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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
In order for the basic contingent-purchase strategy to be profitable, youneed a net increase in market value equal to or greater than the investment level. For example, if you purchased a January 2006 call at 90 orFederal Express (costing 8.20), the stock would need to rise to $98.20per share before your breakeven point (not counting transaction fees).You would need the stock’s value to rise above that level to justify thelong-call contingent-purchase strategy. While this is a disadvantage,you have a lot of time for the outcome to materialize—15 months forthe 2006 calls or 27 months for the 2007 calls.
Reducing Contingent Purchase RisksContingent purchase risk can be reduced in a variety of ways. Here arethree ideas:1. Use a higher strike price. Table 6–1 shows three strike price levels. If you preferred the third increment over the first or secondstrike prices, your investment basis would be lower becausethere would be more points to go to expiration. Looking at the2006 columns, you would spend $35 rather than $290 to buythe higher strike price Pepsi calls, for example.2. Invest in longer term calls. For example, you gain a full year buying 2007 calls instead of 2006; in the case of Exxon Mobil, theadded cost of the first-increment calls is $140, but the addedtime is significant.3. Reduce the cost of long calls by using short-call offsets. The mosteffective way to cut risks and make contingent purchase a profitable strategy is to write short calls against your long-call positions. This secondary strategy is explained in the next section.
The Covered Long CallThe major risk involved with long-call contingent purchase is thesame as for all long-call strategies: If expiration occurs before an adequate price increase occurs in the underlying stock, it is extremely difficult to make a profit in this manner. So, risk involves the sameChapter 6 Alternatives to Stock Purchase
141
problem as every other long-option strategy: time works against you.Even if the stock’s market value rises, you still need to overcome thetime value problem.There is a way to achieve this. Assuming that some or all of the stocksin this example increase in value before expiration, you can employ asecondary strategy designed to recapture the premium cost of the longcall. The basic strategy is to sell a call with a higher strike price and earlier expiration than the long positions. Does this work out?Let’s assume that you bought one of each of the closing strike price 27month calls for the 10 model portfolio stocks and invested $6,375. Youhope that during the next 27 months, the price will appreciate enough inthese 10 stocks to make the contingent purchase a profitable strategy. Atthe same time, you would like to get back some or all of the $6,375 youinvested in long LEAPS calls. To make this illustration comparable, let’sassume that all 10 stocks were to increase between 5 and 10 points in thenear future—not enough to ensure profitability on the long-call purchases, but enough to put the secondary strategy into effect. To estimatethe future value of calls given the increased market value of the underlying stock, we review current premium values for calls 5 points abovecurrent value. For example, in the case of Pepsi Cola, where we areinvolved with a range of calls in the 50-strike price range, we review callswith current strike prices of 55. In the case of each stock, we can compare the long-call cost to current value of one price increment abovethose positions. This is summarized in Table 6–2.In this table, we estimate future premium values based on two assumptions. First, the market value of each underlying stock will rise by 5 to10 points, and second, the current premium values for calls with strikeprices 10 points lower represent fair estimates of future premium value.For example, in the case of Pepsi, we estimate the value of the 55 shortcall by using the current 45 call’s value.
Extrapolating Future Strike PricesIn making this comparison, we have to assume that the relative value ofcalls will remain about the same in the future as it is today. Because futurestrike prices of the short positions are higher than the corresponding
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 6–2 Stocks for Short Sale Against Long LEAPS Positions*Name of CompanyClorox 60 long callClorox 70 short callCoca-Cola 40 longcallCoca-Cola 45 shortcallExxon Mobil 50 longcallExxon Mobil 55 shortcallFannie Mae long call70Fannie Mae short call75Federal Express 90long callFederal Express 95short callGeneral Dynamics100 long callGeneral Dynamics110 short callJ. C. Penney 40 longcallJ.C. Penney 45 shortcallPepsi Cola 50 longcallPepsi Cola 55 shortcallWashington Mutual40 long callWashington Mutual45 short callXerox 15 long callXerox 17.50 short callTotal long positioncostsTotal short positionprofits
SymbolCLXKO
$38.90
XOM
FNM
FDX
GD
JCP
PEP
WM
XRX
CurrentPrice$55.91
$48.70
$67.65
$87.78
$100.01
$38.20
$48.48
$38.43
$14.32
January20072.851.002.55
January20065.102.304.00
1.05
2.15
3.10
4.50
4.50
2.70
6.20
8.30
4.30
6.00
8.20
12.30
5.90
10.10
9.90
13.90
5.60
9.60
3.90
5.70
2.15
3.00
2.90
4.30
1.20
2.30
2.55
3.10
1.10
1.65
0.800.3042.95
2.551.6063.75
27.10
41.40
Note: Stock prices and option premium values based on closing prices as ofOctober 22, 2004 (source: Chicago Board of Exchange, CBOE). Estimatedshort-call premium values are based on current premium of calls with strikeprices 5 points below indicated levels; and assuming that underlying stockvalues were to rise five to 10 points.
Chapter 6 Alternatives to Stock Purchase
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original long positions, exercise is a no-risk outcome. If the short calls areexercised, they are offset by 5 points lower value in each of the long calls;those long calls could be surrendered to satisfy the call in each instance.For example, if you bought an Exxon 50 for $310 and later sold an Exxon55, exercise would create a 5-point profit for you. You would use yourlong call to offset the exercised short call. The risk is eliminated becauseof the following:• Each long position provides cover for the short positions.• Exercise of short positions creates a profit of 5 points betweenthe short and long positions.• Expiration of short positions occurs 12 months prior to longpositions; if the short calls expire, you end up with continuinglong positions at a zero cost basis.This illustration is based on the belief that the market value of theseshares will grow within the next 27 months. Hopefully, if your stockselection skills are good, your contingent purchase experience can takethe course shown in the example. When you enter into a contingentpurchase strategy at a time when marketwide prices are low, chancesare better than average that this course of price change will occur. In theexamples shown, the average spread for 15-month calls was 63 percent,meaning that—based on the belief that this ratio remains approximately the same—you could expect to recapture 63 percent of your long costthrough writing short calls. (This may be affected to a degree becauseshort calls have earlier expirations.) The ratio for 27-month calls was 65percent, about the same.The long-call contingent plan with short-call offset is an example of howyour disadvantage can be turned to an advantage. When you are long incalls, you have a time disadvantage. Using higher strike price, shorterexpiring calls flips the time value in your favor. You buy time value on thelong side, but you sell it on the short side. Given the example in whichmarket value of underlying shares has grown, this is a good method formaking the strategy work well. You preserve the original locked-in strikeprice, but you recapture your long-premium investment.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
The strategy assumes that the higher strike priced short calls will expireworthless. You risk exercise in this strategy, but that would produce a 5point profit as long as you use the next increment of strike prices forthe short positions. You can also roll forward to avoid or defer exercise.However, remember that this strategy remains conservative only as longas the short position does not expire later than the long position.
Using the Forward Roll EffectivelyRolling forward is attractive when the underlying stock’s price is rising.The purpose in rolling is to avoid exercise; at the same time, the shortpositions cannot expire later than the long position. What should youdo if and when exercise appears imminent?For example, let’s say you originally purchase a Coca-Cola 40 call expiring in 27 months and later sell a 45 call scheduled to expire 3 monthsearlier. Today, the stock’s market price is 2 points above the short call’sstrike price. You could roll the short position forward 3 months to deferexercise; you could also roll forward and up to the next strike increment; that puts the call out of the money by 3 points and creates a situation in which both short and long calls expire at the same time. Thisis not desirable because you will probably want to exercise the long callafter the short call has expired.An alternative is to roll both long and short positions. Roll the short callforward and up to escape the in-the-money status; also roll the long position forward. By closing the current position and opening one with a laterexpiration, you will have to pay additional premium. However, as long aspremium levels for the long and short positions offset one another withina close range, this adjustment is worthwhile. You replace the short-callstrike price with a new short call 5 points higher. This avoids exercise or,in the event of exercise, creates a 5-point increase in future profit.Another choice is to replace the current long position with a later expiring call and also increase to the next higher strike increment. Becausethis position is already in the money, you can probably buy the highercall at a reduced intrinsic value of 5 points. So, while you increase yourfuture purchase price at exercise by 5 points, you save 5 points today by
Chapter 6 Alternatives to Stock Purchase
145
replacing the existing long call with a higher strike price. The fourchoices in this situation, illustrated in Figure 6–1, are as follows:1. Roll the short call forward to a later expiring position.2. Roll the short call forward and up to the next strike increment.3. Roll the short position forward and up, and roll the long position forward.4. Roll both positions forward and up.1 - ROLL SHORT FORWARDstrike
2 - ROLL SHORT FORWARD AND UPstrike
short
strike increments
tshorlong
strike increments
t
strike increments4 - ROLL SHORT AND LONGFORWARD AND UP
3 - ROLL SHORT FORWARD AND UP;ROLL LONG FORWARDstrike
shor
strike
shor
t
long
strike increments
Figure 6–1 Rolling strategies, contingent purchase cover.
The viability of these rolling techniques depends on current optionpremium values. As a general rule, rolling forward produces higherincome because you are “buying” more time. Rolling up is likely to offset that time advantage, especially when you move from in-the-money
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
to out-of-the-money status. The, In picking a rolling strategy, considerthe net balance between credit or debit, compared to the advantagesgained by avoiding exercise or changing strike price.
Short Puts and Contingent PurchaseYou are not limited to long LEAPS calls to enter a contingent-purchasestrategy. You can also use short puts. When you sell puts, you arerequired by your brokerage firm to have adequate funds on deposit tosatisfy exercise of the put, if and when that occurs. The benefit of theput strategy is that money flows to you rather than away from you.Time value is also an advantage. You receive a premium for selling theput, and that premium value declines over time, even when the stock’svalue falls to in-the-money price levels. Time value may offset intrinsicvalue to a degree.Using the same stocks as examples for reviewing long-call strategies,we can use puts to set up a short-position contingent purchase. Webegin with a review of the strike price. If you would be happy toacquire shares at that price, based on the fundamentals, then the shortput is an excellent strategy. It can go in one of two possible directions.First, the stock does not move in the money, in which case you canlater buy the puts to close at a profit or allow them to expire. Second,the stock’s market value declines below strike price; in this event, youcan either wait for exercise or roll forward and down to avoid or deferexercise. When you roll forward and down, you expose yourself tomore time, but you reduce the basis in the event of later exercise byone strike price increment.
The Value of Selling PutsTable 6–3 summarizes a series of puts below current market value forthe 10 stocks in our model portfolio.In the section concerning long calls, diversification was sensiblebecause the long position was employed. In a strategy with short positions, the same rationale applies in the sense that you do not know
Chapter 6 Alternatives to Stock Purchase
147
Table 6–3 Stocks for Contingent Purchase Using Short PutsName ofCompany
Symbol
CurrentPrice*
Clorox
CLX
$55.91
Strike prices 50/45/40Coca-Cola
KO
XOM
FNM
FDX
GD
JCP
PEP
WM
XRX
3.80
2.40
1.40
1.55
0.50
0.10
—
1.20
—
2.30
1.10
0.45
3.30
1.80
0.90
6.80
4.90
3.40
—
6.60
—
6.30
4.50
—
8.60
6.70
5.10
8.60
4.60
2.30
11.10
7.20
4.20
2.90
1.45
0.60
—
2.35
—
2.10
0.95
0.40
3.00
1.70
0.85
2.80
1.30
0.50
3.80
2.05
—
1.00
0.50
0.20
1.45
0.75
0.35
$38.43
Strike prices 35/30/25Xerox
0.45
$48.48
Strike prices 45/40/35WashingtonMutual
—
$38.20
Strike prices 35/30/25Pepsi Cola
2.75
$100.01
Strike prices 100/90/80J.C. Penney
3
$87.78
Strike prices 85/80/75GeneralDynamics
2
$67.65
Strike prices 65/60/55FederalExpress
1
$ 48.70
Strike prices 45/40/35Fannie Mae
January 2007 Puts
3
2
$ 38.90
Strike prices 35/30/25ExxonMobil
January 2006 Puts1
$14.32
Strike prices 12.50/10/7.50
* Stock prices and option premium values based on prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).
which stock will rise and which will fall in market value. At the sametime, you probably would not prefer to acquire shares of all 10 stocks inour example if current market value declined below the indicated strikeprice levels. You can use the short-put contingent-purchase strategy onany single stock or on a combination of issues, depending on your willingness to leave funds on deposit and also based on the attractiveness ofthis strategy.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
If you decided to short puts on all of these stocks, you could also varythe strike prices and expiration dates. In Table 6–3, we present 15month and 27-month expirations to demonstrate how the time valuein short puts can work to your advantage. While you would not have toselect puts with the same expirations, we can judge this strategy bymaking comparisons. For example, if you restricted your analysis to themedium-level strike price, you would receive premiums totaling $2,080(for the 15-month puts) or $3,275 (for the 27-month puts).2 The nettransaction would not involve receipt of those premiums, however. Thenet margin requirement would simply be reduced by those levels. Inthis sample mid-range strike price, the net purchase amounts are summarized in Table 6–4 on page 150.These net payments would have to be made only if and when the putswere exercised. So, in determining whether it makes more sense toemploy 15-month or 27-month puts, you need to realize—in this example, at least—that the difference between these two studies is very close.
The Value of Shorter Exposure TermsGiven the shorter time span of the 15-month mix of puts, it is preferable to employ these for several reasons:1. Less time is required for leaving funds on deposit. The money youhave to leave on deposit in the event of exercise—whetherinvolving one stock or all five—will be committed a full yearless if you use the shorter expiring options.2. Turnover profits are higher. By using puts with closer expiration,you are free to repeat this strategy if and when the short putsexpire. As a result, you can create more short-term profits orcontingent purchase opportunities.3. Time value premium decline more rapidly. Time value premiumtends to evaporate with greater speed in the months prior to
2 Because not all indicated strike prices reported availability, we estimated some values. For
Clorox, we estimated a 1.00 premium for the January 45 put.
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149
Table 6–4 Purchase Prices, Net of Short-Put Premium
Company
PutStrikePrice*
Symbol
15-MonthExercise
27-MonthExercise
Clorox
45
CLX
$4,500
$4,500
Coca-Cola
30
KO
3,000
3,000
Exxon Mobil
40
XOM
4,000
4,000
Fannie Mae
60
FNM
6,000
6,000
Federal Express
80
FDX
8,000
8,000
GeneralDynamics
90
GD
9,000
9,000
J.C. Penney
30
JCP
3,000
3,000
Pepsi Cola
40
PEP
4,000
4,000
WashingtonMutual
30
WM
3,000
3,000
Xerox
10
XRX
1,000
1,000
Total exercisecost
$45,500
$45,500
Less premiumsreceived
–2,080
–3,275
Net purchaseprices
$43,420
$42,225
* Stock prices and option premium values based on closing prices as ofOctober 22, 2004.Source: Chicago Board of Exchange (CBOE).
expiration than in preceding months. Thus, the 15-month putslose time value much more rapidly than the 27-month putswithin the coming 15 months. If you determine that it would bebetter to close and replace these short positions prior to expiration, it would be more profitable with the 15-month puts.
150
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
We return to the same question we ask for all strategies. Is it conservative? Does this strategy suit your risk profile, and would you behappy to acquire stock on the basis of exercised short puts? Whilestock values would be lower in the event of exercise, your basis wouldbe discounted by the premium received. You would probably not wishto enter short contingent-purchase positions on a portfolio of 10stocks all at the same time; this example simply illustrates the overalleffect of doing so. The strategy is more applicable to most situationsby looking at a single stock and calculating the likely outcomes basedon its price movement.For example, if you sold the January 2006 Federal Express 80 put, yourpremium income would be 4.5 points, so your basis in the stock uponexercise would be $75.50 (before calculating net trading costs). As longas the exercise occurred at a time when the stock’s market value wasbetween $75 and $80 per share, this contingent purchase would notcreate a paper loss. However, even when exercise does create a loss, youcan employ rescue strategies to offset that loss.
Rescue Strategy Using CallsLet’s say you sell a put as part of your contingent-purchase strategy andthe put is exercised. It creates a paper loss. What can you do to recoverin this situation?The solution depends on the point value of the net loss. In the preceding example, we showed how the Federal Express put exercise wouldnot create a net loss if the stock’s market value was between $75 and$80 per share. However, what if market value declined below that level?The first strategy to employ is the roll forward and down to avoid ordefer exercise. For example, once the Federal Express stock fell belowstrike price, you could replace the 80 put with a later expiring 75 put.Even so, if the stock were to continue to decline, it could eventually beexercised. Market prices may also fall suddenly, so you do not alwayshave the opportunity to employ a rolling strategy. Exercise could occurwithout advance warning.
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151
Rescue Strategy Based on Smart Stock ChoicesWhen you end up with stock put to you above current market valueand your basis still produces a net loss, you have three choices. First,you can simply wait out the market.Second, you can sell a covered call to offset the paper loss. The dangerin the covered call position is that it may be exercised. You do not wantto set up a situation in which exercise would create an overall net loss,so premium level of the call has to be adequate to offset the paper loss,trading costs, and income tax on your gain. If that is not possible, thenit makes no sense to write a call.The third choice is to employ a combination of average-down strategiesand short calls. This strategy assumes that you are willing to buy moreshares of the stock. Remember, the underlying assumption for all ofthese conservative strategies is that (a) you have prequalified the stock,(b) your hold continues to apply, and (c) you would be happy to acquiremore shares. For example, let’s assume that your net basis in FederalExpress is $75 per share and that current market value is about $70 pershare. If you were to buy 200 more shares, your average basis would be$71.67 per share. What is the current value of the 75 calls, given variousexpiration dates? In our previous examples, we saw that Federal Express15-month calls brought about 6 points of premium even when strikeprice was 7 points in the money (compare Table 6–1: Federal Expressmarket value at $87.78, 15-month 95 call valued at 5.90).In this example, with average cost of $71.67 per share, we may alsoassume we could locate a 75 call available for about 6 points in premium. So, if you bought an additional 200 shares at 70 on top of the current value of 75, average basis would change to $71.67 per share, andyou could then sell three calls with strike price of 75, receiving about 6points for each:
152
Total basis in stock, 300 shares @ 71.67
21,500
Less premium received, 3 calls @ 6
–1,800
New net basis (65.67 per share)
19,700
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
In the event of exercise, the 300 shares would be called away at $75 pershare compared to your adjusted basis of $65.67 per share. Total profitbefore trading costs and taxes is $9.33 per share, or $2,799. This rescuestrategy is illustrated in Figure 6–2
1
4-
oints4.70 p- - - - - - - -------
5
- - 9.- -33 p- -oints--
6
7
--
----------
3
ts6 poin - - - - - --------
-----
--
--
2
---
78777675747372717069686766656463626160
Figure 6–2 Rescue strategy, average down with covered calls.
The strategy has seven segments, as reflected in the figure:1. The original put was exercised with a strike price of $75 pershare.2. The net basis in acquired shares was $70.30: strike price less$4.70 premium.3. An additional 200 shares are purchase at $70 per share.4. The new net basis is $71.67 per share.5. Three 75 calls are sold at 6.6. The new basis is $65.67 per share.7. The calls are exercised at $75, creating a profit of $9.33 pershare.
Chapter 6 Alternatives to Stock Purchase
153
Programming a Profitable ResultEven though the sequence of events depicted in Figure 6–2 included a significant point decline in the stock, when the stock’s price recovered andthe last calls were exercised, the outcome was profitable. But what if thestock’s price did not recover? The new basis (step 6) was $65.67 per share,but what if current market value remained at $60. In this situation, if thecalls expired worthless—which would happen as long as market valueremained below $70 per share—you would be free to sell the shares, simply hold for long-term appreciation, or use more option strategies.There is a tendency to think about stocks in terms of current marketvalue in relation to past market value. If a stock is at $79 per share andover time it falls to $60, the general opinion is that its value has fallen.So value—as defined in terms of market price—tends to be a relativeidea. However, as the rescue strategy reveals, you can forget about relative value and use options to reduce your basis. This adjusts the perception that the stock has fallen from the original cost of $79 to $60; if youreduce your basis to $65.67 through various options strategies, the realistic gap is only 5.67 points, not 19 points. When combined with priceaveraging, the use of covered calls can turn a loss situation into a smaller paper gap or even into an overall profitable situation.
The Ratio Write—Before Adjustingto Make It ConservativeA somewhat less conservative strategy is the ratio write. However, riskscan be eliminated so that the ratio write fits within the definition of conservative risk. First, an explanation of the unadjusted strategy: the ratiowrite is a method in which you partially cover your calls. For example, ifyou own 300 shares and you sell four calls, it is a 4-to-3 ratio write. Youcould view this as having three covered calls and one uncovered call, oras a 75 percent coverage ratio. The higher the number of shares, thelower the risk. For example, 400 shares with five uncovered calls is anapproach with less risk than 300 shares with four uncovered calls.The advantage of the ratio write is that it increases premium incomewith only moderate increase in risk. A variation on the ratio write is to
154
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
spread strike prices over a range. For example, if your basis in 400shares of stock is $22 per share, and the stock is now worth $21, youmay decide to write five calls; you could employ a combination of twocalls with striking prices of $25 and three with later expiring strikeprices of $30. The risk is relatively low for two reasons. First, all calls areout of the money, and the two upper-level strike prices are 9 pointshigher than the current market value. Second, two of the calls willexpire sooner, and that eliminates all of the market risk for the remaining calls, also eliminating the uncovered portion of the ratio write. Ifthe stock’s price exceeded the strike price of 25, you could roll forwardand up on any or all of these positions to avoid exercise.In this example of the ratio write, the strategy could be rolled forwardand up indefinitely to avoid exercise and to keep risks at a manageablelevel. Even if the 25 calls were exercised, the 30 calls could either beclosed or rolled; so unless the stock’s price soared quickly past the higher strike price, risk of exercise would not be immediate.
Converting the Ratio Write into a Conservative StrategyEven with this logic, the ratio write continues to present risks that contradict your risk profile. The solution involves using a method forreducing worst-case risk by offsetting the exposed top-side uncoveredcall. That is achieved by going long on a higher strike price call to offsetthe uncovered position.For example, consider once again the Federal Express range of options.Let’s assume that you own 300 shares with an original basis of $80 pershare; today’s price is $87.78 per share. The month is October. You entera ratio covered call position involving four calls, but you also buy anadditional call, which essentially eliminates all of the ratio risk. The following represents using actual closing values as of October 22, 2004:Sell two January 2005 90 calls @ 2.50
$500
Sell two April 2005 95 calls @ 2.15
430
Buy one April 2005 100 call $ 1.05
–105
Net credit
$825
Chapter 6 Alternatives to Stock Purchase
155
In this situation, you have created a combination yielding 9.4 percentreturn in 6 months, which annualizes out at 18.8 percent. Half of theexposure lasts 3 months until January; the other half goes out 6months, until next April. The exposed additional 100 shares are protected by the April 100 long call. In the worst-case scenario—all shortpositions exercised—you could use the long call to satisfy assignmentof the fourth short call, costing you $500 (the difference between the100