjusteddown to $59.95:($6,765 + $6,000 – $775) = $5,995 (200 shares)Although current market value of the stock in this situationmay be below your net basis, we have to assume that youentered this strategy with a few important qualifications inmind: You considered $60 per share a fair price for the stock,and you are happy to acquire additional shares because thisstock meets your long-term fundamental criteria. Having 200shares may also be seen as a way to double the potential returnsin writing future short positions. It is advisable, however, to
216
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
wait until the price rebounds to ensure that all outcomes ofshort-option positions would be profitable.5. The stock’s market value falls below the put strike and remainsthere. This is the worst outcome of all—whether you writeshort options or not. If you simply keep your 100 shares, aprice decline has no mitigation. In having generated 7.75 pointsof reduced basis from selling puts, you naturally hope the pricereturns to previous levels. Even so, this situation may require arescue strategy. discussed in detail later in this chapter.
The Augmented Strategy—A Short StraddleUsing the previous analysis, let’s see what happens if you write a straddle instead of creating a strike price gap. You do this when you wouldfind it most desirable to have either or both options exercised.Assuming that you write a straddle as close as possible to current market value of the stock, you could create potentially high premium valuein the options.Looking once again at the ten stocks in our model portfolio, we find thestatus of calls and puts closest to current market value, as shown inTable 8–3.It is essential in this analysis that you emphasize annualized returnrather than dollar value of option premium. Clearly, the potential$2,360 you could receive for writing a Federal Express 27-month straddle is far higher than the $410 you would receive doing the same strategy on a Xerox January 15-month position. But the dollar values alonedo not tell the whole story. In fact, the annualized return on the Xeroxstraddle is far better than the annualized return on Federal Express.Dollar values alone are deceptive. In this comparison, owning 600shares of Xerox represents approximately the same capital level as owning 100 shares of Federal Express, and the option premium is higher onXerox as well. To make the comparisons valid, we need to annualize allof these returns, as shown in Table 8–4.
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217
Table 8–3 Stocks for Conservative Short Straddle15-Month OptionsName ofCompany*
Symbol
CurrentPrice
Clorox
CLX
$55.91
50 strikeCoca-Cola
KO
XOM
FNM
FDX
GD
JCP
PEP
WM
12.50 strike
XRX
$3.80
$2.55
$3.70
$4.00
$4.90
$5.80
$2.30
$7.00
$3.30
$6.20
$9.20
$8.30
$11.10
$10.90
$6.30
$15.00
$8.60
$9.90
$8.60
$13.90
$11.10
$3.90
$5.20
$5.70
$6.40
$2.90
$4.10
$4.30
$5.00
$5.00
$2.80
$5.40
$3.80
$3.10
$1.00
$3.90
$1.45
$38.43
35 strikeXerox
$10.00
$48.48
50 strikeWashingtonMutual
$2.15
$38.20
40 strikePepsi Cola
$8.00
$100.01
100 strikeJ.C. Penney
Put
$87.78
85 strikeGeneralDynamics
Call
$67.65
70 strikeFederalExpress
Put
$48.70
45 strikeFannie Mae
Call
$38.90
40 strikeExxon Mobil
27-Month Options
$14.32
* Stock prices and option premium values based on closing prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).
218
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 8–4 Annualized Return, Conservative Short Straddle
Stock andStrike Prices*Clorox 5015-month27-monthCoca-Cola 4015-month27-monthExxon Mobil4515-month27-monthFannie Mae 7015-month27-monthFederal Express8515-month27-monthGeneralDynamics 10015-month27-monthJ.C. Penney 4015-month27-monthPepsi Cola 4515-month27-monthWashingtonMutual 3515-month27-monthXerox 12.5015-month27-month
(A) TotalPremium
(B)CurrentStockPrice$55.91
$1,0151,380
(C)SimpleReturn
(D) MonthstoExpiration
AnnualizedReturn**
18.2%24.7
1527
14.6%11.0
16.1%22.9
1527
12.9%10.2
16.6%21.1
1527
13.3%9.4
22.8%28.7
1527
18.2%12.8
19.6%26.9
1527
15.7%12.0
18.5%25.0
1527
14.8%11.1
23.8%31.7
1527
19.0%14.1
16.1%20.6
1527
12.9%9.2
20.3%23.9
1527
16.2%10.6
28.6%37.4
1527
22.9%16.6
$38.90$625890$48.70$8101,030$67.65$1,5401,940$87.78$1,7202,360$100.01$1,8502,500$ 38.20$9101,210$48.48$7801,000$38.43$780920$14.32$4.105.35
* Stock prices and option premium values based on closing prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).** The calculation to annualize involves the following two steps:Divide total premium (Col. A) by stock value (Col. B) to arrive at simple return (Col. C).Annualize with the following formula to reflect return on a 12-month basis:[col. C ÷ col. D]  12
Chapter 8 Combination Conservative Techniques
219
How the Dollar Values Alone Can MisleadA comparison between 100 shares of Federal Express versus 600 sharesof Xerox helps to clear up how this works. We need not only to annualize returns, but also to make capital investment comparable:
Stock
Stock cost
Optionpremium
Net cost
Federal Express100 shares
$8,778
$2,360
$6,418
Xerox 600 shares
$8,592
$2,460
$6,132
This brief comparison demonstrates that annualized return is the keyindicator. In this sample, the higher dollar-value (Federal Express)spread produced only 12.0 percent annualized return while reducingstock net basis to $6,418. Xerox produced a 22.9 percent return andreduced the basis of 600 shares down to $6,132—a lower net basis for afar higher rate of return.Returning to our 100-share example in Table 8–4, it is clear that, withoutexception, the annualized yield on the 15-month options is superior toreturns on the 27-month options. This is true not only because annualizedyield is higher, but also because the turnover period is a full 12 months less.In this straddle, we create consistently high current returns on an annualized basis; however, it is also quite likely that the short options will be exercised. If you accept the premise that exercise of either the call or the put(or both) would be desirable, then this straddle example is quite impressive. The strategy works best when the short call and put strikes are asclose as possible to current market value of the underlying stock. GeneralDynamics is the only stock in the 10-stock model portfolio that meets thattest. For Clorox, we picked the 50 strike because 55s were not available forthe 15-month group of expirations. We prefer to write options as close aspossible to at the money. This maximizes the potential return.The highest yielding position is the 15-month Xerox straddle, returning22.9 percent on an annualized basis. This reduces the basis in the stockfrom the current price of $14.32 per share to $10.22 because you receive$4.10 for opening the straddle—a very impressive initial discount in
220
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
the price of the stock. Many of these stocks would produce impressivereturns; to keep our analysis consistent, we summarize the 15-monthstraddle for Fannie Mae 70 call and put, which yield 18.2 percent:Price of stock
$6,765
Short call premium
–620
Short put premium
–920
Net
$5,225
This produces a wide profit zone, as summarized in Figure 8–3.
15.4
points
Fannie Mae (FNM) *
Strike price, call and putExercise zone
tspoin15.4
88878