<s> Options Trading for theConservative Investor:Increasing Profits withoutIncreasing your Risk
Michael C. Thomsett
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OPTIONS TRADINGFOR THE CONSERVATIVEINVESTOR
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OPTIONS TRADINGFOR THECONSERVATIVEINVESTORINCREASING PROFITS WITHOUTINCREASING YOUR RISK
Michael C. Thomsett
Library of Congress Number: 2004118239
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Tom OsentonCustomer Share Marketing: How the World’s Great Marketers Unlock Proﬁtsfrom Customer LoyaltyBernd H. Schmitt, David L. Rogers, and Karen VrotsosThere’s No Business That’s Not Show Business: Marketing in Today’s ExperienceCultureYoram J. Wind and Vijay Mahajan, with Robert GuntherConvergence Marketing: Strategies for Reaching the New Hybrid ConsumerPersonal FinanceDavid ShapiroRetirement Countdown: Take Action Now to Get the Life You WantSteve WeismanA Guide to Elder Planning: Everything You Need to Know to Protect Yourself Legallyand FinanciallyStrategyEdward W. Davis and Robert E. SpekmamThe Extended Enterprise: Gaining Competitive Advantage through CollaborativeSupply ChainsJoel M. Shulman, With Thomas T. StallkampGetting Bigger by Growing Smaller: A New Growth Model for Corporate America
CONTENTSPreface xviiAcknowledgments xxiAbout the Author xxiii1SETTING THE GROUND RULES 1The Ground Rules 2A Model Portfolio 4
2OPTION BASICS 7The Workings of Option Contracts 8Option Attributes to Determine Value 9Intrinsic and Time Value Premium 9Long-Term Options and Their Advantages 10Strike Price of Options 11The Time Advantage for Short Sellers 12
Long and Short 13Taking Profits Without Selling Stock 14Buyer and Seller Positions Compared 15Understanding Short Seller Risks 16
Calls and Call Strategies 16Is the Strategy Appropriate? 17
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Option Terms and Their Meaning 18The Cost of Trading 19In, At, or Out of the Money 20
Puts and Put Strategies 22The Overlooked Value of Puts 23The Insurance Cost of Puts 24Conservative Guidelines: Selling Puts 25Puts as a Form of Contingent Purchase 26
Listed Options and LEAPS Options 27Using Long Calls in Volatile Markets 28Using LEAPS Puts in a Covered Capacity 30
Coordinating Strategies with Portfolio Goals 31Option and Stock Volatility: The Central Element of Risk 34Critical Analysis of Volatility 35Free 20-Minute Delayed Quotes 36The Black-Scholes Model 37Identifying Your Market Opportunities 38Limiting Your Strategies to Conservative Plays 41Identifying Quality of Earnings 43
Trading Costs in the Option Analysis 43Calculating the Net Profit or Loss 44
Tax Rules for Options: An Overview 45The Importance of Professional Advice and Tax Planning 46
3OPTIONS IN CONTEXT 49The Nature of Risk and Reward 50Using Volatility as the Primary Risk Measurement 51Options Used to Mitigate Stock Investment Risk 53Another Kind of Volatility 55Lost Opportunity Risk and Options 57
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Perceptions About Options 58Finding the Conservative Context for Options Trading 58Strategic Timing and Short-Term Price Changes 59
Short Positions, Naked or Covered 61The Uncovered Call—A Violation of the ConservativeTheme, Usually 61A Stock’s Likely Lowest Theoretical Price Level 62Short Put Risks—Not as Drastic as Short Call Risks 63
Margin Requirements and Trading Restrictions 65Other Margin Rules 65
Return Calculations—Seeking Valid Comparisons 67Return If Exercised 71Return If Expired 74
Long-Term Goals as a Guiding Force 76Exercise as a Desirable Outcome 78
4MANAGING PROFITS AND LOSSES 83Your Conservative Dilemma 85Deciding How to Establish Your Policies 86
Managing Profits with Options 87Basing Decisions on the Fundamentals 87The Reality of Risk 89
Overcoming the Profit-Taking Problem 90Realizing Profits Without Selling Stock 91Further Defining Your Personal Investing Standards 92When a Rescue Strategy Is Appropriate 94Reverting to a Secondary Strategy 95
Managing the Inertia Problem 97Inertia Management 98
Contents
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Taxes and Profits 100Options Used for Riding Out Volatility 104
5OPTIONS AS CASH GENERATORS 105The Covered Call Concept 106Who Makes the Decision? 107
Examples: Ten Stocks and Covered Calls 108Working within Pre-Established Standards 109Calculating the Gain Comparatively 110
Smart Conservative Ground Rules 114A Conservative Approach 119Tax Ramifications of Covered Calls 123Six Levels of Separation (of Your Money) for Taxes 126
Rolling Forward and Up—Exercise Avoidance 128The Types of Rolls 129
The Exercise Acceptance Strategy 131Remembering to Limit Yourself to Conservative Strategies 131
6ALTERNATIVES TO STOCK PURCHASE 133Leverage and Options 134Applications of Contingent-Purchase Strategies 136
The Long-Call Contingent-Purchase Strategy 138Diversifying Exposure with Several Stocks in Play 138Reducing Contingent Purchase Risks 141
The Covered Long Call 141Extrapolating Future Strike Prices 142Using the Forward Roll Effectively 145
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Short Puts and Contingent Purchase 147The Value of Selling Puts 147The Value of Shorter Exposure Terms 149
Rescue Strategy Using Calls 151Rescue Strategy Based on Smart Stock Choices 152Programming a Profitable Result 154The Ratio Write—Before Adjusting to Make It Conservative 154Converting the Ratio Write into a Conservative Strategy 155Ratio Writes for Rescue Strategies and Higher Current Returns 157
Rescue Strategy Using Puts 157The Risk of Continued Price Declines 157
Covered Calls for Contingent Sale 159Picking the Right Conditions for Forced Exercise 159
7OPTION STRATEGIES IN DOWN MARKETS 161Thinking Outside the Market Box 162Remembering the Fundamentals 163Conservative Versus Speculative: Remembering the Difference 164
The Long Put: The Overlooked Option 165When the Stock’s Price Rises 165When the Stock’s Price Falls 168
Short Puts: A Variety of Strategies 169Conservative Ground Rules for Short Puts 170Comparing Rates of Return for Dissimilar Strike Prices 172Three Types of Rescue Strategies 175
Using Calls in Down Markets 176Calls Used for Leverage, but Not for Speculation 178
Evaluating Your Stock Positions 180Rescue Strategies and Opportunity 180Examining the Causes of Price Volatility 181
Contents
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Deciding When to Sell and Replace Stock 183
Stock Positions and Risk Evaluation 185The Relationship Between Stock Safety and Options 185Examining Your Risk Profile 186
Options and Downside Risk 187The Down-Market Benefits of Options 187
Option Planning with Loss Carryover 190Timing: Matching Current-Year Profits and Losses 190
8COMBINATION CONSERVATIVETECHNIQUES 193Spread Techniques 194Advanced Spread Terminology 196
Straddle Techniques 197Short Straddles for Conservative Positions and High Ratesof Return 197
Long or Short Positions 198Mixing the Long and the Short 199
Theory Versus Practice 200Simplicity as a Worthy Goal 201Worst-Case Outcome as a Desirable Result 202
Tax Problems with Combination Strategies 203The Anti-Straddle Rule and Its Effect 203
The Ultimate High-Return Strategy 204A Review of Your Conservative Assumptions 205
Examples of the Strategy in Practice 206Pick Your Portfolio 207Pick Expiration Dates 207
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Review Trading Range Trends 207Look for Available Options and Strike Prices 208Compare Yields 211Select Stocks for the Short Combination Strategy 212
Outcome Scenarios 214Planning Ahead for Each Outcome Scenario 214
The Augmented Strategy—A Short Straddle 217How the Dollar Values Alone Can Mislead 220Maximum Advantage: Large-Point Discounts 222
Rescue Strategies 223Three Valuable Rescue Strategies 223
9STOCK SELECTION AND THE OPTIONCONTRACT 225Remembering Your Conservative Profile as a Priority 227Dangers and Pitfalls in Using Options 227Allocation by Risk Profile 228Using Options to Reduce Market Risk 230
Temptation to Select Most Volatile Stocks 230Creating a List of Potential Investments
231
Creating Sensible Conservative Standards 232The Five Conservative Standards for Stock Selection 232
Maintaining Fundamental Clarity 236Distinctions: Risk Standards Versus Brand Loyalty 237
The Importance of Taxes in the Option Equation 238Five Tax Guidelines 239
Option Volatility to Judge Stocks 240Volatility as an Early Indicator 240
Contents
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AppendixOPTION TRADING STRATEGIES 243
Glossary 247Index 253
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PREFACEThe Elusive Goal: Low Risk and High YieldIs it truly possible to match low risk with high yield? Most experts question the idea that there are ways for risk-averse investors to outperformthe averages. However, conservative investors can exploit a narrow bandof potential strategies to dramatically increase yields and, at the sametime, manage risks within their self-defined risk limitations.To some conservative investors, options are too exotic and too risky. Ifa range of strategies is too much trouble or contains too many pitfalls,it is not worth pursuing. But we proceed on the premise that a conservative investor is not necessarily someone who does not want to expandbeyond a well-understood and short list of investment possibilities.Being a conservative investor does not necessarily mean that you areunwilling to examine new ideas, expand your portfolio, or take acceptable risks. It means that you are not interested in speculation or inexposing yourself to the possibilities of high risk.Investors tend to be aware of the potential for high returns without alsoacknowledging that such strategies are usually accompanied byunavoidable high risks. This is where the inexperienced suffer losses inthe market. The lack of experience that attracts the novice to speculation in options and other high-risk strategies has caused much grief inthe market. When we look back at the dotcom years, we see that manyfirst-time investors made quick paper profits, only to lose it all in a sudden reversal of fortunes. But conservative investors know that puttingall of their capital in a single industry is ill advised, especially if theyselect companies that have never reported a net profit or whose stockhas risen over $200 per share in a few months or whose actual corebusiness is only vaguely defined.Given these observations, conservative investors naturally seek methods for using their capital that achieve some very specific goals, including the following:
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1. Preserving spending power after both inflation and taxes.2. Avoiding unacceptable market, liquidity, and diversificationrisks.3. Protecting profits without loss of invested positions.These goals are typical for conservative investors and actually wouldserve moderate investors just as well. They all involve methods ofavoiding loss. As a conservative investor, you are not averse to risk in anyand every form; essentially, you are averse to unexpected surprises. Thisis perhaps the most important distinguishing characteristic betweenyou and other investors. The majority of novice investors are surprisedwhen they lose money in the market but, in retrospect, should theyhave been surprised? In most situations, the novice was operating oncertain assumptions concerning potential profits, but was unaware ofthe related risk or the degree of risk exposure. Otherwise, his or herinvestment decisions probably would have been different.With this in mind, we offer a more realistic definition of the conservative investor: one who is experienced enough to be aware of both yieldand risk, and who makes decisions based on that broad awareness.Conservative investors are not as likely as other investors to be taken bysurprise when they lose money in the market. Another aspect of thisexpanded definition distinguishes between risk profile and the willingness to use creative and alternative strategies. The conservative is notclose-minded and does not reject exotic instruments like options merely because of their reputation as high-risk. Instead, the well-informedconservative is likely to examine claims about high-yield potential withan open mind. You may be skeptical and, at the same time, willing tolisten to the suggestion that the combination is at least possible. A limited number of strategies do, in fact, offer the potential for various conservative applications to meet the three goals common to conservativeinvestors: preserving capital, avoiding unacceptable risk, and protectingpaper profits. We have summarized 12 strategies in this book (see theappendix) and qualified them in terms of risk levels.This book does not suggest that you have to become an expert in a broadrange of complex or exotic options strategies. Instead, it proposes a
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rather limited number of strategies appropriate for conservativeinvestors. Our purpose is to respect the risk limitations in the conservative strategy while showing how experienced stock market investors canexpand their yield levels significantly, protect existing positions, andcome through down cycles in the market intact.
Preface
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ACKNOWLEDGMENTS
M
any thanks to Michael Panzner, Rudy Morando, HarryDomash, and Steve Kursh, all of whom added to this projectwith their suggestions. Also, I am most grateful to my editor,Jim Boyd, for his steady hand and guidance.
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ABOUT THE AUTHORMichael C. Thomsett has publishedmore than 60 books on investing andbusiness topics, including Stock Profits:Getting to the Core (FinancialTimes/Prentice Hall, 2004) and manyother books concerning options andstock market investing. His best-selling Getting Started in Options (JohnWiley & Sons, 2005) is in its 6th edition and has sold over 200,000 copies.He has written many other books published by John Wiley & Sons, AmacomBooks, and Dearborn. Thomsett livesin Port Townsend, Washington.
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1SETTING THE GROUNDRULES
In any discussion of an investment strategy, we begin with aseries of assumptions. Our assumptions tie in to yourconservative profile: You have prequalified stock; you believethese stocks will rise in value over time; fundamentals areessential in stock selection; you would be happy to buy moreshares; and there are a number of companies that meet yourstandards. We have identified 10 companies that make up a“model portfolio” to illustrate the options strategies in this book.
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This book explains how conservative investors can employoption strategies to (a) enhance current income without increasing market risks; (b) protect long-positions through optionsused for insurance; and (c) use options as a form of contingency involatile market conditions.
The Ground RulesBecause you are a conservative investor, we base all of the arguments inthe book on a series of underlying assumptions. These ground rulesshould always be kept in mind because they relate to your risk profileand to your investing philosophy. We use five underlying assumptionsin this book:1. You will limit option activities to stocks you have prequalified. Weassume as a necessary starting point that your portfolio—andthe stocks you use for options strategies—includes stocks youbelieve in as long-term-hold stocks and that you consider thesestocks permanent parts of your portfolio (as long as the fundamentals remain strong). This is an important attribute becauseit is not conservative to buy stocks solely to use for optionsstrategies. A conservative approach to options must include thepremise that your activities will be limited to the strongest possible stocks you can find.2. You believe that your stocks will rise in value. A conservativeinvestor naturally expects stocks to rise in value; otherwise, whykeep them? But this seemingly obvious point has relevance inthe underlying assumptions of this book. Many of the discussions of strategies are premised on a belief that over the longterm, the subject stock’s market value will rise. Many optionsstrategies work best when stocks do not rise, so our second
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underlying assumption is in line with the conservativeapproach. This means you want to accumulate shares of valueinvestments; you expect prices to rise over time; and you willchange a hold to a sell when the fundamentals change. However,at the same time, some options strategies are designed to takeadvantage of short-term volatility. When marketwide volatilityaffects short-term prices in your stocks, you have an opportunity to pick up discounted shares, take profits (without having tosell stock), or average down your overall basis. Of course, theproposal that you should average down would be conservativeonly if the basic assumptions were valid. You would want toemploy such a strategy only for stocks in which you have astrong belief as long-term value investments.3. You accept the premise that fundamental analysis of stocks is anessential first step in the process of examining optionopportunities. There are no fundamental attributes for options.These are intangible contractual instruments, and they have novalue on their own; thus, you can only judge the tangible valueof stock as a means for selecting appropriate options strategies.Many first-time options traders make the mistake of overlooking this basic reality. They select options (and stocks) based onthe immediate return potential, but ignore the very real marketrisks of the underlying stocks. This violates the conservativetenet that stocks should be chosen for their fundamentalstrength and growth potential.4. In the event of a temporary downward movement in a stock’sprice, you would be happy to buy more shares. Some investorsmay be unwilling to pick up more shares of a particular stock,even when the opportunity to buy discounted shares is presented. In this book, several strategies are introduced proposingthat additional shares may be purchased (or exposed to contingent purchase) using options. If this is not the case in a particular situation, then those suggestions should be passed over. Youmay have a strict formula for diversification or asset allocationthat you use to limit risks in any particular stocks, for example,so strategies aimed at increasing your holdings in one stockwould contradict your portfolio management standards in suchChapter 1 Setting the Ground Rules
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an instance. Strategies proposing that you set up situations inwhich more shares may be picked up work only if that suggestion conforms to your overall portfolio plan.5. You believe that there are an adequate number of available stocksthat meet your criteria. Some investors become convinced thattheir short list of stocks is the only list available to them. Thus,if they were to sell shares of stock from their portfolio, theywould be unable to reinvest profits in equally acceptablestocks. We assume that you do not believe this and that you areaware that probably dozens of stocks meet your fundamentalcriteria—in terms of price level, PE ratio, volatility level, dividend payment history, and a range of other analytical tests.Accordingly, if a particular stock is sold from your portfolio,we also assume that you are tracking a number of other stocksthat you could and would purchase upon sale of stocks youcurrently own.Incidentally, this practice makes sense whether you trade options or not.The fundamentals can change for any stock, so if a hold stock changes toa sell, you need to reinvest funds. As a matter of basic portfolio management, every investor probably has a secondary list of stocks that wouldbe used to replace sold stocks from the current portfolio. The need formaintaining this list relates to options trading because some strategiesresult in selling shares of stock. In those cases, you want to reinvest capital in a new issue on your list of qualified stocks.
A Model PortfolioIn the examples used in the following chapters, we use our five underlying assumptions to demonstrate how options work within the conservative framework. We also developed a model portfolio of 10 stocks,which we use in various combinations throughout. This helps to tietogether the various examples and range of possible outcomes. Thismodel portfolio is by no means a recommendation of stocks youshould own. It was selected to include stocks with some commonattributes. Seven of the 10 have increased dividends every year for the
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
past 10 years and have also reported low volatility in trading. Eight ofthe 10 have exhibited rising market value in recent years. (exceptionswere Coca-Cola and Xerox). All of these stocks have available both listed options and long-term options (LEAPS®), enabling us to look at avariety of scenarios for each conservative strategy.Employing a single portfolio throughout the book is also helpful inanother way. Not every strategy works well for each stock in our modelportfolio, so we can walk through the selection process to demonstratehow a particular strategic decision is made. While your portfolio maycontain a number of excellent value investments, some strategies simply do not work at all times or in all cases. You can compare the different potential for strategies across a range of stocks by following themodel portfolio throughout the explanations in each chapter.The values of each stock, current bid, and asked value of every optionused in this book are based on the closing prices reported by theChicago Board of Exchange (CBOE) on October 22, 2004. Table 1–1summarizes this model portfolioTable 1–1 Model Portfolio
Stock Name
Trading Symbol
Closing Price*
Clorox Company
CLX
$55.91
Coca-Cola
KO
38.90
Exxon Mobil
XOM
48.70
Fannie Mae
FNM
67.65
Federal Express
FDX
87.78
General Dynamics