ies
23
$8
Profit/(Loss)
$6$4DELLCov. Write
$2$0($2)($4)$22.50
$25.00
$27.50
$30.00
$32.50
DELL Price at Expiration
Figure 1.4 Long DELL vs. Covered Write
tight range around its current price, the strategy becomes very interesting. Chapter 2 analyzes this strategy in depth.Writing Covered PutsThe writer of a put option assumes the obligation to purchase sharesof the stock under option at the exercise price until the expirationdate. If the investor has sufﬁcient cash set aside to fully pay for thestock should she be assigned, the put is covered (or cash-secured, asnoted earlier).Sometimes investors are looking to add shares of a particularstock to their portfolio and are willing to pay the going marketprice. They then simply instruct their broker to buy this equity. Atother times, they are looking to purchase a stock but are not willing to pay the current price. They would rather wait for the stockto come down to a level where it represents a better buying opportunity. They can either monitor the price of the stock and pounceif it gets down to their target price, or they can place an open orderinstructing their broker to buy the shares at a stated price. In eithercase they run the risk of the stock “running away” from them; thatis, its going up signiﬁcantly before they have had a chance to takea long position.An alternative strategy to the waiting game or the open order isto write a put option. Look at the following quotes:
24
The Options Strategist
Caterpillar (CAT):May 55 put:
$59.49$1.10
An investor would like to add CAT to her portfolio but is unwilling to pay $59.49. She decides to write the May 55 put instead ofplacing an open order to purchase shares at $55. The May optionshave nine weeks until they expire. Let’s compare her decision towrite puts to the open order alternative.Risk. The ultimate risk is stock ownership: both the put writer andthe investor who places an open order to buy the stock at $55 couldend up as stock owners and would thereby have the full downsiderisk of the stock. In our example, the investor who places the openorder would have $55 at risk (the cost of the stock). With just $53.90at risk (the $55 cost of the stock less the $1.10 option premiumreceived), the put writer has a slight advantage.Stock never gets down to target price. If CAT does not driftdown to $55 by option expiration, neither investor will end up owning the stock. The difference is that the investor who placed the openorder will have nothing to show for his efforts, while the put writerwill keep the $1.10 option premium for writing the put. The putwriter is in fact being paid to wait, and when the put expires worthless, she may have the opportunity to write a CAT July 55 put andcapture additional option premium. A net advantage to the putwriter.Cost of changing one’s mind. The investor who places anopen order can change her mind at any time, at no cost, so long asshe does this before CAT hits $55. Changing her mind could meandeciding not to purchase the stock after all, or moving her buyingtarget up or down. The put writer’s situation is a bit more complexas she may be able to change her mind even after CAT has dippedbelow the $55 strike price. The put writer can cancel her obligationto buy CAT by covering the puts she wrote; i.e., by buying back theMay 55 puts. If CAT has risen or remained unchanged, she willprobably be able to buy back the puts for less than the premium sheobtained when writing them, generating a small proﬁt. If, on theother hand, CAT has fallen below $55 and the puts have not yet been
Options 101: Basic Terms, Deﬁnitions, and Strategies
25
assigned, our investor will still have a chance to cover her puts, butshe may be doing so at a loss if the options are trading above the$1.10 premium she received. So a mixed verdict: no cost to theinvestor who placed the open order and who acts in due time, butfor the put writer a little more time to act (as it is extremely unlikelythat the options would be assigned as soon as CAT hits $55) but thepossibility that covering the short put position will result in a loss.Stock at target price only brieﬂy. If CAT pulls back from itscurrent price and drops to, say, $54.50, where it trades for a fewdays, and then rallies back to the $60 area, an investor who placedan open order will have purchased the shares at $55 as she was waiting in the queue bidding $55. The put writer will probably not beassigned on her short put, especially if CAT makes only a brief tripbelow $55. The investor with the open order only needs CAT totrade down to $54.99 to purchase her shares; the put writer willeither need CAT to be below $55 at expiration (in which case it isvirtually certain she will be assigned on her puts) or for the stock todrop signiﬁcantly below the option’s strike price in order to getassigned early. A slight advantage goes to the investor with the openorder.Table 1.4 calculates the put writer’s proﬁt and loss for variousCAT prices at option expiration.Before we comment on some of the numbers in Table 1.4, let’sreview the three alternatives open to the writer of a put option.
Table 1.4CAT Priceat OptionExpiration
Change inCAT Pricefrom $59.49
Value of55 Put
PremiumReceived fromWriting 55 Put
Proﬁt/(Loss)on 55 Put
$65
$5.51
$0
$1.10
$1.10
$60
$0.51
$0
$1.10
$1.10
$55
($4.49)
$0
$1.10
$1.10
$50
($9.49)
($5.00)
$1.10
($3.90)
$45
($14.49)
($10.00)
$1.10
($8.90)
26
The Options Strategist
■
If the option is out-of-the-money, the simplest choice is to let thisoption expire worthless. In our example, this outcome wouldrequire CAT to be trading above $55 at expiration.
■
The put writer may decide to cancel her obligation by covering(buying back) the written option. If the option is trading below$1.10 when it is covered, the trade results in a proﬁt; otherwise,a loss would have to be absorbed.
■
Wait for the option to be assigned. If CAT is trading below $55and the expiration date is fast approaching, the investor whosticks to her game plan of buying CAT at $55 does nothing andwaits to be advised by her broker that she has been assigned onher short put position and is therefore now a CAT shareholder.
Given these three alternatives, the numbers in Table 1.4 can beinterpreted as follows: if CAT ends up above $55 at option expiration, the put writer will pocket $1.10 as the option expires worthless. If CAT drifts down below $55 and the decision is made to coverthe put, the loss realized is that given in the far-right-hand column.But if the put writer decides to wait for assignment and purchasethe stock, the losses calculated in the far-right-hand column wouldonly represent unrealized losses on the stock purchased at $55 butwith a cost basis of $53.90. In this last instance the investor wouldown the shares and would be at risk of any further decline in theprice of CAT but would also be in a position to beneﬁt from anyrally in the price of the stock. If this investor wrote the put in orderto purchase CAT on a pullback in its price, we have to assume thather outlook for the longer term is that at $55, CAT represents goodvalue and that she is comfortable holding these shares, even thoughthey may now be below her purchase price.Figure 1.5 gives a visual representation of the strategy’s potentialproﬁt and loss, keeping in mind that if the stock is purchased onassignment, the losses are unrealized.As a reference point, Figure 1.5 also illustrates the proﬁt and lossof a long stock position taken at a $59.49 price. Not illustrated is theresult of placing an open order to purchase CAT at $55; the proﬁtand loss on such an order would depend on whether or not CATtraded down to $55 over the next nine weeks.
Options 101: Basic Terms, Deﬁnitions, and Strategies
27
$15
Profit/(Loss)
$10$5Short 55 Put
$0
Long CAT
($5)($10)($15)$45
$50
$55
$60
$65
$70
CAT Price at Expiration
Figure 1.5 Long CAT vs. Short 55 Put
The Building BlocksThe four strategies described here represent all the building blocksnecessary to create any option position. The following chapters willlook at these strategies on their own and in conjunction with oneanother in more complex positions such as spreads and straddles.
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BASICINVESTMENTSTRATEGIES
M
OST OPTION STRATEGISTS use the expressions cov-
ered write and buy/write interchangeably to refer tothe same option strategy. We beg to differ.Although both strategies involve a long stock position and the writing of call options, we view thecovered write and the buy/write as two distinct strategies to beused in different investment environments.For investors who have never traded listed options, the coveredwrite is probably the best place to get their feet wet; we will makeit this chapter’s starting point as well. For most brokerage ﬁrms,covered writing is a “Level 1” strategy, which means it is relativelyeasy to get approval for it and it may represent the ﬁrst step in getting experience to move on to more complex strategies.29Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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The Options Strategist
Covered WritingAs explained in Chapter 1, a covered write combines a long stockposition with written call options. The ﬁrst question we need toanswer is when would an investor initiate a covered write.Entering into the StrategySay you own 500 shares of Harley-Davidson (HDI) that you purchased a little while ago and that are now trading at $50.01. Thestock has moved up nicely since you purchased it, and although youare not ready to pull the trigger you would certainly become a selleron a rally to the $55 area. A couple of clicks of your mouse and youﬁnd the following quotes on HDI call options:July 55 calls (4 weeks):August 55 calls (8 weeks):November 55 calls (21 weeks):
$0.55–$0.65$1.15–$1.30$2.60–$2.75
If you are looking to sell your shares at $55 you could alwaysenter an open order with your brokerage ﬁrm instructing them tosell your shares when they reach this target price. Or you could consider writing ﬁve HDI call options. You would be assuming the obligation to sell your 500 shares at $55, a price you are comfortablewith. Should you write the July calls, the August, the November, orlook at the even longer-dated options? November looks like a longtime away. July is just around the corner, but $0.55 on 500 sharesrepresents $275 before transaction costs, not what you consider asigniﬁcant amount. The August calls look interesting: $1.15 pershare translates into $575 before fees, not a negligible amount, andyou are comfortable holding your shares over the next eight weeks.Instead of placing an open order to sell your shares at $55, you writeﬁve of the August 55 calls.Possible OutcomesThe best thing that can happen to you (meaning the outcome thatgenerates the highest proﬁt) is for HDI to rally somewhere north of$55 by the August expiration date, the call options to be assigned,and for you to sell your shares at your target price of $55. Of course,
Basic Investment Strategies
31
an investor who writes options receives a premium, which he getsto keep. This amount would be credited to his account on the business day following the trade (one-day settlement), and since thereis no margin required on this option position, the cash can be withdrawn or reinvested. Another way to look at it is that if the calls areassigned and you do end up delivering your shares at $55, youreffective selling price would be $56.15—$55 from the sale of thestock and $1.15 from writing the options.The second possibility is for HDI to rally but not reach $55. Itcould be anywhere in the $51 to $54 range at August expiration, inwhich case the calls you wrote would expire worthless and youwould keep the option premium. In addition, you could either sellyour shares, write another ﬁve 55 calls (expiring in September orOctober), or revise your target price. In any case, you would stillpocket the $1.15 per share you received when you initiated theoption position.Finally, HDI could drop in price by August expiration. At thispoint it will be necessary to revise your original target price of $55.Is this still realistic? Do you still want to hold the shares? Is $50 amore realistic exit point? If you answered yes to the last question,then writing September or October 50 calls may make the mostsense. In any case, you still keep the $1.15 option premium.And what if, should HDI rally past $55, you decide to reconsideryour target price of $55? We deal with this topic later in the chapter,in the section titled “Rolling Strategies.”Covered Writing Against Losing PositionsIt’s easy to set a selling target on a stock that was purchased at alower price. But what if you bought shares of AOL Time Warner(AOL) in the $30 to $31 range and the stock in now $27.66? Does itmake sense to write covered calls?To answer this question, forget about options. You bought AOL,the stock is down, and you are reevaluating this investment. If youcome to the conclusion that it is best to cut your losses and reinvestthe funds somewhere else, then covered writing may be a strategicalternative. For instance the two-month 30 calls are trading at $0.80.If you write these and the stock rebounds to $30, you could get outeven or with a slight proﬁt. But the option’s premium of $0.80 may
32
The Options Strategist
be a small consolation if the stock continues its southbound journeyand ends up in the $20 range.If you are a disciplined investor, you have sold stocks at a loss.Writing covered calls against a losing stock position can ease thepain. Some investors refuse to write calls under these circumstancesbecause they don’t want to lock in a loss. But whenever you sell astock at a price below its cost basis, you are also locking in a loss.Another way to deal with losing stock positions is the repair strategy outlined in Chapter 5.The Naked Covered WriterAlthough the expression appears to be an oxymoron, we haveencountered many naked covered writers. These are investors who,to continue with the same example, may hold shares of HDI andhave no intention of selling them. They look at the July 55 calls andconclude: “This stock will never get to $55 over the next four weeks,so I’ll write the July 55 calls. It’s not a lot of money, but it’s freemoney.”Naked covered writers are effectively writing uncovered calloptions. It’s not that they don’t hold the underlying security theymight be forced to deliver, but that they have no intention of making good on their obligation. They may as well not own the shares,but then they would run into problems with their brokerage ﬁrm’scompliance department. So they use stocks they own to margin theiruncovered option positions.We all know what happens at some point. Within two weeks, HDIrallies to $56 or $57 and the naked covered writer is forced to coverhis short option position. He pays $2 or $3 for options he wrote at$0.55. If you recognize yourself here, it’s time to own up. Maybe youhave been going to cocktail parties telling everyone that you havebeen “trading options” by writing some covered calls. Except thatyou never, or rarely, let a stock get called away. When your shortcalls go in-the-money, you cover them so you won’t have to sell yourshares. This is probably a very good indication that covered writingis not for you. Maybe you don’t have the temperament or the riskproﬁle of a covered writer. As long as you recognize it, this shouldnot be a problem. There are plenty of other options strategies outthere (eight additional chapters follow this one), and one or twomay be better suited to your investing style.
Basic Investment Strategies
33
Covered Writing ConclusionWe view covered writing primarily as a strategy to help you set selling targets. For a lot of investors, writing covered calls increasestheir discipline: they are forced to decide today at what price theywill sell a stock they own. They will need enough discipline not toturn into a naked covered writer.Another take on covered writing is that it can be a proﬁtable alternative to entering open sell orders on stocks in a portfolio. There isno cost to entering an open sell order, but there is also no beneﬁt tothe investor if the underlying stock never reaches the order’s selling price. Writing a covered call can be viewed as “getting paid” towait, for the option premium is kept whether the stock reaches theoption’s strike price or not. The downside of the covered write isthat an open order can be canceled at any time at no cost. The covered writer who changes his mind can cover his short option position, but if the stock has rallied sufﬁciently, buying back these callsmay result in a trading loss on the option position.
The Buy/WriteWe view the buy/write as a package: an investor buys a stock andwrites call options simultaneously—a trade that is easily placed atmost brokerage houses. If the covered write is a strategy used to sellstock at target prices, the buy/write is initiated with the aim of earning a speciﬁed rate of return on the overall strategy.Assume, for example, that an investor is looking to establish abuy/write on Microsoft (MSFT) trading at $64.05. The followingshort-term options are listed for trading:February 65 call (3 weeks):February 70 call (3 weeks):February 75 call (3 weeks):March 65 call (7 weeks):March 70 call (7 weeks):March 75 call (7 weeks):
$1.35–$1.45$0.15–$0.25$0.00–$0.10$2.45–$2.55$0.75–$0.80$0.20–$0.25
Our investor selects the March 65 calls (we’ll discuss option selection below), buys 400 shares of MSFT, and writes four of the selected
34
The Options Strategist
calls at $2.45. There are two returns that should interest investorsinitiating buy/writes: the static and the if-called returns.Static ReturnThe static return answers the question What will my return be if theprice of the underlying stock remains unchanged? It is calculated asfollows:$2.45⫽ 3.98%$64.05 ⫺ $2.45It is also customary to annualize this return, especially when comparing buy/writes using options with varying terms to expiration.This is done as follows:3.98% ⫻ 52 weeks⫽ 29.5%7 weeksA more reﬁned calculation of this return would take into accounttransaction fees and dividends (if any) that would be received.Remember to include dividends as part of your return on investment if the ex-date (and not the payable date) falls between the daythe position is initiated and the options’ expiration date.Some may argue that we are double-counting the option premium in the above calculation because it appears in both the numerator (representing the proﬁt earned) and the denominator (where itreduces the initial investment). To understand where we are coming from, assume an investor initiates a buy/write in an accountthat is initially empty. She purchases the shares at $64.05 andreceives $2.45 for writing the call. She obviously has to pay for thestock, but the option premium can be used to partially pay for theseshares. So she needs to deposit only $61.60 per share in her accountto fully pay for the position. This is her initial investment and thedenominator in our equation. If the price of the shares remainsunchanged, the options expire worthless and she is left with theshares worth $64.05—a proﬁt of $2.45 and equal to the option premium; this is the numerator in our equation.
Basic Investment Strategies
35
If-Called ReturnThe if-called return represents the best-case scenario. This returnwill be earned only if the underlying stock rises above the options’exercise price, the options are assigned, and the shares are sold at$65. Its calculation is similar to the static return calculation, but italso includes the stock’s appreciation from its purchase price($64.05) to its potential selling price ($65). This represents the maximum return the strategy can generate.$2.45 ⫹ $0.95⫽ 5.52%$64.05 ⫺ $2.45Once again, it is customary to annualize this last return.5.52% ⫻ 52 weeks⫽ 41%7 weeksThere are two assumptions behind this last eye-popping number.The ﬁrst is that MSFT will rise above $65 and the shares held willbe called away. The second is that buy/writes with similar if-calledreturns will also generate their maximum potential returns. So takethe 41% with a grain of salt and don’t expect that kind of return consistently with this strategy.Expiration and Strike Price SelectionThe preceding example quoted six available option series, whichwas only a fraction of all the options listed. April and July expirations were also available, as were two series of LEAPS expiring inroughly 12 and 24 months. The strike prices also stretched from $25to $110 for some of the short-term options and from $30 to $180 forthe LEAPS. Where does one begin in selecting expiration and strike?First, a lot of options can be eliminated simply because they areso far in- or out-of-the-money. Looking at the February options welisted, the 70 call was bid at $0.15, and there was no bid on the 75call (and those with higher strikes). The February 65 call was $1.35bid; calculating the annualized returns with this call we get 37% forstatic and 63% for if-called. The numbers look better than those
36
The Options Strategist
obtained with the March 65 call, but transaction fees will representa greater percentage of the option premium and the ﬁnal numberscould end up being close to equal, especially the static return.Moving to the March options we note the 75 calls bid at $0.20 (notworth it in dollar terms) and the 70 calls at $0.75. What about thislast one? Here are the returns:Static:
$0.75⫽ 1.18% or 8.8% annualized$64.05 ⫺ $0.75
If-called: $0.75 ⫹ $5.95⫽ 10.6% or 78% annualized$64.05 ⫺ $0.75By comparing the returns from the March 65 and 70 calls we canfocus in on one of the key decisions relating to the buy/write. The65 call has a higher static return, 29.5% annualized, than the 70 call(8.8% ann.). On the other hand, the 70 call has a higher if-calledreturn of 78% annualized versus 41% for the 65 call. The trade-offcomes down to higher static return (obtained with at-the-moneyoptions) or higher if-called returns (generated by writing out-of-themoney calls). Keep in mind that a buy/write has a higher probability of earning its static return than of earning its if-called return.Also notice that as one writes calls that are further and further outof-the-money, more and more of the strategy’s total potential returncomes from stock appreciation and not from the premium receivedfrom writing the options. The potential if-called return of the March65 call was $2.45 from the options’ premium and $0.95 from stockappreciation; for the March 70 call, there was $0.75 of option premium and a full $5.95 of stock appreciation. The more out-of-themoney the call written, the more the overall position starts lookinglike a straight long stock position.There is no one correct answer, but when establishing a buy/write, keep the following in mind:■
Shorter-term options will produce higher annualized staticreturns; be wary of returns generated by options that have lessthan one month until expiration. These numbers are not realisticbecause it is impossible to repeat a two-week buy/write 24 timesin one calendar year.
Basic Investment Strategies
37
■
There is a relatively low probability of realizing the if-calledreturn of shorter-term options. Remember, this requires the stockto move up to or above the option’s strike price by the expirationdate.
■
The further out-of-the-money the written call, the more the position behaves like a pure equity position. If you are so bullish ona $50 stock that you are only willing to write the 60 strike, maybeyou should simply forget about the option. The small premiumreceived will probably not generate a signiﬁcant static return andis probably an inadequate payment for the upside you are givingup.
Breakeven and Downside ProtectionIn addition to the two returns calculated above, investors usuallyrefer to a third number: the strategy’s breakeven. Our MSFTbuy/write had us purchasing shares at $64.05 and writing theMarch 65 calls at $2.45. Our net outlay was $61.60, which representsthe strategy’s breakeven point. A $61.60 stock price at option expiration would have us losing $2.45 on the stock but realizing a gainof $2.45 on the options expiring worthless. We would be breakingeven because even though the gain on the option is a taxable event,the unrealized loss on the stock isn’t (unless we immediately sell thestock).Downside protection simply tells us how far below the currentstock price our breakeven point is. A $61.60 breakeven gives us 3.8%downside protection.In-the-Money Buy/WritesIs there any argument in favor of an in-the-money buy/write? Forinstance, one could purchase Procter & Gamble (PG) at $81.88 andwrite a six-week 80 call at $3.40. Since the call is in-the-money, thestatic return will be the same as the if-called return (if the stockremains unchanged, the call will be assigned). The proﬁt potentialis limited to $1.52 (the $3.40 of option premium less the loss on thestock purchased at $81.88 and sold at $80), a 1.94% return, or 16.8%annualized. This is a more conservative strategy as its maximum
38
The Options Strategist
proﬁt will be attained even if the price of the stock drops, as long asit does not go below $80.What about moving even further in-the-money and writing thesix-week 75 call for $7.30? The proﬁt potential is now down to$0.42—a return of 0.56%, or 4.8% annualized. This is probably toolow a return as it was calculated before transaction costs were takeninto account.Turning to a more volatile stock, we ﬁnd Amazon.com (AMZN)trading at $14.05, the 11-week 12 1⁄2 call at $2.75 and the 11-week 10call at $4.50. Crunching the numbers we ﬁnd that the 12 1⁄2 call yieldsa proﬁt of $1.20, or 10.6% (50% annualized), and the 10 call a $0.45proﬁt, or 4.7% (22% annualized). If the 22% annualized rate ofreturn that would be realized even if AMZN dropped $4 (a full 28%of its current price) sounds very appealing, please read the next section on stock selection and turn to the section on taxes in Chapter10. This last point would be moot if the position were initiated in atax-deferred account.Stock SelectionYou have a certiﬁcate of deposit that is coming due and, given thelow interest rates, you decide to enter the equity markets via abuy/write. You have narrowed your search to two candidates, andwhen you calculate the potential returns with two-month optionsyou obtain the following:Bills Pills: Static return: 1.5%(9% ann.)Bobs Lobs: Static return: 2.2%(13.2% ann.)
If-called return: 3.1%(18.6% ann.)If-called return: 4.5%(27% ann.)
Looks like a no-brainer: Bobs has a higher static and a higher ifcalled return. Why bother with Bills? But wait. Selecting yourbuy/writes strictly on the basis of returns is a recipe for disaster.Bobs is providing higher returns because the options are tradingwith higher premiums. But high option premiums usually reﬂecthigher risk. If you build a buy/write portfolio based on the highestreturns available, you will end up owning a collection of extremelyhigh-risk stocks. Is this what you are trying to accomplish?
Basic Investment Strategies
39
Most investors view the buy/write as a risk reduction technique,so it is doubtful that those attracted to the strategy would want toﬁll their portfolio with today’s most volatile issues that may turn outto be in tomorrow’s equity obituaries. The most important point toremember is that a buy/write involves purchasing a stock. If youwere not doing a buy/write, would you still want this stock in yourportfolio? If the answer is no, you should not include it in yourbuy/write program.Selecting stocks for buy/writes. If you are a straight stockbuyer, you must be able to identify stocks that will go up in price inorder to make proﬁtable trades. However, if you are initiatingbuy/writes you need only identify stocks that will remainunchanged or go up for the strategy to be proﬁtable. The good newsfor investors who use options is that the stocks that remainunchanged or go up (the buy/write candidates) outnumber thestocks that go up (the long stock candidates).
Rolling StrategiesThese follow-up strategies are as applicable to covered writes asthey are to buy/writes although their primary appeal will be toinvestors using buy/writes.Rolling OutA few months ago you initiated a buy/write, purchasing Johnson& Johnson (JNJ) and writing the March 65 calls. It is now Wednesday before option expiration and JNJ has rallied to $66. Assumingthe stock remains unchanged over the next 48 hours, you will beassigned on your calls and forced to deliver your shares. Should youlet well enough alone, or should you take action and see if you canmilk this position for another month? Consider the followingmarkets:JNJ:March 65 call:April 