, this trader’s option position will go upapproximately $1,010 in value. This also tells us that if ABCDE goesdown $1 the options will lose $1,010 in value. This is where we canstart thinking of delta in terms of stock equivalent. If the optionposition gains $1,010 on a $1 rise in the price of the stock and generates an equal loss on a $1 drop, it is fair to say that the option position is behaving like 1,010 shares of stock. Holding 1,010 shares ofstock would generate the same gains and losses as this option position, at least initially.If this market maker is risk averse, which most are, how can shehedge herself? Being long the equivalent of 1,010 shares, her hedgewould be to sell short 1,010 shares of ABCDE. The resulting stockand options position would offset one another: if the stock rises $1,the options produce a $1,010 gain and the short stock a $1,010 loss;on a $1 drop of ABCDE the options lose $1,010 which is offset by acomparable gain in the short stock position. The fancy term used todescribe this technique is delta hedging, and a position where theoptions’ and the stock’s deltas add up to approximately zero isreferred to as delta neutral.As noted, deltas change as the price of the stock moves around.So the hedge created by this market maker is not perfect, as theoptions’ deltas will change at different rates and the stock’s deltawill remain constant. See Chapter 9.This is all very good for professional traders, but what about thevalue for your average options trader? Calculating a position’s netdelta can provide useful information when using strategies thatinvolve as few as two options, such as bull call spreads, discussedin Chapter 6. For instance, a trader who purchases a call with a 0.61delta and writes a different call with a delta of 0.40 has a net position delta of 0.21. This would tell him by how much ($0.20) hisspread can be expected to change in value for a $1 move in the priceof the underlying stock.Impact of VolatilityWhat impact does a stock’s volatility have on its options’ deltas? Ahigher volatility will have an effect similar to having a longer datedoption, as illustrated in Figure 4.4. The logic is straightforward:more time or a higher volatility gives the underlying stock a chance
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to make a major move. Although Figure 4.4 illustrates deltas for twodifferent time frames it could also depict the deltas for a lowervolatility stock (equivalent to the 15-day option) and of a highervolatility stock (represented by the 45-day option).Although deltas are always fractional and expressed in hundredths, traders often refer to an option with 77 deltas, or they talkabout being short 600 deltas. This is traders’ lingo—the decimalpoints are dropped and fractions are treated as whole numbers.
The Risks of Early AssignmentAll equity options are American-style options, meaning that theirholder may exercise them on any business day up to and includingthe third Friday of the expiration month. The converse is that writers of equity options run the risk of being assigned early on anystock option they write. Is it possible to quantify the risk of earlyassignment?Early Assignment on Call OptionsTo gauge the risk of early assignment, it is useful to view the situation from the option buyer’s perspective and to ask ourselves ifthere is any economic gain to be had by exercising an option early.Take the holder of an in-the-money call who intends to exercise heroption and take delivery of the stock. Her call gives her the right topurchase 100 shares at $65, and since it is an American-style option,she could exercise it today, pay $6,500, and receive 100 shares of theunderlying stock. But tomorrow she will have the same right to paythe same $6,500 and receive the same 100 shares. What incentivedoes she have to exercise early? Why spend the money today whenshe can wait until tomorrow and earn one day’s interest on herfunds in the interim? And will she want to spend the money tomorrow when she can wait another day and earn another day’s interest?Clearly, call holders have little or no reason to spend now whenthey can spend later, so very few calls are exercised early. The oneexception is with dividend-paying stocks. The call holder who exercises her position on the day before the stock goes ex-dividend willreceive the stock and the stock’s dividend. So the question now
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becomes what makes more economic sense: spending the moneynow and getting the dividend, or spending the money later (i.e., atoption expiration), forgoing the dividend but earning interest on thecash that will be used to purchase the stock? A logical investor willexercise when the value of the dividend is greater than the value ofthe interest that should be earned between the ex-dividend date andthe option expiration date. Keep in mind that the dividend amountis a known quantity, and that interest rates are subject to change.Also, investors do not always act the way economics textbooks tellthem to. For example, a speculator who owns an in-the-money callon a stock about to go ex-dividend might not exercise it because hehas no intention of purchasing the underlying stock.Summing up, calls are rarely exercised early and are thereforerarely assigned early, except when a dividend enters into theequation.Early Assignment on Put OptionsOnce again it is best to analyze this situation from the perspectiveof the option holder. An investor purchased a 40 put to protect along stock position a little while ago. The stock has tumbled to $30,and with the put still having one month to expiration this investoris now faced with a dilemma. He could exercise his put early andget $40 for his shares or wait until the expiration date. The advantage of exercising early is that he would rather have the $40 to reinvest today rather than in a month’s time. But by exercising early hewould no longer hold his shares, which could rally back above $40during the next four weeks. What should he do?The question cannot be answered as easily as it can be with theprevious call example. Our investor must now weigh the advantageof getting his money early against the chance that the stock will rallyabove $40, in which case he could sell the stock for more than $40.Our observation is that quite a few investors elect to take the cashas soon as possible and that put options tend to get exercised earlymuch more often than calls. This simply means that the risk of earlyassignment is somewhat higher with short puts than it is for shortcalls, and it is also more difﬁcult to estimate when it will happen.
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ADVANCEDINVESTMENTSTRATEGIESCovered Straddles and CombinationsAssume that some time ago you acquired 500 shares of GeneralMotors (GM) and 500 shares of International Paper (IP). Both stocksare trading around their purchase price and you still hold a favorable opinion of these two stocks. Without trying to ﬁx somethingthat isn’t broken, let’s ask a couple of questions about these holdings. First, would you consider selling these stocks (one or the other)at a higher price? Of course you would. The issue is how muchhigher? So let’s rephrase the question. Would you consider sellingthese stocks 10% above their current price? If you expected thesestocks to double or triple over the next few years, your answer103Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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would probably be no. But a 10% return over a relatively shortperiod of time might interest you.The second question is: would you consider adding to these positions; that is, buying additional shares, if you could purchase them10% below their current prices? You obviously have a favorable outlook on these stocks; otherwise you would not have purchasedthem. And if you bought some shares around their current prices,buying more 10% below where they are trading now might appealto you. But if you decide that you don’t want more than 500 shares,that’s fair enough.Repeat this exercise with the stocks currently in your portfolio. Ifyou ﬁnd one or more for which you answered yes to both questions,there may be an option strategy that can help you meet your investment objectives. So let’s assume that you own 500 shares of IP and500 shares of GM, that you are willing to sell both of these stocks10% above their current price, and that you would purchase an additional 500 shares 10% lower. You could sit and wait for these stocksto move up or down 10% and simply sell or buy when they reachedthose points. But if this were the preferred strategy we would notbe bringing it up in an options strategy book, would we?Covered StraddlesStart with GM, trading at $60.45. You are willing to sell these sharesat a 10% premium, or at $66.50. The indicated option strategy for aninvestor who holds a stock and is looking to sell it at a higher priceis to write covered calls, as seen in Chapter 2. Writing a covered callis agreeing to sell shares of a stock you own at a higher price. Butyou are also willing to add to your position and purchase 500 additional shares of GM at a 10% discount, or at $54.40. The indicatedoption strategy for an investor who is looking to acquire shares ofstock at a price below today’s market price is to write put options(also covered in Chapter 2). Writing put options is agreeing to purchase shares of stock at an agreed price, usually below the currentlevel.It now stands to reason that for the investor who answered yes toboth of our questions the indicated option strategy is to write bothcalls and puts. This strategy is known as a covered straddle if the put’s
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and the call’s strike prices are the same or as a covered combination(often shortened to “covered combo”) if the strike price of the callis higher than the strike price of the put. With GM at $60.45, the June60 calls (with 12 weeks until expiration) could be written for $3.10and the June 60 puts written for $3. The investor who owns GM andwrites the June 60 straddle will face one of two possible outcomesat option expiration: either GM will be trading above $60 or below$60. Let’s examine each outcome.If GM is above the options’ strike price of $60 at June expiration,the outcome will be similar to that of a covered write. The short callswill be in-the-money and will probably be assigned, forcing theinvestor to sell his shares of GM at $60. Like the covered writer, thisinvestor will keep the premium of the written call options, $3.10 inour example. But this investor also wrote some 60 put options,which will expire worthless because the stock will be trading above$60. This second option premium ($3) also is pocketed, so the effective selling price of GM is $66.10—the 60 strike price, plus the $3.10call premium, plus the $3 put premium. Yes, this is $0.40 short ofour selling target price of $66.50, but we’ll consider it acceptable fornow.The second possible outcome at June expiration is for GM to betrading below $60. Our investor is now in the position of the equityput writer: the puts are in-the-money, will probably be assigned, andshares purchased at $60. But once again, two option premiums willbe collected, as the investor keeps the puts’ premium and the outof-the-money calls expire worthless. The effective buying price ofthe additional shares of GM is therefore $53.90—the 60 puts’ exercise price, less the put premium of $3, less the call premium of $3.10.This time we did a little better than our goal of buying 10% belowthe current price.Yes, there is a third possibility—the stock closing exactly at (orvery close to) $60 on the options’ last trading day. What would happen? It’s impossible to tell. Remember that the buyers of the optionsdecide whether or not they will exercise, and in this case there maybe two individuals involved—one deciding whether or not to exercise the calls and another deciding whether or not to exercise theputs. The calls or the puts could be assigned, or both. Although wehave witnessed a lot of bizarre occurrences in the world of options,
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we have yet to see someone being assigned on both the puts and thecalls of a short straddle. However, the only way to completelyremove the uncertainty is for the investor to cover the straddle (buyback both options) or to roll his position to another month (buy backboth June options and write the Julys).
Covered CombinationsOur second stock was IP, trading at $43.01. Against these shares wecould write the July 45 calls for $1.55 and the July 40 puts for $1.30.This strategy, where the strike prices of the puts and the calls aredifferent, is known as a covered combination. The results will besimilar to those for the covered straddle written against GM if, atoption expiration, IP is above the call’s strike price or below theput’s strike price. In the ﬁrst instance, the shares will be sold at $45and both the call premium of $1.55 and the put premium of $1.30will be kept, for an effective selling price of $47.85. That’s more than10% above IP’s price when the strategy was initiated. Should IP endup below $40 at option expiration, additional shares of IP will bepurchased at $40 and both option premiums kept, for an effectivepurchase price of $37.15.But in the covered combo example, there is truly a third potentialoutcome: IP could be trading between $40 and $45 at option expiration. In that case, the calls would be out-of-the-money and expireworthless, and so would the puts. The investor would retain ownership of the original 500 shares of IP, and if her investment objectives are still the same, she could proceed to write anothercombination, say the September 40–45 combo for an additional premium of $2.25. When a second combination is written against astock, some eye-popping numbers often appear. With IP, if the ﬁrstcombo is written for $2.85, and a second one for $2.25 (rememberthat the ﬁrst combination used 16-week options, whereas the second one is assumed to use 8-week puts and calls, which explainsthe lower value of the second combo) the option premiums total$5.10, creating an effective selling price of $50.10 (45 plus $5.10) andan effective purchasing price of $34.90 (40 less $5.10). Very attractive indeed.
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The Extent to Which the Options Are CoveredThe expressions “covered straddle” and “covered combination”could be considered somewhat misleading—at least in regard to the“covered” qualiﬁcation. In a covered straddle or combo, only thewritten call is considered covered; the put, from a risk and a margin perspective, is uncovered, or naked. Which leads to the question of how much margin is required to establish either of thesestrategies. If an investor writes a straddle or combo against a stockthat she owns outright (i.e., she has not borrowed any funds againstthis stock position), then the underlying stock will, in itself, be sufﬁcient to meet the strategy’s margin requirement.Look at it this way: the call is covered by the long stock position,so no margin is required. The short put potentially obligates theinvestor to purchase additional shares of a stock she already owns.Assuming no options are involved and this investor wanted to double up on a stock even though she had no cash in her account, shecould purchase the additional shares on margin by borrowing thefunds from her broker. The original stock and the newly purchasedstock would become the collateral for the broker loan. If this investorwrites a put option, she has not purchased additional shares but hastaken on the obligation to buy these. If the put is assigned, she couldthen purchase the second lot on margin.This is where caution is required. Although it may not be obvious, writing covered straddles and combos leverages the underlying stock position. If the underlying stock has been purchased onmargin (i.e., is already leveraged), writing a covered straddle leverages an already-leveraged position. This is ﬁne as long as everythinggoes according to plan. But throw a monkey wrench into this position and you have a recipe for disaster. We prefer to write straddlesand combos against stocks that are clear of margin debt. See the section on risk management in Chapter 10 for further comments.Testing for SuitabilityThere is a quick test to help you decide if either of these strategiesis right for you, or right for a given scenario. Take Sealed Air (SEE),trading at $43.21. The seven-week options are $1.50 for the 45 call
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and $1.20 for the 40 put. You own 600 shares of SEE and are askedto answer the following three questions:1. Would you be willing to sell your shares at an effective price of$47.70 seven weeks from today? Note that this represents areturn of slightly more than 10% (based on the current stockprice) for a relatively short period of time. If you are like mostinvestors, you would probably agree to this selling price.2. Would you mind earning $2.70 per share on your SEE holdingsover the next seven weeks, assuming the stock stays relativelyunchanged? Another no-brainer. Earning $2.70 represents a 6%return—not bad for seven weeks on a stock that is goingnowhere.3. Do you really want to buy 600 additional shares of SEE at aneffective purchase price of $37.30? This is a more difﬁcult question. If you answer no, or if you are not sure, a covered comboon SEE probably is not right for you under this scenario.
Setting Buying and Selling TargetsThe two preceding examples, GM and IP, set buying and selling targets that were 10% below and above the stocks’ prices. Are theserealistic parameters? Based on our experience, yes. By writing straddles or combinations using one- or two-month options, the 10% targets can be set for the majority of stocks. Only those stocks with avery low volatility will require three- or four-month options.Remember that if you are using one-month options and are able tocreate buying and selling targets 20% or more above and below astock’s price, you should conclude that the options’ market viewsthis particular stock as very risky, as the options reﬂect a very highimplied volatility.What if a 10% band is judged too narrow? A wider combination,say, writing the 50 puts and the 65 calls instead of the 55–60 combo,or longer-dated options, could be used. Each of these solutionsbrings its own problems. Widening the distance between a combination’s strike prices may result in writing options with very lowpremiums: the 50 puts may be trading at $0.20 and the 65 calls at
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$0.30. You may not want to assume all of the risks of this optionposition for a mere $0.50 per share. Writing longer-dated optionscommits you to your obligations for a greater period of time(remembering that it is always possible to cover your short optionsbefore expiration).Straddle or combo—which is better? From earlier chapters readers know that we hesitate to use the term “better.” We prefer to lookat the trade-offs. Straddles will generate more time premium, whichis maximized when options are at-the-money, while combos willcreate relatively higher and lower effective selling and buyingprices. One feature we like about combos is that occasionally theputs and the calls both expire worthless, creating an opportunity towrite a second set of options. When this happens, the economics ofthe overall strategy become quite appealing.Building a Stock PositionCovered straddles and combinations also can be used to build astock position. Let’s assume your goal is to purchase 2,000 shares ofStarbucks (SBUX), currently trading at $24.06. You have no objection to paying the stock’s asking price, but if you could accumulatethe shares at a lower average cost, so much the better. One possiblestrategy is to purchase 1,000 shares at $24.06 and write a coveredcombination, say the April 25 calls at $0.65 and the April 22 1⁄2 putsat $0.55. Your preferred outcome is for SBUX to close below $22.50(but not too far below!) at option expiration. You would then purchase another 1,000 shares of SBUX at an effective price of $21.30($22.50 exercise price less total option premiums of $1.20) and yourﬁnal position would be long 2,000 shares at an average cost of $22.68($24.06 on the ﬁrst 1,000 shares and $21.30 effective purchase priceon the put assignment).Of course, there are two other possible outcomes:■
SBUX goes nowhere by option expiration (nowhere beingdeﬁned as anywhere between $22.50 and $25), the puts and thecalls expire worthless, and you pocket the $1.20 option premium.You now have two choices, assuming your goal is still to accumulate 2,000 shares. You could write another covered combo or
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you could buy another 1,000 shares of SBUX at the then marketprice, keeping in mind that you have still reduced your averagepurchase price by $0.60 (the $1.20 total option premium from thecovered combo divided by 2 since you only wrote 10 calls and 10puts but ended up purchasing 2,000 shares).■
SBUX rises above $25 and you are forced to sell the 1,000 sharesyou own at an effective selling price of $26.20. This is obviouslynot a best-case scenario if you intended to hold SBUX for thelonger term, but it is quite proﬁtable nonetheless. So use thisstrategy only with those stocks you would not mind selling ifthey have a quick run-up after you have initiated your halfposition.
Follow-up ActionAs with other option strategies, covered straddles and combinationsmay at times require follow-up action. Since one of the series, theputs or the calls, will generally be out-of-the-money, there is usuallya need to deal only with the in-the-money options. The exception isif the underlying stock is trading very close to a covered straddle’sstrike price shortly before expiration (say the Wednesday or Thursday before expiration). In this case, the indicated follow-up actionis to cover the short straddle and write the next month out. Forinstance, if you have written an October 65 straddle against sharesyou own and the underlying is at $64.70 two days before optionexpiration, you may want to cover the October 65 straddle and writethe November 65 straddle in order to capture additional time premium. The one downside to this rolling out is that it involves fouroptions and most likely four commissions; if you are short 20 straddles and trading with a discount broker, this will probably not bean issue. If you are short two straddles and paying relatively highcommissions, you may end up with very little additional time premium in your account (but with a happy broker).As noted, follow-up action relating to covered straddles and combinations will only involve one option: either the call or the put,whichever is in-the-money. If the underlying stock has risen abovethe calls’ strike price and no action is taken, the shares will mostlikely be sold upon assignment. An investor could decide to roll out
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the short call position and also would have to consider writing newputs. For example, a 70–75 combo was written against a stock thathas risen to $78 a few days before option expiration. Do nothing andthe stock will be called away (this may be the preferred outcome).But some investors will prefer to roll out the short 75 call, most likelyto the next month, in order to capture additional time premium.What about the puts? With the stock at $78, the one-month 70 putsmay not be trading at a sufﬁciently high premium to justify writingthem. The one alternative left is to write the 75 puts, transforminga 70–75 combo into a 75 straddle. This will increase the amount oftime premium sold but will also raise the overall risk of the position, as the investor could be obligated to purchase shares at $75 upfrom the original obligation of $70.If the underlying has dropped below the puts’ exercise price, follow-up action will have the same general pattern as that in the previous paragraph. Do nothing and additional shares will bepurchased (which once again may be the desired outcome). Roll outthe in-the-money puts and you will capture additional time premium, and you will be left deciding whether or not to write a newseries of calls, either with the same strike price as the original callsor with a lower strike price.
The Repair StrategyLet’s face it: if we purchased only stocks that went up, by now wewould be sailing in the South Paciﬁc or indulging in some offbeathobby such as identifying neotropical caterpillars. But that’s probably not the case.Assume, for instance, that you purchased 400 shares of ClearChannel Communications (CCU) at $60. Before you knew it, CCUwas going across the bottom of your television screen at $50. Andthere was a subtle change in your investment objectives vis-à-visthis stock: the original goal, to make some money, has now becomenot to lose any money. In other words, getting your money backlooks like a very interesting proposition.The last time you found yourself in this situation your brother-inlaw suggested doubling up. If you were willing to buy 400 sharesat $60, why not buy another 400 at $50? This brings your average
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cost down to $55, so a rally back to this level would let you get outof your position without any damage. You only have one problemwith doubling up: it requires investing an additional $20,000. Andthinking about it, you have a second problem with this technique:800 shares will leave you with twice the downside risk that 400shares carry. Lowering your breakeven appears to be an excellentidea, but it doubles your risk and requires substantial additionalcapital. No thank you.Where Options Come InEnter options. With CCU trading at $50.71, the April 50 calls, whichhave 100 days until expiration, are quoted at $4.60–$4.70, and theApril 55 calls are at $2.35–$2.50. Consider the following trade,remembering that you own 400 shares: purchase four of the April50 calls at $4.70, and simultaneously write eight of the April 55 callsat $2.35. No need to be a mathematical genius to calculate that thisoption position can be initiated for even money. Buying four contracts at $4.70 costs $1,880, and writing eight calls at $2.35 brings inthe same amount. There is no cost to you, except for transaction fees.But are you getting involved with uncovered calls here, writingeight contracts when you hold only 400 shares? No. All of the written calls are covered. Your 400 shares cover four of the short calls,and the four calls you have just purchased will cover the other fourshort options. There are no uncovered options involved here andhence no margin requirement.So what have you accomplished? You have in fact doubled up onyour stock position without having to put up any additional capital and without having increased your downside risk. The four calloptions you purchased give you the right to buy 400 additionalshares of CCU at $50. You will obviously exercise this right only ifit makes economic sense to do so. Your downside risk does notincrease. If CCU continues moving down, you will continue toaccrue losses on the 400 shares that you own, but the options, boththose purchased and those written, will all become worthless. Sincethe option position was initiated for even money, if the stock doesdrop and renders all long and short options worthless, the optionswill have no impact on your overall position: they will neither helpyou cut your losses, nor will they increase your accruing losses.
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The strategy only works if you get a little help from the stock.Assume that over the next 100 days CCU rallies to $55. In this caseyou have the right to purchase 400 shares at $50, bringing your average cost down to $55. Selling 800 shares at $55 would let you breakeven. Not bad, as you have taken your breakeven point down from$60 to $55 without having to put up an extra $20,000.What if CCU rallies to $60? You will still have the right to purchase 400 additional shares at $50, but the options you have writtenwill now come into play. By writing eight of the April 55 calls, youwill have committed yourself to selling 800 shares at the strike priceof $55. So although the repair strategy lowers your breakeven(good), it does not let you participate in any price appreciationabove your breakeven point (not so good).Table 5.1 gives the proﬁt-and-loss proﬁle of the overall strategy—stock and options—assuming the original 400 shares of CCU werepurchased at $60.As you look at Table 5.1, keep in mind that the cost of the longoptions and the premium received from the written options are nottaken into account because they cancel each other out. The table hastwo columns for Value of Short 55 Calls because two of these werewritten for every 100 shares held and for every long call option.The table summarizes the foregoing discussion: at prices of $50and below, all options end up worthless and have no impact, positive or negative, on the overall proﬁtability of the position. The overall breakeven point has been lowered to $55, a deﬁnite positive. But
Table 5.1 The Repair StrategyCCU Priceat OptionExpiration
Proﬁt(Loss)on CCU
Value ofLong 50Calls
Value ofShort 55Calls
Value ofShort 55Calls
TotalProﬁt/(Loss)
$65
$5
$15
($10)
($10)
0
$60
0
$10
($5)
($5)
0
$55
($5)
$5
0
0
0
$50
($10)
0
0
0
($10)
$45
($15)
0
0
0
($15)
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above $55, the overall position can do no better than breaking even;this could be perceived as a negative, but will be addressed below.Entering and Exiting the PositionWe should address some practical considerations relative to initiating and closing out this strategy. Initiating the position is fairlystraightforward as most brokers will accept an order such as: “Buy4 CCU April 50 calls and sell 8 CCU April 55 calls for even money.”This type of order ensures that both sides of the order get executedand you are not left with half a position. It also indicates you areindifferent as to the price you pay for the 50 calls, as long as the callsyou are writing fully offset the cost incurred.Exiting the repair strategy can be a little more complicated.Assume that by the options’ expiration date CCU has rallied to $55or higher and that you have decided to get out of your position completely. You will then have two choices: trade out of