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cussed previously. He looked at the matrix of each stock and how the options volume was distributed. What he found was that all 14 stocks hadlots of activity, spread across several call options. He also checked thenews to make sure there had not already been a big announcement thatmight account for the unusual activity. None were eliminated by this rule.So there were still 14 candidates. Here is what happened to thesestocks in the ensuing days. On Friday, October 12, 16 days after the ﬁrstalerts and 13 days after the last alerts, 10 had increased in price, while 4had decreased in price. The stocks (with percentage change) that increased were ADVS (+22.1 percent), RE (+25.5), NETA (+42.5), MYG(+16.3), NWS (+9.49), AH (+16.4), SMTF (+32.3), RATL (46.4), MCDT(+47.8), and CVTX (+7). The four that decreased were CMX (–4 percent),DME (-7), CVC (-7.8), and GD (–.2). Of the candidates that increased inprice, many did so by a substantial percentage, while the percentage dropfor the other four was not as large.These are indeed impressive results. However, with all due respect toJim, by coincidence I think he may have hit an unusually good patch. Mygut feeling is that the success rate, longer-term, is more like 50 percent—or perhaps even as low as 30 percent. A longer-term study is needed to determine this. Still, the approach is a good one—and an exciting one—withquick, exhilarating payoffs. When a trade does not work out, you are not init very long, either.A less than 50 percent success rate should not discourage you. Muchlike the way the venture capitalist operates, where one or two home runscan pay for several duds, your really big proﬁts will come from the occasional trades where you get three, four, and ﬁve times or more from yourinitial investment. One thing to watch out for is the dry spells, sometimeslasting months, when there is no merger activity—such as the bear marketwe were in at the time of this writing.Please read Jim’s excellent article, “Trading Unusual Call Activity,” onthe OptionVue web site, to learn more about Jim’s simple and consistenttrading rules, as he offers some important tips on selecting the best optionstrategy, limiting losses, and running with winners.
COVERED WRITING WITH CONVERTIBLE SECURITIESOften overlooked in the investment arena are convertible securities. Convertible securities are corporate bonds or preferred stock with a conversion privilege. That is, they may be converted into common stock at aprescribed ratio.As Value Line (my favorite source of information about convertible
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securities) is apt to point out, convertible securities offer an attractive alternative to the common stock. First, they are higher quality securitiesthan the common. Holders of convertible bonds and convertible preferreds have a claim on assets before stockholders in the event of ﬁnancialdistress. Second, the conversion privilege causes the convertible securityto participate with the common in upside moves. On the other hand, if thecommon falls, the convertible security’s fall is cushioned by its increasingyield, to the point where its investment value as a simple bond or preferredstock takes over. Many convertibles have a signiﬁcant yield advantageover the common stock—sometimes yielding up to 10 percent or more.That convertibles have more upside potential than downside risk iswhat makes them unique. Much like a long call option, the performanceproﬁle of almost every convertible security curves upward to the right.And since the conversion privilege is perpetual, convertible securities donot experience time decay the way call options do.Long-term investing in top-rated convertible securities can bring aboutan enviable track record. Value Line, for example, boasts a 19 percentcompounded annual return over the past 30 years on its convertible security recommendations. We are going to look at how the returns from thesesecurities might be enhanced further through the sale of covered calls.The standard covered write—where calls are sold against commonstock positions—is a widely used investment strategy. Less well known isthe fact that selling call options against convertible securities is also classiﬁed as a covered write. Carefully selected covered writes using convertible securities can produce some extremely interesting, high return/lowrisk investments.Let’s look at a couple of these now.
Millennium Pharmaceuticals (MLNM)Millennium has a convertible bond. Statistics for this bond, as well as Millennium common, are given in Table 5.1. The projected price and interestearnings performance for the bond is shown in Figure 5.5. Note that thesolid line represents the performance for the bond one year out, while thedashed line represents one half year out.With its upward curvature, this investment looks very attractive. However, is there anything we can do, using options, to lift the left side and perhaps the center?Let’s say we’d be willing to give up some of the terriﬁc potential gainsof the right side to do it. What about selling covered calls? With a conversion ratio of 23.768, one needs to buy 5 bonds in order to write one covered call option, or 9 bonds in order to write two covered call options.We’ll round up to 10 bonds.
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TABLE 5.1 Millennium PharmaceuticalsConvertible Bond
Common Stock
Issue 5.5s2007Price 89Conversion Ratio 23.768Current Yield 6.2%Intrst. Pymt. Dates 3-15, 9-15
Price 23Volatility 58%52 Week High 55.8052 Week Low 16.53Dividend nil
Projected % Change in Cv. Bond vs. the Commonwhen the Common Is 23.05 and the Bond Is 89.37
CommonCv Bond
+50%+17%
+25%+8%
–25%–8%
–50%–14%
FIGURE 5.5 Millennium Pharmaceuticals’ Projected Performance
The calls we’re electing to sell are the just-out-of-the money Jan0325 calls. The performance graph of the combined position is shown inFigure 5.6.The effect of adding the calls is to lift the left side and the center, butpush down the right side. The right side actually slopes down now. Why isthat? Considering that the performance graph for a traditional coveredwrite (based on the common) is ﬂat to the right, and since we are looking
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FIGURE 5.6 Combined Position—Millennium Pharmaceuticals
at a fully covered (no naked options) write here, shouldn’t this investmentalso be ﬂat to the right?Not necessarily. The key lies in how the convertible moves with thecommon. If it moves very slowly, on a percentage basis, it might not beable to compensate for the short calls. This curve slopes down to theright because, as the price of the common goes up, the 10 rising bondscannot gain fast enough to make up for losses coming from the twoshort calls.One could experiment with adding extra bonds to bring up the rightside. However, this is bound to bring down the left side at the same time.An alternative plan for responding to a rising stock price might be to rollthe calls up to a higher strike if the underlying goes above a predetermined price.Look at this investment! It yields up to 58 percent if the stock remainsaround its current price, and it is proﬁtable across a broad range of prices.The overall expected return (as seen in the lower left area of the ﬁgure) is30 percent, plus or minus 18 percent. Contrast this with just owning thebonds, where the expected return is 27 percent plus or minus 41 percent.Evidently, the main impact of selling calls on this investment is to bringthe variance down quite a bit.
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Wendy’s International (WEN)Now let’s look at an example using a convertible preferred stock—theWendy’s $2.50 convertible preferreds. Details on the preferred, as well asthe common, are given in Table 5.2.With a little trial and error, I found that 220 shares in this preferredconveniently put the number of equivalent shares just over 400, so that wecould consider selling four covered calls. (Note that equivalent sharesmeans the number of common shares you would have after converting,and is computed by taking the number of preferred shares times the conversion ratio.)I selected the at-the-money Jan03 30 calls to sell. The performancegraph of the combined position is shown in Figure 5.7.As in the previous example, this investment would be proﬁtableacross a broad range of common stock prices. While the stock is currentlyin a long-term uptrend, if the downside risk is bothersome, you could consider buying some puts to compensate. This would raise the left side butlower the right side and the center of the performance lines. Figure 5.8shows the performance of a possible position where two long at-themoney puts have been added. With the two puts, the performance line wastilted—up on the left side, down on the right.Both of these examples were done using a securities margin of 100percent, fully paying for the convertible. Investors interested in turbocharging these trades are welcome to experiment with buying the convertibles on margin.
TABLE 5.2 Wendy’sConvertible Preferred
Common Stock
Issue $2.50Price 59.00Conversion Ratio 1.893Current Yield 4.2%Div Dates 3-15, 6-15, 9-15,12-15
Price 30.20Volatility 28%52 Week High 31.4552 Week Low 20.00Dividend 0.06/Q
Projected % Change in Preferred vs. the Commonwhen the Common Is 30.20 and the Preferred Is 59.00
CommonPreferred
+50%+30%
+25%+16%
–25%–22%
–50%–45%
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FIGURE 5.7 Combined Position—Wendy’s
FIGURE 5.8 Combined Position with Two Long Puts
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Possible PitfallsIt is important to be aware of the potential pitfalls of this investment approach. The following section is a quote from an article entitled “CoveredCall Writing with Convertible Securities,” by Donald T. Mesler, publishedin the May 1982 issue of the AAII Journal.Anyone actively engaged in an option writing program quickly realizes that there is a great deal more to the strategy than is evidencedby the proﬁt proﬁle describing the outcome at expiration.For example, if the stock drops sharply, should it be sold, hedgedwith another option at a lower exercise price, or held unhedged? Various rollover rules have been developed which deﬁne the strategy for replacing options when stock prices are dynamic. All investors shouldunderstand the alternatives and chart a plan of action in advance.Convertibles complicate these issues further because they areonly a proxy for stock, not a direct substitute. For example, if theunderlying stock advances and the option is assigned, the owner ofthe convertible does not, in fact, have stock to deliver. Stock must bepurchased in the open market for delivery or conversion instructions must be issued. By this action the convertible will be exchanged for stock which can then be used to meet the optionassignment.When converting, however, any premium over conversion valuefor the convertible is lost. In the case of a bond, accrued interest isalso sacriﬁced. Therefore, it is frequently a superior strategy to buystock on the open market to satisfy an option assignment. The convertible is liquidated in a separate transaction.Convertible positions also require more intense surveillance.For example, call provisions may necessitate conversion earlierthan planned. Further, in merger/takeover situations, convertibleholders often receive special offers which must be evaluated carefully. Nevertheless, with proper selection and careful monitoring,these factors seldom have a negative impact on the option writingprogram. They are a small price to pay for the higher expected returns which the convertible offers.Convertible securities are for more conservative investors. In terms ofrisk, they fall somewhere between the risk levels of common stock andhigh-grade corporate bonds. The upward curvature of their performanceconveys an inherent edge. And selling a few covered calls, and/or possiblybuying a few puts, can mitigate what little downside risk they have.
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A good source of information is the Value Line Convertibles Survey,available on a trial and subscription basis from www.valueline.com. As itis important for the investor to understand convertible securities in moredetail than covered here, I recommend that the reader enter into a servicelike this and learn more before investing.When searching for investment candidates, a favorable stock/convertible price relationship is important. You need a convertible whose price issigniﬁcantly enhanced by its conversion value. Such a convertible moveswhen the common moves, and this is important if you’re going to use options positions with the convertible. I look for a conversion premium of 25percent or less—meaning that the security’s conversion value comprises75 percent or more of the value of the convertible.There are more than 200 stocks that have both actively traded convertibles and listed options. Portfolios can easily be constructed to satisfy individual requirements for quality, diversiﬁcation, and risk.
INVESTING IN A ROUGH MARKETWhat can you do when the market looks like it’s in a complete meltdown?Investors are dumping their shares, buyers are too scared to step in, andlong-term holders sit in dejected silence. Is there an appropriate optionstrategy if you think this might be the bottom?While some prefer to stay out until a bottom has been clearly formed,others, like myself, are incorrigible bottom ﬁshers. I know myself, andwhat I know is that I just can’t stand to be out of a rising market. So if Idon’t try to pick the bottom, I’ll just end up paying more for stocks ontheir way up.“Okay, then. Just buy now and hold for long term—what’s the problem?” you might say. Well, what if these stocks go to half price again fromhere? I’ll be in anguish.Can options help? Yes they can. At the same time that I buy stock, Ican also buy puts. This gives me all the upside potential of owning thestock, while the puts serve as an insurance policy in case the stockkeeps dropping.Interestingly, buying calls creates the very same performance curve asbuying stock and buying puts, but uses a lot less money. An appropriatenumber of calls can be bought that provides the same upside potential asowning the stock, but for a fraction of the cost. Thus, more of your capitalcan remain in cash.Investing this way creates a built-in stop. For example, if the callscost 15 percent of what buying the stock would have cost, then buying the
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calls is equivalent to buying the stock and setting a 15 percent downsidestop. Using calls also gives you two extra advantages. The big advantageis that if the stock dips 15 percent or more and then comes back, you’restill in it. (With stock, you would have been stopped out and then missedthe recovery.) The other advantage is that your idle cash gets to earn interest in the meantime.One caveat: If the stock ends up at the same price come expiration,the option will have lost all its time value. If this was an at-the-money orout-of-the-money option, it lost all its value. In contrast, if you had boughtstock, you’d have broken even.When buying calls, the question naturally arises, “What duration andwhat strike price should I select?” This is an important question, becauseit can make the difference in the calls costing anywhere from 10 to 50percent of the equivalent quantity of stock. The duration depends onhow long you expect the recovery might take. If you think it might takesix months, then get six-month options or perhaps a little longer. Remember, if your ﬁrst calls end up worthless because the market dropsanother 20 to 50 percent, you can be thankful you didn’t have shares,then buy calls again. As for strike price, I would recommend buying theat-the-money calls.Why not use LEAPS? You can, but LEAPS cost more, and thereforeyou have more capital at risk. If you use LEAPS, you would probably wantto set a stop-loss point.When the market has fallen sharply, buying a few calls is a great wayto put your toe in the water immediately, rather than waiting for a clearbottom to form. Rather than setting a stop on the calls, you can just ﬁgurethat the calls might become a complete loss. But who knows? They mightget you in on the ﬁrst leg of a new uptrend. Often the ﬁrst gains as a market comes off a bottom can be some of the largest percentage gains. Buying calls gives you the feeling of being “in,” and yet having your losseslimited automatically.
Using the Covered Combo in Volatile MarketsIn tumultuous markets you would think there would be abundant optionstrading opportunities. Turns out, it’s not that simple. In such an environment, options are very expensive. That would suggest ﬁnding a way of selling them, but what is a good, safe way to sell them? Covered writing isokay, but it leaves you holding the bag in a swift decline. And naked writing is pretty dangerous in a volatile environment.Question: Would you enjoy picking up some good stocks just belowcurrent price levels? If so, the answer may very well be the covered combo.The covered combo strategy consists of a covered write (long stock
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and short call) plus a short put. In order to receive some good premiumand downside protection, an at-the-money or just-out-of-the-money call istypically selected to form the covered write.The put is typically selected at a strike below the current stockprice, at a price where you would be happy to buy more shares of thisstock. Technically, this short put is a naked option. However, it’s not adangerous option. If the stock falls below the put’s strike price you maybe assigned, thus buying more shares. You simply need to be preparedto do this.Since the covered combo has you selling options, this strategy takesfull advantage of currently inﬂated option prices.In a volatile market, literally hundreds of stocks can be ripe for covered combos. A key is to pick a stock you’d like to own, or perhaps oneyou own already. Then you ﬁgure out how many shares to buy (if any) andwhich calls and puts to sell.Say, for example, we liked Microsoft (MSFT), once trading at 96.Microsoft’s historical volatility chart shows IV (implied volatility) atextremely high levels currently (see Figure 5.9). This means its optionsare expensive.The following covered combo might be considered:Buy 500 shares of Microsoft stockSell 5 calls Jul 100Sell 5 puts Jul 90
FIGURE 5.9 Historical Volatility of Microsoft
at 96at 10.5at 7
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Let’s analyze this trade. With the stock at 96, the proposed out-of-themoney call sale would give us 10.5 points of downside protection. In otherwords, the stock could drop to 85.5 before we incurred a loss. These expensive options give us a lot of downside protection!Then add to that the credit received from selling the puts. Regardlessof where the stock price goes, the extra 7 points received from selling theputs can be considered as helping us buy the original 500 shares of stockfor 7 points less. Considering the proceeds from the puts and the calls together, we’re effectively buying the stock for approximately 78.5. That’s17.5 points below current market value!If the stock falls below 90, our then in-the-money puts would probablybe assigned, and we’d be buying an additional 500 shares of stock at 90. Sothe ﬁrst 500 shares cost us 78.5 each. The second 500 (if the stock dropsbelow 90) cost us 90 each. That means we got 1,000 shares at an averageprice of 84.25. Not bad, when you consider that the current price of Microsoft is 96. Magic!So what’s the catch? The catch is that if the stock falls further, we’relosing $1,000 per point on our 1,000-share stock position. But presumablythis was an acceptable risk for us as willing stock investors. If, instead,the stock soars, we make $10,580 and no more, as our upside gains arecapped by the short calls. Figure 5.10 illustrates the Microsoft coveredcombo.
FIGURE 5.10 Covered Combo—Microsoft
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Notice that the shaded areas, representing the ﬁrst and second standard deviation price moves, extend to an extremely wide price range, reﬂecting the high-volatility environment. The OptionVue 5 software usedthis high volatility in its projection of possible future stock price behavior.Even when we let the program assume this continued high volatility(which is unlikely to continue through July expiration, 139 days hence),this investment looks very good.Interestingly, the graph does not show what happens in all circumstances. It is conservative. It only shows what happens if the stock goesstraight from its current price to other prices represented along the horizontal axis. If the stock drops to 90 and you get assigned an extra 500shares, and then the stock goes back up, your outcome is better than thegraph depicts—much better.
Buying Deep In-the-Money OptionsBuying deep in-the-money (ITM) options is a good way of carrying out directional trading in a high-volatility environment.Although markets are unpredictable, one thing is certain: High volatility won’t last forever. Sooner or later, volatility has to come back down. Asit does, the at-the-monies (ATMs) and out-of-the-monies (OTMs) are goingto be hurt, while the deep ITMs will be relatively unaffected, since theyhave very little time value.One reason I like using deep ITM options is that as the market trends,it naturally experiences one- or two-day setbacks, and these setbacks affect my deep ITM calls very little on a percentage basis. I am more comfortable seeing my position through, and because they have very little timepremium, I am not nervous about time decay.On a risk/reward scale, purchasing deep ITM options falls betweenthe higher-leverage/higher-risk purchase of ATM or OTM options, and themore sedate buying of vertical debit spreads. Buying vertical debitspreads and buying deep ITM options are both good strategies for insulating yourself from the effects of falling volatilities. However, the purchase of deep ITM options is more straightforward, as it does not involveas many transactions.Buying LEAPS can accomplish a similar thing. However, buyingdeep ITM (usually nearby) listed options is a little higher on the risk/reward scale because they move point-for-point with their underlying.Also note that LEAPS possess a much greater vega risk (exposure to afall in volatility).Some traders might object that deep ITM options have a widerbid/asked spread, causing the trader to experience higher transactioncosts. I have not found this to be a problem, especially if you can direct
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trades to the best market. If you cannot direct your trades, placing an order between the bid and the asked is often successful.Some investors also object, psychologically, to paying a higher pricethan about 6 per option, preferring options priced between 2 and 5. This isnot rational. A friend once refused to buy a stock priced above 100. I explained to her that the price itself makes no difference; it’s the ﬁnancial ratios that count.Holding deep ITM calls (or puts) is like buying (or shorting) the underlying stock, in a sense, as deep ITM options move point-for-point with theirunderlying. However, buying deep ITM options costs less than the stock,allowing you to either leverage up or retain cash for other investments.For example, let’s consider Dell stock and options. At one time, Dellwas trading at 26.5 and seemed to be in the early stages of an uptrend. Togo long, you could buy 1,000 shares of stock for $26,500. Or you couldconsider buying calls. The nearbys (with three weeks to go) were pricedas follows:Strike3027.52522.520
Bid0.401.202.504.406.50
Asked0.501.302.604.606.70
Time Premium0.451.252.550.500.10
As you can see, the deep ITM calls have a time premium of only 0.10.That means the passing of time and a possible volatility drop could onlytake 0.10 away from you in the next three weeks! The equivalent of 1,000shares of stock can be had by buying just 10 of these options for $6,700. Ineffect, it’s like buying cheap, $6 warrants. If Dell simply rises three points,the warrant will go to $9.Contrast that with the experience of those who buy the ATM or OTMoptions. First, with their delta of 50 each (as the stock moves one point,the option moves about half a point), getting a 1,000-share equivalent stakewould require buying 20 of the ATM options. This position would cost$5,200. Say the stock moves up a bit, then pulls back over the next coupleof days, returning to its starting price. Now your option is worth a bit lessthan what you paid, making you wish you’d waited until now to buy it.Then the stock advances a couple of points. Nice, but your options areworth about 3 at this point—up only slightly because of one week’s timedecay. Rather frustrating.The ITM option buyer, however, is satisﬁed to see his option up twopoints at the end, and never having seen it fall below his purchase price in
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the meantime. So when you’re looking at going long (or short), considerusing deep ITM calls (or puts).
Using Index Options to Protect a Stock Portfolio“The worst bear market since 1974–1975,” the Wall Street Journal saidof the Nasdaq in the year 2000. Those of us who endured it may neverforget it.The good news is that hedging with options is a terriﬁc way to ﬁghtback. The simplest ways of hedging a stock portfolio are buying puts orselling calls. Of the two, buying puts is preferable, because if a wave ofselling carries the market deep, puts work harder for you the farther thesell-off goes. This happens automatically because as the puts get driveninto the money, their delta increases. In contrast, short calls would be going out of the money at that time, their delta dropping, and their protectiongrowing weaker.You can either buy puts on each of your individual stock holdings, orbuy an appropriate number of index puts. I prefer the latter because it’smuch simpler to get in and out of puts at various stages of a bear market.Ideally, you should pick an index that is indicative of your portfolio andhas a liquid options market. For instance, the QQQ (Nasdaq 100) matchesup well with a portfolio of tech stocks and its options are heavily traded.To ﬁgure an appropriate number of index options to buy, start withthe dollar value of your stock portfolio, divide by the price of the index,and apply a “fudge factor” for beta. For example, if you have reason tobelieve your stocks are 30% more volatile than the QQQ, multiply by1.30. The result is the number of equivalent deltas of the index yourportfolio represents.Let’s say you have a $150,000 portfolio of high-tech stocks. Divide bythe price of the QQQ (currently 40) and multiply by a beta fudge factor of,say, 1.30, and you have approximately 4,900 QQQ deltas. In other words,it’s as though you have approximately 4,900 shares of the QQQ.To hedge this fully, you would need to buy enough puts (and/or sellenough calls) to bring your net delta down to zero. Using at-the-moneyputs, with a typical delta of 50 each, this would require 98 puts (4,900 divided by 50).To partially hedge, you could buy fewer than 98 put contracts. To overhedge (something I like to do when I feel sure the market is going down),you could buy more than 98 contracts.To illustrate how effectively options can be used to cushion the pain ofa bear market, I would like to relate my experiences of late 2000.From September 1 through mid-November, I allowed my stock portfolio to go unhedged, because I was not convinced that we were in a bear
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market. (In retrospect, I can see all the head-and-shoulder formationsclearly now.) As a result, my portfolio was decimated. However, in midNovember I decided to ﬁght back. I sold off several losing stocks to raisec