 price.  Covered  calls  can  also  be  combined  with  a  number  ofbearish options strategies to create additional downside protection.
Covered Call Case Study
Covered calls are often used as an income strategy on stocks that we areholding long-term. They also can be used as a short-term proﬁt maker bypurchasing the stock and selling the call at the same time. The idea is tosell a call against stock that is already owned. If we do not want to give upthe  stock,  we  must  be  willing  to  buy  the  option  back  if  it  moves  in-the-money. However, if we feel the stock will not rise above our strike price,we would beneﬁt by selling the call.
On December 1, 2003, shares of Rambus (RMBS) were falling back af-ter an attempt to break through resistance at $30. The stock rose to a highof  $32.25,  but  ultimately  ended  ﬂat  on  the  session  right  at  $30  a  share.Viewing the chart, we might have decided that $30 would hold and that en-tering a covered call strategy might work well.
By entering a short call, we have unlimited risk to the upside. How-ever, by owning the stock, we mitigate this risk because we could use thestock to cover the short call. Let’s assume we didn’t already own Rambus,so we need to purchase 500 shares at $30 and sell 5 December 30 calls at$2.05 each. Our maximum proﬁt for this trade is $1,025 [(2.05 × 5 ) × 100]and this occurs if the stock is at or above 30 on December 19. The maxi-mum risk is still large because the amount of the credit for selling the callsdoes little for a major drop in the stock. Our breakeven point is at 27.95,
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which is ﬁgured by taking the credit received and subtracting it from theprice of the underlying at trade initiation (30 – 2.05). Figure 4.13 shows therisk graph for this trade.
Though we have limited our upside risk by using stock to cover theshort call, we still have signiﬁcant risk to the downside if the stock wereto fall sharply. However, if the stock remains near $30, we get to keep theentire credit, even though there wasn’t a loss in the shares of stock. Sincethe passage of time erodes the value of the option, it’s best to use short-term options.
In our example, shares of RMBS did try several times to break higher,but each time resistance held and the stock ultimately closed at $26.37 on
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Covered Call Case Study
Strategy: With the stock trading at $30 a share on December 1, sell 5 De-cember 30 calls @ 2.05 and buy 500 shares of Rambus stock.
Market  Opportunity: Expect  consolidation  in  shares  after  failure  tobreak out.
Maximum Risk: Limited as the stock moves lower (as the stock can onlyfall to zero). In this case, the loss is $790.
Maximum  Proﬁt: Credit  initially  received.  In  this  case,  5  calls  @  2.05each = $1,025.
Breakeven: Price of the underlying asset at trade initiation – call optioncredit. In this case, 27.95: (30 – 2.05).
Margin: None.
expiration December 19. At expiration, the stock position was down $3.63a share, or $1,815: (3.63 × 500). However, the loss was offset by the $1,025received  from  the  credit  from  the  short  calls.  So,  the  trade  results  in  a$790  loss.  A  trader  could  continue  to  sell  calls  against  the  stock  eachmonth if it is felt the stock will remain near the strike price.
LONG PUT
In the long put strategy, you are purchasing the right, but not the obliga-tion,  to  sell  the  underlying  stock  at  a  speciﬁc  price  until  the  expirationdate. This strategy is used when you anticipate a fall in the price of the un-derlying shares. A long put strategy offers limited proﬁt potential (limitedbecause  the  underlying  asset  can  fall  no  further  than  zero)  and  limiteddownside risk. It is often used to get high leverage on an underlying secu-rity that you expect to decrease in price.
If you want to go long a put, your risk curve would look like the graphin Figure 4.14. Note how the proﬁt/loss line for a long put strategy slopesupward  from  right  to  left.  When  the  underlying  instrument’s  price  falls,you make money; when it rises, you lose money. Note how the proﬁt on along put is limited as the price of the underlying asset can only fall to zero.The long put strategy is often used to get high leverage on an underly-ing security that is expected to decrease in price. It requires a fairly smallinvestment and consists of buying one or more puts with any strike andany expiration. The buyer of put options has limited risk over the life ofthe option, regardless of the movement of the underlying asset. The put
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FIGURE 4.14 Long Put Risk Proﬁle
option  buyer’s  maximum  risk  is  limited  to  the  amount  paid  for  the  put.Proﬁts are realized as the put increases in value as the underlying asset’svalue falls. Buying a put is a limited-risk bearish strategy that can be usedinstead of shorting stock. It is best placed when the option is exhibitinglow implied volatility. Keep in mind that the further away the expirationdate is, the higher the premium. But the cost that time contributes to a putpremium  must  be  balanced  out  by  the  need  for  sufﬁcient  time  for  theunderlying shares to move into a proﬁtable position.
Long Put Mechanics
Let’s create an example by going long 1 January XYZ 50 Put @ 5. The costof this position is $500 (5 × 100 = $500) plus commissions. The maximumrisk for this trade is limited to the premium of the put option while the re-ward  is  limited  to  the  downside  until  the  underlying  asset  reaches  zero.Looking at the risk graph in Figure 4.14, notice how potential proﬁt andloss  values  correspond  to  underlying  share  prices.  Can  you  see  thebreakeven point? The breakeven is calculated by subtracting the put pre-mium from the put strike price. In this trade, the breakeven is 45 (50 – 5 =45),  which  means  that  XYZ  would  have  to  fall  below  45  for  the  trade  tostart making a proﬁt.
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Exiting the Position
Choosing  an  exit  strategy  depends  on  the  movement  of  the  underlyingshares as well as changes in volatility.
• XYZ falls below the breakeven (45): Either offset the long put byselling a put option with the same strike and expiration at an accept-able proﬁt or exercise the put option to go short the underlying mar-ket. You can hold this short position or cover the short by purchasingthe shares back at the current lower price for a proﬁt.
• XYZ rises above the breakeven (45): You can wait for a reversalor offset the long put by selling an identical put option and using thecredit received to mitigate the loss. The most you can lose is the initialpremium paid for the put.
In this example, let’s say the price of XYZ falls from $50 to $40. Thisresults in a rise in the premium of the October 50 put to 13.75. You nowhave a decision to make. To exit a long put, you can offset it, exercise it,or let it expire. To offset this position, you can sell the March 50 put andreap a proﬁt of $875: (13.75 – 5) × 100 = $875. If you choose to exercisethe position, you will end up with a short position of 100 shares of XYZat $50. This would bring in an additional credit of $5,000 (minus com-missions).  However,  you  would  then  be  obligated  to  cover  the  shortsometime in the future by purchasing 100 shares of XYZ at the currentprice. If you covered the short with the shares priced at $40, you wouldmake a proﬁt of $500: (5,000 – 4,000 = $1,000 for the stock minus $500for the cost of the put). Therefore, offsetting the option yields a higherproﬁt.  In  fact,  you  almost  never  want  to  exercise  an  option  with  timevalue remaining because it will be more proﬁtable to simply sell the op-tion. In addition, exercising the long put requires enough money in yourtrading account to post the required margin to short the shares.
Long Put
Strategy: Buy a put option.
Market Opportunity: Look for a bearish market where you anticipate afall in the price of the underlying below the breakeven.
Maximum Risk: Limited to the price paid for the put option premium.
Maximum  Proﬁt: Limited  below  the  breakeven  as  the  stock  price  canonly fall to zero.
Breakeven: Put strike price – put premium.
Margin: None.
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Long Put Case Study
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A long put involves the purchase of just one option strike and one expira-tion month. Buying a long put is a strategy that beneﬁts from a decline in theunderlying security. However, unlike selling stock short, there isn’t a needto use margin and entering the put is an easy process. As with any long debitstrategy, a long put will suffer from time decay, so we want to use optionsthat have at least 60 days, and preferably more, until expiration.
By entering a long put, we have limited our risk to the initial cost ofthe put. At the same time, we have limited reward to the downside as theunderlying can only fall to zero. Let’s go back to the fall of 2000 and seehow  entering  a  put  on  the  Nasdaq  100  Trust  (QQQ  or  Qs)  would  haveworked following a triple top formation.
The Qs moved above 100 on August 31, but then formed a bearish pat-tern on September 1. At this time, it seemed that a break back below 100would be bearish for the Qs. Thus, on September 5, an option trader couldhave entered a long put when the Qs closed at $99.50.
The  December  100  puts  could  be  purchased  for  $8  each.  Our  maxi-mum risk would then be $4,000 if we were to buy ﬁve contracts. Figure4.15 shows the risk graph for long puts on the Qs.
The risk graph shows that as the Qs fall, the puts increase in worth. Ofcourse, if this trade were to be held until expiration, the price of the Qswould need to be below 92 to make a proﬁt. However, the quicker the Qsdrop, the larger the proﬁt in the near term. In order to see a double in thistrade, a move to about 85 would need to occur.
At  the  close  of  trading  the  very  next  day  (September  6),  these  putswere worth $9.38, a gain of nearly $700 in one day. The Qs continued tofall during the next several months, leading to a sharp decline for security,but  a  large  increase  in  the  long  puts.  Selling  continued  after  the  Qs  fell
Long Put Case Study
Strategy: With  the  security  trading  at  $99.50  a  share  on  September  5,2000, buy 5 December 100 puts @ 8.00 on the Nasdaq 100 Trust (QQQ).
Market  Opportunity: Expect  decline  in  shares  following  bearish  chartpattern.
Maximum Risk: Limited to initial debit of $4,000.
Maximum Proﬁt: $46,000 if Qs were to go to zero. In this case, the putsincreased to $17 each for a proﬁt of $4,500.
Breakeven: Strike minus the initial cost per put. In this case, 92: (100 – 8).
Margin: None.
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FIGURE 4.15 Risk Graph of Long Puts on the QQQ (Source: OptioneticsPlatinum © 2004)
through their 200-day moving average and were unable to recapture thisprior support level. On the close of trading October 3, 2000, the Qs were at84 and the puts were now selling for $17 each. At this time, the long putscould have been sold for a proﬁt of $4,500: [(17 – 8) × 5] × 100 = $4,500.
SHORT PUT
A short put strategy offers limited proﬁt potential and limited, yet highrisk.  It  is  best  placed  in  a  bullish  market  when  you  anticipate  a  rise  inthe  price  of  the  underlying  market  beyond  the  breakeven.  By  selling  aput option, you will receive the option’s premium in the form of a credit
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into  your  trading  account.  The  premium  received  is  the  maximum  re-ward for a short put position. In most cases, you are anticipating that theshort put will expire worthless.
If  you  want  to  go  short  a  put,  your  risk  curve  would  look  like  thegraph in Figure 4.16. A short put strategy creates a risk proﬁle that slantsdownward  from  right  to  left  from  the  limited  proﬁt.  Notice  that  as  theprice of the asset falls, the loss on the short put position increases (untilthe price of the underlying stock hits zero). Additionally, the proﬁt is lim-ited to the initial credit received for selling the put. When the underlyinginstrument’s price rises, you make money; when it falls, you lose money.This strategy provides limited proﬁt potential with limited risk (as the un-derlying can only fall to zero). It is often used to get high leverage on anunderlying security that you expect to increase in price.
As  explained  earlier,  when  you  sell  options,  you  will  initially  receivethe premium for which you sold the option in the form of a credit into youraccount.  The  premium  received  is  the  maximum  reward.  The  maximumloss is limited to the downside until the underlying asset reaches zero.
What kind of a view of the market would you have to sell puts? Youwould  have  a  bullish  or  neutral  view.  The  breakeven  for  initiating  thetrade is the strike price at which the puts are sold minus the premium re-ceived. If the market were to rise, the position would increase in valueto  the  amount  of  premium  taken  in  for  the  puts.  Looking  at  the  riskgraph, notice that as the price of the asset falls, the loss of your short put
FIGURE 4.16 Short Put Risk Graph
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position increases (see Figure 4.16). This strategy requires a heavy mar-gin  deposit  to  place  and  is  best  placed  using  short-term  options  withhigh implied volatility, or in combination with other options.
Short Put Mechanics
Let’s  create  an  example  by  going  short  1  January  XYZ  50  Put  @  5.  Themaximum proﬁt on this trade is equal to the amount received from the op-tion premium, or $500 (5 × 100 = $500) minus commissions. To calculatethe  breakeven  on  this  position,  subtract  the  premium  received  from  theput strike price. In this case, the breakeven is 45 (50 – 5 = 45). If XYZ risesabove $45, the trade makes money. You earn the premium with the passageof time as the short option loses value.
A short put strategy creates a risk proﬁle that slants downward fromright to left (see Figure 4.16). Notice that as the price of the asset falls, theloss of your short put position increases until the price of the underlyingstock hits zero. This signiﬁes that the proﬁt increases as the market priceof the underlying rises.
Exiting the Position
A short put strategy offers three distinct exit scenarios. Each scenarioprimarily depends on the movement of the underlying shares.
• XYZ  rises  above  the  put  strike  price  (50): This  is  the  best  exitstrategy. The put expires worthless and you get to keep the premium,which is the maximum proﬁt on a short put position.
• XYZ reverses and starts to fall toward the breakeven (45): Youmay want to offset the position by purchasing a put option with thesame strike price and expiration to exit the trade.
• XYZ  falls  below  the  put  strike  price  (50): The  short  put  is  as-signed and the put writer is obligated to buy 100 shares of XYZ at $50per  share  from  the  put  holder.  The  short  put  seller  now  has  a  longshares position and can either sell the XYZ shares at a loss or wait fora reversal. The maximum loss occurs if the price of XYZ falls to zero.The short put writer then loses $5,000 (100 shares × 50 = $5,000) lessthe  $500  credit  received  from  the  premium,  or  a  total  loss  of  $4,500(5,000 – 500 = $4,500).
Short Put Case Study
When we buy a put, we want the underlying security to move lower. Thus,when  we  sell  a  put,  we  want  the  stock  to  rise.  However,  our  maximum
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Short Put
Strategy: Sell a put option.
Market  Opportunity: Look  for  a  bullish  or  stable  market  where  a  riseabove the breakeven is anticipated.
Maximum  Risk: Limited  as  the  stock  price  falls  below  the  breakevenuntil reaching a price of zero.
Maximum Proﬁt: Limited to the credit received from the put premium.
Breakeven: Put strike price – put premium.
Margin: Required. Amount subject to broker’s discretion.
proﬁt is the premium we receive for selling the put, so if we expect a largemove higher in the stock, we would be better off to buy a call. Selling aput is best used when we expect a slightly higher price or consolidation totake place.
When a stock falls sharply to support in one or two sessions, this isoften  a  good  time  to  look  at  selling  puts.  If  we  expect  that  the  stockmight start to consolidate following a decline, selling a put could pro-vide  nice  proﬁts.  However,  the  risk  remains  rather  high  because  thestock  could  continue  to  fall  and  a  put  seller  is  at  risk  the  whole  waydown to zero.
On July 31, 2003, shares of Cardinal Health (CAH) fell $10 to about$55 a share. This drop might have seemed overdone given the circum-stances  and  a  trader  could  have  entered  a  short  put  near  the  close  ofthe  session.  The  August  55  put  could  be  sold  for  $1.65,  which  meansselling  ﬁve  contracts  would  bring  in  $825.  We  want  to  use  the  frontmonth  option  because  time  value  works  in  our  favor.  If  CAH  were  tostay at $55 or move higher by August 15, the trader would receive themaximum proﬁt.
The risk graph shown in Figure 4.17 details how the risk in this tradeis rather high compared with the reward. This means that margin will bean  issue  and  that  a  large  amount  of  margin  will  be  needed  to  enter  thistype of trade. The breakeven point for this trade is calculated by subtract-ing the credit received from the strike price (55 – 1.65 = 53.35). Thus, evena slight move lower would still generate a proﬁt in this trade, but if CAHwere to fall below $53.35 the losses would start to grow.
Fortunately, shares of CAH did move higher after this decline, leavingthe  trader  with  the  maximum  proﬁt  of  $825  from  the  sale  of  ﬁve  puts.Later, we will talk about a less risky way to proﬁt using spreads instead ofnaked options.
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FIGURE 4.17 Risk Graph of Short Puts on CAH (Source: Optionetics Platinum © 2004)
Short Put Case Study
Strategy: With the stock trading at $54.75 a share on July 31, 2003, sell 5August 55 puts @ 1.65 each on Cardinal Health (CAH).
Market Opportunity: Expect CAH to consolidate or move higher follow-ing large one-day drop in shares.
Maximum Risk: Unlimited as stock falls all the way to zero.Maximum Proﬁt: Initial credit received. In this case, $825: (5 × 1.65) × 100.
Breakeven: Strike price minus the initial credit per put. In this case, 53.35:(55 – 1.65).
Margin: Extensive.
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COVERED PUT
You can also use a covered put in a bearish market to proﬁt from a possi-ble increase in a short stock or futures position. A covered put consistsof  selling  the  underlying  futures  or  stock  position  and  selling  a  put  tocover  the  underlying  asset’s  position.  This  trade  can  be  very  risky,  be-cause it involves short selling a stock, which requires a high margin. Thereward on a covered put is limited to the difference in the initial price ofthe short underlying asset minus the strike price of the short put plus thecredit received for the option premium.
Covered Put Mechanics
In  this  example,  let’s  go  short  100  shares  of  XYZ  @  50  and  short  1  JuneXYZ 45 Put @ 2.50. The risk graph below shows a covered put position atexpiration.  Once  the  market  moves  to  the  upside  above  the  breakeven,there  is  unlimited  risk.  Margin  is  $7,500  (stock  price  plus  50  percentmore);  however,  the  credit  on  the  short  stock  is  $5,000.  In  addition,  thecredit  on  the  short  put  is  $250.  Total  credit  is  $5,250.  The  maximum  re-ward on this trade occurs if XYZ closes at or below 45 at expiration. Themaximum proﬁt for this trade is $750: (50 – 45) + 2.50 × 100 = $750. Figure4.18 shows the risk proﬁle for the covered put example.
As  with  most  short  strategies,  this  trade  is  hazardous  because  it
FIGURE 4.18 Covered Put Risk Graph
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comes  with  unlimited  risk.  The  breakeven  of  a  covered  put  strategyequals the price of the underlying asset at trade initiation plus the optionpremium. In this trade, the breakeven is 52.50: (50 + 2.50 = 52.50). Thatmeans that if XYZ moves above $52.50, the trade will lose $100 for eachpoint  it  rises.  In  fact,  the  higher  the  underlying  asset  climbs,  the  moremoney will be lost (see Figure 4.18).
Exiting the Position
Since a covered put protects a stock only within a speciﬁc range, it is vitalto monitor the daily price movement of the underlying stock. Let’s investi-gate optimal exit strategies in the following scenarios:
• XYZ declines below the short strike price (45): The short put isassigned and you are obligated to buy 100 shares of XYZ from the op-tion buyer at $45 per share. However, you can unload these shares forthe short share price of $50. This exit process garners the maximumproﬁt of $750.
• XYZ  declines  below  the  initial  stock  price  (50),  but  remainsabove the short strike price (45): The short put expires worthlessand you get to keep the premium received. No losses have occurredon the short stock position and you are ready to place another cov-ered put to bring in additional proﬁt on the position if you wish.
• XYZ  rises  above  the  initial  stock  price  (50)  but  stays  belowthe  breakeven  (52.50): The  short  stock  position  starts  to  losemoney, but this loss is offset by the credit received from the short put.As  long  as  the  stock  stays  below  the  breakeven,  the  position  willbreak even or make a small proﬁt.
• XYZ rises above the breakeven (52.50): Let the short put expireworthless  and  use  the  credit  received  to  partially  hedge  the  loss  onthe short stock position.
Both covered calls and covered puts are high-risk strategies, althoughthey can be used to try to increase the proﬁt on a trade. It is essential to beaware  of  the  risks  involved  and  to  be  extremely  careful  in  selecting  theunderlying markets for your covered call or put writing strategies.
Covered Put Case Study
A  covered  put  can  be  used  to  proﬁt  in  the  short  term  by  going  short  astock and then selling a put to bring in additional income. The reason acovered put is not a suggested strategy for most traders is because it hasunlimited risk. The sale of the put does help offset the cost of the short
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Covered Put
Strategy: Sell the underlying security and sell an OTM put option.
Market Opportunity: Slightly bearish to neutral. Look for a market whereyou expect a decline or stability in price with little risk of the market rising.
Maximum Risk: Unlimited as the price of the underlying increases to theupside above the breakeven.
Maximum Proﬁt: Limited to the credit received on the short put option +(price of security sold – put option strike price) × 100.
Breakeven: Price of underlying security at trade initiation + put premiumreceived.
Margin: Required. Amount subject to broker’s discretion.
stock