to venture beyond covered call writing in your tax-deferred account.
Options and TaxesOf the two inevitable facts of life, death and taxes, we would muchhave preferred to write about the former. Unfortunately, we couldnot ﬁnd enough relevance to the topic at hand. This section must beread with the following caveat in mind: the IRS can change the rulesat any time, and given the lag inherent in published material, anyor all that follows could be completely out of date. Do not take anytax-related action without consulting your tax advisor.In a nutshell, options are securities (like stocks and bonds), andoption transactions create capital gains and losses. For simpletrades, buying an option and selling it later, the tax treatment isstraightforward: short- or long-term capital gains (or losses) will begenerated. Writing options also generates capital gains, althoughwriting LEAPS of more than 12 months results in a short-term, nota long-term, gain or loss, even if the option position is closed out orexpires more than 12 months after the option was written. Writing
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options does not create a tax liability: the option’s premium is heldin suspense, and a gain or loss is realized when the option is closedout or when it expires.Covered WritingIt is late November and a stock you purchased a little under a yearago has ﬁnally proven you right and has just doubled to $100. Youare now sitting on a nice unrealized gain, but you are not as willingto liquidate as you probably should be. You reason that if you canhold on just a little longer, your short-term position will become along-term one and beneﬁt from the lower tax rate. And if you carrythis stock into the new year, you can delay paying the capital gainstax another 12 months. You think of buying protective puts, but thestock’s recent volatility makes them prohibitively expensive.Then you think of writing a covered call. Since the run-up in thestock is recent, there are some nice in-the-money calls, such as theJanuary 70, that you could write for a little over $30. You wouldimmediately pocket $30, hedge your position down to $70, and rideinto the new year with little to worry about. Does it sound too goodto be true? It is.The covered write in the preceding example does not ﬁt the definition of a qualiﬁed covered call (QCC). If you wrote this call, thestock’s holding period would be reset to qualify for long-term capital gain status and you would have to hold the stock another 12months. For stocks trading between $60.01 and $150, the optionwritten to create a qualiﬁed covered call cannot be more than twostrike prices below the stock’s closing price on the previous tradingday and, in certain circumstances, cannot be more than $10 in themoney. So with your stock trading at $100, you could write the 90calls, which would qualify as a QCC, but this would suspend yourholding period; the time meter is turned off but not reset to zero.As noted at the beginning of this section, we are dealing with thetax laws as of this book’s writing, and things may have changed. Sohow do you write covered calls without having ﬁrst to consult yourattorney and your tax advisor? The short answer is to stick to at- orout-of-the money calls. If you do, you will not have to worry aboutthe QCC rules. If you would like to write an in-the-money option,then a call will either qualify as a QCC (in which case the holding
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period of stocks held short term is suspended) or it will not (and theholding period of stocks held short term will be terminated). Theintent of the law is to prevent investors from writing deep in-themoney calls and retaining a stock position with very little risk. Asyou have guessed, the difference between a QCC and one that isn’tis the amount by which the call is in-the-money, and this varies asa function of the stock’s price.A further wrinkle to the QCC rules was added in 2002. EffectiveJuly 29, 2002, a further adjustment must be made if the calls writtenhave a term of more than one year. To determine the amount bywhich a call is in-the-money, the price of the stock has to be adjustedupward by 2% per quarter (uncompounded) and the old QCC rulesapplied. For a 13-month option, the price of the stock would beadjusted upward by 8%. So a $100 stock would be deemed to be at$108, making the 100 calls the lowest strike to qualify for a QCC (the100 calls are deemed to be two strikes in-the-money, the most allowable). For a 22-month option, the price of the stock would beadjusted upward by 14%, so for the same $100 stock, the loweststrike to qualify under QCC rules would be the 105. Finally, underthe new rules, no call with a term of more than 33 months can qualify as a QCC, regardless of its strike price.The Wash Sale RuleThe wash sale rule is designed to prevent the following: it is midDecember and you are sitting on 1,000 shares of Big Loser Corp.bought earlier in the year at $44 and now trading at $33. A shortterm capital loss of $11,000 would ease the pain this coming April.You sell your shares to realize a short-term capital loss, and a weeklater you repurchase another 1,000 shares because you are convinced that things will turn around and you don’t want to be leftbehind when the train leaves the station.Wash sale rules will not let you recognize your capital loss on theabove trades. A sale is deemed to be a washed sale if a “substantially identical” security to the one sold is purchased within 30 daysof the sale. Within 30 days means 30 days before as well as after thesale date.You have two choices in this situation: double your risk for 30days by buying 1,000 shares in mid-November and selling youroriginal shares in mid-December, or go 30 days without owning the
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stock after you realize your loss and hope the stock doesn’t get awayfrom you. A variation on the ﬁrst choice would be to purchase calloptions more than 30 days before you sell your shares and exercisethese more than 30 days after you have sold your stock position. Yesyou have to double your exposure to the stock, but the capitalrequired is bound to be signiﬁcantly less than a straight double up.The Collar SagaCollars, as discussed in Chapter 8, are a great way to reduce the riskof a stock position. Sometime in the mid-1990s, some U.S. Treasuryemployees started wondering if investors who “collared” a stockwere reducing both their risk and their upside potential to such anextent that they were effectively out of their position. The idea surfaced that collaring a stock too tightly would be treated as an effective sale; that is, any accrued proﬁt on the stock would have to berealized. Then came a debate as to the meaning of “too tightly” andhow this related to the options’ time to expiration. Another idea wasﬂoated that any collar involving LEAPS would trigger a tax liability. The decade, century, and millennium have come and gone without this issue being resolved.As of this writing, collars are on the back burner. But they havemoved from there to the front burner and back numerous times.Before initiating a collar make sure new rules have not come intoplay.Tax Advice from the ExpertsErnst & Young LLP has written a publication titled Taxes & Investing: A Guide for the Individual Investor that can be found on theChicago Board Options Exchange’s website. We recommend downloading this document because it was prepared by tax specialists,not by an options strategist.
Finding Your StyleWe noted in the Introduction that we would limit ourselves to strategies that can be implemented in the real world by investors andtraders. Readers should not take this as a challenge to go out and
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initiate every strategy that was described in this book. As you readthrough the various chapters you probably thought, “This strategyis something I can see myself doing,” and at other times youthought, “Who in their right mind would want to try this?”A lot of investors and traders limit themselves to a few mainstrategies, with the occasional use of something more exotic. Someoption writers, for example, limit themselves to writing puts onstocks they wish to acquire and calls on stocks they would be happyto sell. They might occasionally use the repair strategy or buy a protective put, but, for the most part, they stick to writing. Somespreaders love to purchase longer-dated options (mostly LEAPS)and write shorter-term options against them. They rarely ever ownstocks. We also know some options buyers who would never getcaught with a short option position.Your goal should be to identify the strategies that ﬁt your investing and trading style and are appropriate for your level of risk tolerance. You can then proceed to master these strategies and todevelop your own options trading style.
INDEXAmazon.com, volatility of, 93American-style options, 3,173–74, 183–84, 239–40Amgen, volatility of, 93Annual meetings, 13AOL Time Warner, volatilityof, 93At-the-money, 7–8, 197calls, 64, 78deltas, 96index options, 186volatility and, 88Bear call spreads, 140–41, 189Bear market, 135–37Bear put spreads, 135–37, 209Beta, 236Bid-ask, 7
Binomials, 10Black-Scholes option pricingmodel, 10, 92, 234–36Breakeven return, 37, 63, 143buying call options, 12buying put options, 17Broad-based index options,174–75Broadcom, volatility of, 93Bull call spreads, 127–34,189entering orders, 134maximum theoretical value,132–33selection, 133–34Bull market, 55bull call spreads, 127–34Bull put spreads, 138–40251
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252
Index
Butterﬂies, 192–94directional, 196–97short, 196strike prices, 194Buy/write investment strategy,33–39breakeven, 37downside protection, 37expiration, 35–37if-called return, 35in-the-money, 37–38static return, 34stock selection, 38–39strike price selection, 35–37Buyers’ rights, 3Buying a straddle, 141–46Buying call options, 11–15,45–49, 55–68. See also Calloptionsannual meetings, 13breakeven point, 12buy call/start saving strategy,47–49corporate literature, 13dividends, 13to hedge a short stock,163–66index options, 185–86investment strategies, 45–49long cash/long call strategy,45–47proﬁtability at optionexpiration, 13–15risk, 12selection, 56–63time constraints, 12–13trading strategies, 55–68upside potential, 12Buying index collars, 181–83
Buying protective puts, 176–81.See also Protective putsBuying put options, 15–19. Seealso Put optionsbreakeven point, 17buying protective puts,176–81capital required, 16–17dividends, 17half-collar, 207–11index options, 185–86investment strategies, 43–45proﬁtability at expiration,17–19protective puts, 43–45, 203risk, 16suitability, 17time constraints, 17trading strategies, 68–75Buying volatilitycall back spreads, 148–51put back spreads, 151–55straddles, 141–46strangles, 146–48Calendar spreads, 197–200Call back spreads, 148–51compared to other strategies,150–51impact of volatility, 151Call buyer, 3Call options, 2. See also Buyingcall optionscovered, 20–23covered calls, 20–23, 247–48deltas, 96–97early assignment, 100–101proﬁtability boundary, 65–66sweet spot, 63–64
Index
Call spreadsbear call spreads, 140–41bull call spreads, 127–34,189call back spreads, 148–51Call writing. See Writing optionsCapital gains and losses, 246CBOE Gold Index, 174CBOE Volatility Index. See VIXindexCisco Systems volatility, 93Collarsequity, 182, 202–7index, 181–83longer-dated, 204shorter-dated, 204taxes and, 249zero-cost, 204Combinations. See Coveredcombinations; StranglesCondor, 194–97directional, 196–97short, 196Contingent obligation, 3Corporate options, 201–11deﬁnition, 212Corporate stock, 212–16Covered calls, 20–23, 247–48qualiﬁed covered calls (QCC),247–48Covered combinations, 106–11compared to coveredstraddles, 109follow-up action, 110–11setting targets, 108–9stock position and, 109–10testing for suitability,107–8Covered put options, 23–26
253
Covered straddles, 103–6,107–11compared to coveredcombinations, 109follow-up action, 110–11setting targets, 108–9stock position and, 109–10testing for suitability, 107–8Covered writing, 30–33. See alsoWriting optionsagainst losing positions,31–32naked covered writing, 32Credit spreads, 137–41Day traders, 186Deltas, 94–100at-the-money call options, 96complex positions, 98–99in-the-money options, 96out-the-money options, 96relation with “Greeks,”233–34volatility and, 98–99Diagonal spreads, 200Directional butterﬂies,196–97Directional condor, 196–97Diversiﬁcation, 245Dividends, 11, 80–82buying call options, 13buying put options, 17pricing options and, 80–82DJX Index, 175Dow Jones Industrial Average,174, 175Dow Jones TransportationAverage, 174Downside protection, 37
254
Index
Early assignmentcall options, 100–101put options, 101Enron, 201Equity collar, 182, 202–7Equity options, 2, 4, 49–53. Seealso OptionsErnst & Young LLP, 249ETFs. See Exchange-tradedfunds (ETFs)European-style index options,173–74, 183–84, 239Exchange-traded funds (ETFs)investment strategies, 168–71options on, 167–171parallel with index options,175–76Exercise, deﬁnition of, 8Exercise price, 2, 5, 10, 79–80Expiration cycle, 5Expiration date, 5, 56, 197buying call options, 66–67buying put options, 73–74repair strategy, 116Expiration decisions, 44–45time to expiration, 82–86Expiration month, 2Expiration week, 2Front spreads, 155–58put front spreads, 158–59Gamma, 227–229relation with “Greeks,”233–34General Electric, volatility of, 93Genzyme, volatility of, 93Granted option. See Writtenoption
Hedgingcorporate options, 201–11corporate stock, 212–16index options, 175–76, 176–81partial insurance, 208–11short stock, 163–66Holder, deﬁnition of, 7Horizontal spreads. See CalendarspreadsIBM, volatility of, 93If-called return, 35, 37In-the-money, 7–8buy/write investmentstrategy, 37–38calls, 59, 64, 84, 212, 213deltas, 96short put, 154–55In-the-money buy/writeinvestment strategy, 37–38Index collarsbuying, 181–83taxes, 249 See also CollarsIndex mutual funds, 167Index options, 4American-style, 173–74,183–84, 239–40broad, 174–75butterﬂies, 192–94buying calls and puts, 185–89calendar spreads, 197–200cash settlement, 172–73company risk, 184–85condors, 194–97European-style, 173–74,183–84, 239fractional underlyings, 175industry risk, 184–85investment strategies, 176–83
Index
last trading day, 174long, 183market risk, 184–85narrow-based, 174–75parallel with ETFs, 175–76special features of, 171–76spreading, 189–92strike price, 176trading strategies, 183–200Insurance, 45partial, 208–11Intel, volatility of, 93Interest rates, 11, 80–82option pricing and, 236–39risk-free, 204–5International Business Machines,volatility of, 93Intrinsic value, 7, 239–40Investment strategies, 29–53,103–25buy/write investmentstrategy, 33–39buying call options, 45–49covered combinations, 106–11covered straddles, 103–11in-the-money buy/writeinvestment strategy,37–38index options, 176–83leveraging, 118–25repair strategy, 111–18JDS Uniphrase, volatility of, 93Johnson & Johnson, volatilityof, 93Last trading day, 5LEAPS, 6, 35–37, 56, 175, 246taxes and, 249
255
Leveraging, 118–25, 243–44borrowing, 118–19expanding range, 122–24options, 119–22Long, deﬁnition of, 6–7Long calls, selling, 67–68Long cash/long call strategy,45–47Long index options, 183Long straddle, 229–30Long-Term CapitalManagement, 244Margin, deﬁnition of, 9Margin call, 10Married call, 164–66Maximum theoretical value,132–33Microsoft, volatility of, 93Mutual fund, 181Naked covered writing, 32Naked option. See UncoveredoptionNarrow-based index options,174–175Nasdaq-100 Index. See NDXindexNDX index, 189–90OEX index, 175, 223Open interest, 9Option chain, 7Option class, 6Option premium, 7Option price. See PricingoptionsOption series, 6Option type, 6
256
Index
Options. See also Call options;Put optionscreation of, 4deﬁnition, 2on exchange-traded funds,167–71offered below intrinsic value,239–40as securities, 246shorter-term, 36–37strategies, 11–27in tax-deferred plans, 246taxes and, 246–249theoretical concepts of,217–40writing, 19–23Option’s premium, 2Out-of-the-money, 7–8calls, 59, 84, 85, 87, 213deltas, 96index options, 186put buyers, 188puts, 74–75volatility, 88Overleveraging, 244Overvalued options, 92PMC-Sierra, volatility of, 93Premium, deﬁnition of, 2Pricing modelsBlack-Scholes option pricingmodel, 10, 92, 234–36Pricing options, 10–11. See alsoExercise price; Strikepricesdividends and, 80–82interest rates and, 80–82,236–39volatility and, 64–65, 86–94,232
Procter & Gamble, volatilityof, 93Proﬁtabilityboundary, 65–66, 72–73buying call options, 13–15buying put options, 16,17–19call options, 65–66writing covered calls, 21Protective puts, 43–45, 176–81expiration decisions, 44–45insuring, 45strike decisions, 44–45Put-call parity equation, 238Put front spreads, 158–59Put options, 2, 3. See also Buyingput optionsbuying, 15–19, 43–45, 68–75covered, 23–26deltas, 96early assignment, 101proﬁtability boundary, 72–73protective, 43–45, 176–81sweet spot, 72writing equity put options,49–53Put spreadsbull put spreads, 138–40Put writing. See Writing optionsQualiﬁed covered calls (QCC),247–48Repair strategy, 111–18entering, 114–16exiting, 114–16expiration date, 116high-volatility stocks, 116–18options and, 112–14strike price, 116
Index
Returnsbreakeven, 37expected, 90if-called, 35static, 35–37on trading capital, 57–58,61–62Rho, 232Riskbeta, 236buying call options, 12buying put options, 16company risk, 184industry risk, 184market risk, 184–85writing covered calls, 21writing covered puts, 24Risk management, 241–45Rolling strategies, 39–43rolling down, 42–43rolling out, 39–41rolling up and out,41–42writing equity put options,51–53Russell 2000 Index, 174Seller, deﬁnition of, 3Selling volatility, 155–59front spreads, 155–58put front spread, 158–59straddles, 155–58Short, deﬁnition of, 6–7Short butterﬂies, 196Short condor, 196Short stocks. See also Stocks,shortingbuying call options to hedge,163–66Short straddle, 229–30
257
Shorting stocks. See Stocks,shortingSiebel Systems volatility, 93“Sold.” See also Written optiondeﬁnition of, 3Spiders, 168Spin-offs, 80SpreadsAmerican-style vs. Europeanstyle, 183–84bear call spreads, 140–41bear put spreads, 135–37bull call spreads, 127–34, 189bull put spreads, 138–40calendar spreads, 197–200call back spreads, 148–51credit spreads, 137–41deﬁnition, 128diagonal spreads, 200front spreads, 155–58index option spreads, 183,189–92put front spreads, 158–59SPX index, 175–76, 181SPY index, 175–76Standard & Poor’s 100 Index,175, 185Standard & Poor’s 500 Index,173, 174, 178Standard & Poor’s DepositaryReceipt (SPDR), 168Stock price, 10, 60, 78–79Stock selection, 38–39Stock split, 79reverse, 80Stocksbuying call options to hedge,163–66corporate stock, 212–16high-volatility, 116–18
258
Index
Stocks, shorting, 68–69, 163–66ﬁnancial problems, 69married calls, 164–66psychological problems, 69Straddles, 103–6, 107–11,155–58. See also Coveredstraddleslong, 229–30short, 229–30Strangles, 146–48Strike prices, 56, 79, 200. See alsoExercise pricebutterﬂies, 194buy/write investmentstrategy, 35–37index options, 176, 200repair strategy, 116synthetics, 161–62Sweet spotcall options, 63–64put options, 72Synthetics, 159–63choosing strike prices,161–62short synthetics, 162–63Tactical issues, 241–50diversiﬁcation, 245risk management, 241–45Tax-deferred plans, 246Taxes, 246–49collars and, 249covered writing, 247–48wash sale rule, 248–49Taxes & Investing: A Guide for theIndividual Investor, 249Theoretical issues, 217–40maximum theoretical value,132–33
Theta, 230relation with “Greeks,”233–34Time decay, 82–86, 186, 197Time spreads. See CalendarspreadsTime to expiration, 10–11,82–86Time value, 7To be assigned, 8–9Trading days, 174Trading levels, 245Trading strategies, 55–75,127–66bear put spreads, 135–37bull call spreads, 127–34buying call options, 55–68buying calls, 55–68buying volatility, 141–55credit spreads, 137–41index options, 183–200selling volatility, 155–59Trading style, 249–50Trading volume, 912 Technologies, volatilityof, 93TXU Corp, volatility of, 93Uncovered option, 9Underlying stock, 2Underlying value, 5Undervalued options, 92Vega, 231relation with “Greeks,”233–34Verizon Communications,volatility of, 93VIX index, 186–88, 223–27
Index
Volatility, 11, 61assumption, 64–65buying, 141–55calculating, 218–22call back spreads, 151call buyers, 186–89deltas and, 98–99forecasted, 92future, 91historical, 89–91, 218–20implied, 91, 222–27interday, 220–22pricing options and, 64–65,86–94, 232put buyers, 186–89real-world, 93selling, 155–59Wal-Mart, 201Wall Street Journal, 168Wash sale rule, 248–49Writing options, 19–23covered, 30–33
259
Writing call options, 203half-collar, 207–11Writing covered calls, 20–23alternating with put writing,53dividends, 22–23to ease out of a position,170–71proﬁtability, 21risk, 21Writing covered puts, 23–26, 24changing mind, 24–25risk, 24target price, 24–26Writing put options, 49–53alternating with covered callwriting, 49–50to