part of theoptions or exercise your long calls and wait for assignment of thewritten options. Your goal should be to maximize your proceedsafter transaction costs, and this should dictate which route you take.Assume, for instance, that CCU has risen to $57 or $58 on expiration week. The ﬁrst way to exit the overall position is to wait untilthe Friday before option expiration, exercise your long calls, andwait for assignment on your short calls. You run the risk of earlyassignment on your short option, but this should not be an issueunless the stock’s ex-dividend date is some time before expiration.(Early assignment and ex-dividend dates were discussed in Chapter 4.) The cost of exiting the position in this fashion will be thetransaction costs of exercising your long calls and of being assignedon your short options.The second alternative is to close out your long options and halfyour short options, by selling four April 50 calls and buying to coverfour April 55 calls. The value of this spread will be close to $5. Butit is highly unlikely, because of the bid-ask spread on both options,that you will be able to sell this position for the full $5. Assume thebest you can do is to sell this spread for $4.90. Should you do so, orshould you exercise your long calls and wait for assignment on yourshort options? Exercising and waiting for assignment will generate$5 before transaction costs. Would these be less than $0.10 per share?
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If so, then the ﬁrst technique of exercising and waiting for assignment makes more sense. On the other hand, if you can sell thespread for $4.95 less transaction costs, and this nets you more thanexercising/waiting for assignment would, do so; then simply waitfor the last four short calls to be assigned and deliver your original400 shares. You will need to sharpen your pencil, taking into accountall transaction costs to determine which is the better way to closeout this strategy.Exit Fear, Enter GreedLet’s try to think this strategy through in realistic terms. You bought400 shares of CCU at $60 and the stock is now just north of $50. Youread about the options’ repair strategy and think it’s great: no capital required, no additional downside risk, and you bring yourbreakeven down to $55. You call your broker and execute the trade.The stock starts to show signs of life—$52, $53—and you are feeling pretty good. Then, $54, $55—you’re a genius; the stock is whereyou want it to be and you are about to break even. But CCU keepsgoing, and suddenly it’s trading at $58, $59. Now the repair strategy starts looking idiotic: just as your stock is about to go aboveyour acquisition cost (and make you some money), you are aboutto be forced to sell your shares at $55.It looks like you have changed your mind and greed is taking overfrom fear. You want out of this option strategy but are afraid to askhow much it’s going to cost you. Take another look at Table 5.1, paying attention to the value of the options if the price of CCU is $60 atexpiration. Each 50 call is worth $10, and the 55 calls are worth $5.Getting out of the option position means selling the four long 50calls at $10 (a $4,000 credit) and buying to cover the eight short 55calls at $5 (a $4,000 debit). Guess what: you can get out of the optionposition at no cost, except for transaction fees.Two points to be noted. First, with CCU at $60, the option position could be closed out for even money only very close to expiration. One week prior to expiration (keeping all the pricing variablesconstant) the 50 calls would be trading around $10, but the 55 callswould be closer to $5.15, implying a $0.30 per share cost of winding down the spread. Second, if CCU is higher than $60, then youhave no choice but to pay up to close out the options. At $62, for
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The Options Strategist
example, the 50 calls would be worth $12, the 55 calls $7, for a netdebit of $2 per share. In fact, the debit required to close out the position will be equal to the amount by which CCU is trading above $60($2 at $62, $7 at $67, etc.)
Selecting Expiration Date and Strike PricesIn our example, CCU had dropped from $60 to $50.71, a fall ofslightly more than 15%. The repair strategy was initiated for evenmoney using roughly three-month options (100 days until expiration). These are actually good parameters to keep in mind. You willﬁnd it relatively easy to repair stocks down 12% to 18%, maybe even20%, using two-, three-, or sometimes four-month options. Whatabout stocks down more than 20%? For instance, assume we hadpaid $70 for CCU; with the stock around $51, this would representa drop of close to 28%. Can anything be done?Yes, but the greater damage will take longer to repair. On the sameday we initiated the repair strategy with the 100-day April options,some 273-day January LEAPS calls were quoted as follows: January50 call $8.90–$9.20; January 60 call $5.00–$5.20. It would thereforehave been possible to purchase four of the January 50 calls and writeeight of the 60 calls for a small credit. The overall position wouldlower the breakeven to $60. This makes sense: the more a stock isdown, the longer it will take to repair it, and the more of a bouncewill be needed to reach the breakeven point. (Remember that in ourﬁrst example CCU only had to rally $5 to $55 to break even, not the$10 needed here with the LEAPS.)By using LEAPS it is possible to repair stocks down 30% andsometimes 40%. But this is the limit. Unfortunately, there is notmuch we can do with dot-bomb and Enron-type disasters.
Repairing High-Volatility StocksHow much did it cost you to learn that high-ﬂying stocks are theones most likely to come crashing down? Well, here’s a bit of goodnews: the more volatile stocks are also the ones that are easiest torepair.When we created our CCU example, its options were trading withan implied volatility of 40%. Let’s assume a similar stock, called
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Unclear Communications (UNCL), was also trading at $50.71, butthat this latter equity was more volatile and its options traded witha 60% implied volatility. We can obtain the following theoreticaloption prices for UNCL:February options (37 days): 50 call: $4.2555 call: $2.25April options (100 days):50 call: $6.7555 call: $4.80Let’s assume we also acquired UNCL at $60 and are simply trying to break even on our position. With CCU we needed to go outto April to initiate the repair strategy for even money. With UNCLthe same 50–55 spread can be initiated for a small credit using theFebruary options. This is obviously a positive as a quick bounceover the next ﬁve weeks would permit us to break even. Lookingfurther out, we can calculate the following theoretical LEAPS pricesfor UNCL:January LEAPS (273 days):
50 call: $10.9560 call: $7.5070 call: $5.20
With CCU, the 50–60 repair strategy was initiated for a smallcredit of $0.80. The same spread with UNCL results in a $4.05 credit(2 ⫻ $7.50 ⫺ $10.95), and a 50–70 spread can be created for a smalldebit of $0.55 (2 ⫻ $5.20 ⫺ $10.95). These afford us the followingtwo choices: the 50–60 spread creates an effective selling price of $70,to which we add the initial credit of $4.05, allowing us to repair astock that was purchased at $74. The 50–70 spread creates an effective selling price of $90, from which we must subtract the initialdebit of $0.55, letting us repair a stock that was bought at $89.By now you should be getting the idea: the repair strategy workswell with higher-volatility stocks. Of course, for the strategy to workwe need some help from the underlying—it has to rally at least partway to our purchase price. If things go from bad to worse and thestock continues to drop, our options will not protect us against thisdowndraft. The one exception, where some downside protection isobtained, is when the repair strategy is initiated for a credit. TheUNCL 50–60 spread was initiated for a $4.05 credit. If this stock con-
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The Options Strategist
tinues on its downward path and all options expire worthless, this$4.05 credit is kept and helps reduce any additional accruing losses.Investors are often interested in the repair strategy but bewildered by the number of option series listed and the even morenumerous ways in which they can be combined to create variousspreads. So a few words are in order about the mechanics of therepair strategy. Start with the current price of the stock. You willwant to purchase the calls that are closest to being at-the-money.Then assess the damage. If the stock is down $10, you need to create a $5 spread; if it has dropped $20, you will need a $10 spread. Ifyou are dealing with a $40 stock that you purchased for $50, youshould be looking to buy the 40 calls and to write the 45 strike. Interms of expirations, start with 90-day options: the 40 calls are trading at $3.10 and the 45s at $1.35. Using these would cost you $0.40.So you look at the next available month (options with 118 days untilexpiration) and ﬁnd the 40 calls are $3.50, while the 45s are $1.75.By using the latter options, you can initiate the position for evenmoney.While it is nice to initiate the repair strategy for even money, andeven nicer to do so for a small credit that will pay for transactionfees, you shouldn’t out of hand reject a repair spread that can onlybe initiated for a small debit. If you have $70 sunk into a losingequity position, putting up an additional $0.50 per share to signiﬁcantly reduce your breakeven point might not be a bad idea andshould not be dismissed as throwing good money after bad.
Leveraging an Equity PositionTraders, probably more than investors, have an interest in creatingleverage. Still, numerous investors are looking to leverage all or partof their portfolio, which is why this strategy is included in thischapter.Traditional Leverage: BorrowingThe old-fashioned way to create leverage is to purchase stocks withborrowed funds, commonly referred to as buying on margin. Quitesimply, margin magniﬁes returns, both to the upside and to the
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Table 5.2Buy SLB (Margin)
Buy SLB (Cash)Proﬁt/(Loss)
Return onInvestment
Proﬁt/(Loss)
InterestCost
TotalP/(L)
Return onInvestment
$67
$8
13.6%
$8
($0.15)
$7.85
26.6%
$65
$6
10.2%
$6
($0.15)
$5.85
19.8%
$63
$4
6.8%
$4
($0.15)
$3.85
13.0%
$61
$2
3.4%
$2
($0.15)
$1.85
6.3%
$59
0
0%
0
($0.15)
($0.15)
(0.5%)
$57
($2)
(3.4%)
($2)
($0.15)
($2.15)
(7.3%)
$55
($4)
(6.8%)
($4)
($0.15)
($4.15)
(14.1%)
$53
($6)
(10.2%)
($6)
($0.15)
($6.15)
(20.8%)
$51
($8)
(13.6%)
($8)
($0.15)
($8.15)
(27.6%)
SLB
downside. This is illustrated in Table 5.2, which compares purchasing shares of Schlumberger (SLB) at $59 on a fully paid basis, andbuying the same amount of stock on 50% margin (which signiﬁesthat the investor puts up 50% of the stock’s purchase price, borrowing the balance from her broker).The returns on a cash basis are calculated on an initial investmentof $59. For the margin purchase we assumed that the stock is held30 days and interest on the loan is 6%. The returns for the marginpurchase are calculated based on an initial investment of $29.50. Asyou can see, buying SLB on 50% margin nearly doubles the returnsto the upside but causes twice as much damage on the downside.In theory, a 50% drop in the price of SLB would result in a 100% lossof the initial investment (not including interest expense), but it isdoubtful that a brokerage ﬁrm would let an investor stay with sucha position all the way down unless other securities were in theaccount to margin the position.Alternative Leverage: Remove Borrowing, Add OptionsThe upside to leveraging a stock position is higher returns, thedownside greater losses. Is there any way that one could capture the
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The Options Strategist
former without having to accept the latter? Let’s start with somemarkets.SLB:Aug. 60 call:Aug. 65 call:
$58.92$4.10–$4.30$2.20–$2.25
Note that the August options have a little more than four monthsuntil expiration. An investor has $30,000 to commit to SLB, enoughto purchase 500 shares, but because of his very bullish forecast forthe next few months he is considering purchasing 1,000 shares using50% margin. An alternative strategy would be to buy 500 shares ofSLB, buy ﬁve August 60 calls, and write ten of the August 65 calls.The stock purchase would use up the $30,000, but the option position would be initiated for no cash outlay, as the cost of the 60 calls($2,150) would be fully covered by the premium received from writing the 65 calls ($2,200).If you read the previous section, you will recognize this strategyas the repair strategy repackaged and used to a different end. Nevertheless, it is worth looking at the numbers in depth. Table 5.3 summarizes the strategy at option expiration for various SLB prices.
Table 5.3Proﬁt/(Loss)on SLB
Value of60 Call
Value of65 Calls
TotalReturn onProﬁt/(Loss) Investment
$67
$8
$7
2 ⫻ ($2)
$11
18.7%
$65
$6
$5
$0
$11
18.7%
$63
$4
$3
$0
$7
11.9%
$61
$2
$1
$0
$3
5.1%
$59
0
$0
$0
0
0%
$57
($2)
$0
$0
($2)
(3.4%)
$55
($4)
$0
$0
($4)
(6.8%)
$53
($6)
$0
$0
($6)
(10.2%)
$51
($8)
$0
$0
($8)
(13.6%)
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121
Profit/(Loss)
$15$10$5$0($5)($10)$50
$55
$60
$65
SLB Price at Expiration
Figure 5.1 Buy SLB ⫹ Calls
In ﬁlling in Table 5.3 we took two shortcuts. We ignored the slightcredit ($50) that was generated when the option position was initiated, and we rounded up the cost of SLB from $58.92 to $59. Compare the returns on investment when SLB falls below $59 to thereturns on purchasing SLB on a cash basis in Table 5.2: they are thesame, indicating that our strategy has the downside risk of a cashinvestment in 500 shares. From $60 up to $65 the returns are similar to those obtained with stock purchased on margin. The difference is that with the options there is no interest expense, but theleverage aspect of the strategy does not kick in until the stockreaches $60 (from $59 to $60 the investor only beneﬁts from theappreciation of 500 shares). As with the repair strategy, no furthergains accrue once the stock hits the short options’ strike price. Theper share proﬁt and loss of this strategy is illustrated in Figure 5.1.Notice that in Figure 5.1 the proﬁt-and-loss line rises from $60 to$65 at an angle steeper than 45 degrees. In fact, over this range, profits increase by $2 for every $1 SLB goes up. This is the ﬁrst time aline on any of our payoff diagrams has not been rising or falling ona one-for-one basis with the underlying stock.By using options, our investor leverages his stock purchase—notby buying shares with borrowed funds, but by obtaining the rightto purchase additional shares at $60, just slightly above the stock’scurrent price. This right to double up is ﬁnanced by writing coveredcall options whereby he agrees to sell both the 500 shares he now
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The Options Strategist
owns and the 500 shares he has the right to purchase at a price of$65. Obviously, an investor would enter into this strategy only if hisprice target for the stock was somewhere in the $65 range. Or wouldhe?Expanding the Strategy’s RangeTake a look at the following quotes:SLB:Jan. 60 call:Jan. 70 call:
$58.92$6.60–$6.80$3.10–$3.30
An investor who has a $70 target price on SLB could leverage hisposition by purchasing one of the January 60 calls and writing twoof the January 70 calls for each 100-share lot he purchases. He willnot be able to establish the option position for even money becausethe call purchased will cost $6.80 and the two calls written will generate only $6.20 in total premium. But most investors would probably be willing to pay an additional $0.60 per share (on a stocktrading at $58.92) in order to leverage this stock from $60 to $70.When compared to the August options, the January calls double therange over which the stock can be leveraged. Why would anyonebother using the August options?The reason is simple: this strategy will generate its maximumproﬁt potential only when the options are close to expiration. Thinkabout what happens if SLB quickly runs up to $70, the price wherethe strategy hits its maximum proﬁt using the January options. Forevery 100 shares held the position is short two of the 70 calls. Thesewill then be at-the-money options and probably still hold a lot oftime premium. Unwinding the position would entail covering theseoptions (i.e., paying all that time premium to buy them back), whichwould inevitably reduce the gain realized. To illustrate this point,Figure 5.2 estimates the per share value of the stock and optionsposition at three points in time: at expiration (which reﬂects thestrategy’s maximum proﬁt potential), one month before option expiration (to show how much of the strategy’s gain is actually capturedduring the last month), and one month after the strategy was initiated (to show the impact of a quick run-up in the price of SLB—
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123
$25
Profit/(Loss)
$20$15$10
At Exp.T + 30 DaysX ⫺ 30 Days
$5$0($5)($10)($15)$50
$55
$60
$65
$70
$75
SLB Price
Figure 5.2 SLB ⫹ Options
remember that the strategy was initiated when the January optionshad a little over nine months until their expiration).There are two costs to this strategy. The ﬁrst is its limited upsidepotential. The second is a hidden cost. To realize the maximumproﬁt potential for a given SLB price, an investor will have to waituntil close to the expiration date. Observe in Figure 5.2 that if SLBrises to $65, $70, or $75 30 days after the position has been initiated(labeled T ⫹ 30 Days in the ﬁgure), the options do not add any leverage to the position. The proﬁt-and-loss line climbs at a 45-degreeangle, the same result that would be obtained with an unleveragedstock purchase. Note further that if SLB is trading at $70 one monthbefore expiration (labeled X ⫺ 30 Days), our stock-plus-option strategy generates a proﬁt of approximately $17 per share, higher thanthe $11 gain a straight stock purchase would yield, but less than the$21 possible with the stock plus options strategy.The comments made in the repair strategy section about unwinding the stock and option positions and changing one’s mind alsoapply to investors “buying one and writing two” to create leverage.On the latter topic, if an investor used the January options and if bythe expiration date SLB were trading at $80, it would be possible tounwind the call positions for close to even money by selling one ofthe 60 calls at $20 and buying to cover two of the 70 calls at $10 each,or $20. If the stock does go to $80 and the options are unwound, theend result will be a loss of leverage. If an investor bought 500 shares
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The Options Strategist
at $58.92, he will still hold these shares (now at $80) and the optionposition will have had very little ﬁnancial impact because it was initiated for a $0.60 debit and closed out for even money.In the balance are no interest expense and the downside risk of acash basis position, versus leverage limited to a determined rangeand a strategy that only realizes its maximum potential close tooption expiration. Is it worth initiating such a position? We thinkso, especially if one is expecting a quick $5 increase in the price ofa stock or has a longer-term outlook and does not object to waitinguntil option expiration. In this latter case, if the underlying stockruns up, the position starts behaving like a covered write, anotherposition that generates its maximum return only at, or close to,expiration.Also, for some investors, this may be the only way to obtain leverage in certain accounts. Some brokerage ﬁrms permit bull callspreads in tax-deferred accounts (IRAs, 401(k)s, etc.). Since ourleverage strategy consists of a covered write (long 100 shares, shortone call), which all brokerage ﬁrms allow in tax-deferred accounts,and a bull call spread (long one call, short a higher strike call), itmay be possible to execute this strategy in what are essentially cashaccounts.Final VariationSometimes it is difﬁcult to get the stars to line up. Take the case ofan investor who has sufﬁcient cash to purchase 1,000 shares ofNational Semiconductor (NSM) and is looking to leverage her purchase with call options. She expects NSM to rise to $35 over the nextthree months and pulls up the following quotes:NSM:December 30 calls:December 35 calls:
$30.00$3.10–$3.30$1.30–$1.40
Buying 10 of the 30 calls and writing 20 of the 35 calls wouldresult in a $0.70 per share debit—an amount our investor is unwilling to pay. She could establish the 30–35 call spread for even moneyif she used longer-dated options, but she is unwilling to commit her-
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125
self to this position for more than three months. Is she totally out ofluck?She will have to compromise, but there is no need for her to dismiss the use of options. By ﬁddling with the numbers she comes upwith the following: purchasing 6 of the December 30 calls wouldcost $1,980, and writing 16 of the December 35 calls would generate $2,080, netting her a $100 credit, sufﬁcient to pay for her transaction costs. Her ﬁnal position would be long 1,000 shares, with theright to acquire 600 additional shares at $30 and the potential obligation to sell 1,600 shares at $35.Our investor was unable to double up using options whileremaining within her trading parameters. But she was able to enterinto a position for even money where she would earn $1.60 for everydollar that NSM rose above $30 until it reached $35. She leveragedher position by 60%, accepting that half a loaf (or 60% of a loaf) isbetter than none at all.Determining the right number of options to buy and write takesonly a few minutes. Start with the number of shares you are looking to purchase on a cash basis: in our example, this was 1,000. Ifyou are long 1,000 shares, you can write 10 call options. Now startbuying the 30 calls. If you purchase 5, you can write 15 of the higherstrike calls since you own 1,000 shares and have the right to purchase an additional 500. Buying 5 of the 30 calls costs $1,650, andwriting 15 of the 35 calls generates a $2,100 credit. Repeat the exercise for 6 and 16 calls (as above) and then for 7 and 17 (which endsup costing $100). The decision to establish a 6-by-16 rather than a 7by-17 spread is purely a question of whether or not an investor iswilling to pay $100 for the upside potential of an additional 100shares. This example also shows how situations that may not lookviable at ﬁrst can be turned to an investor’s advantage with a littleimagination and a sharp pencil.
More LaterCollars, an advanced investment strategy, are discussed in Chapter8. Even if you have no interest in hedging corporate stock or options,make sure you read about this strategy.
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C
H
A
P
6T
E
R
ADVANCEDTRADINGSTRATEGIESBull Call SpreadsTraders who start out by purchasing call options quickly realize thatit is best to purchase calls on stocks that will move signiﬁcantly.High-volatility stocks have a greater probability of moving signiﬁcantly, but the option premiums on those stocks are correspondinglyhigh. Buying calls on high-volatility stocks is not a slam dunk.To illustrate this point, take a look at the following 91-day optionson Siebel Systems (SEBL), trading at $31.71:May 27 1⁄2 call:May 30 call:May 32 1⁄2 call:May 35 call:
$7.00–$7.10$5.50–$5.70$4.30–$4.40$3.20–$3.40127
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The Options Strategist
Table 6.1
OptionPremium
UpsideBreakeven
Percentage Increasein SEBL toBreak Even
May 27 1⁄2 call
$7.10
$34.60
9.1%
May 30 call
$5.70
$35.70
12.6%
May 32 1⁄2 call
$4.40
$36.90
16.4%
May 35 call
$3.40
$38.40
21.1%
Table 6.1 looks at the upside breakeven at expiration in both dollar and percentage terms, assuming the options are bought at theoffered price.Purchasing the slightly in-the-money 30 call requires SEBL toincrease by close to 13% just to break even. Few traders are lookingjust to break even. Of course, if expectations are that this stock willgo up by 30% to 40% over the next three months, buying these callsmay be an appropriate strategy. But what if a trader is bullish onSEBL but not to the point of purchasing these calls? Should he walkaway and start looking elsewhere for trading opportunities? This iswhere spreads enter the picture.A spread is any option position that combines a long and a shortposition. A bull call spread involves purchasing one call option andwriting a different call with the same expiration date but a higherstrike price. For example, a trader could purchase the May 30 call at$5.70 and simultaneously write the May 35 call at $3.20 to create abull call spread. To understand this spread, it is best to break itdown into its component.Buying the 30 call gives the trader the right to purchase shares ofSEBL at $30. By writing the 35 call this trader also assumes the obligation of selling shares of SEBL at $35. The trader does not own anyshares of stock, but his short call is considered covered because hehas the right to buy shares if necessary (although most brokerageﬁrms require spreads to be done in a margin account).Bull call spreads fall into the subcategory of debit spreads. Thisindicates that the position will be initiated for a net debit, $2.50 inour example (the cost of the 30 call, $5.70, less the premium received
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Advanced Trading Strategies
Table 6.2SEBL Price atOption Expiration
Value ofLong 30 Call
Value ofShort 35 Call
Value of30–35 Call Spread
$28
$0
$0
$0
$29
$0
$0
$0
$30
$0
$0
$0
$31
$1
$0
$1
$32
$2
$0
$2
$33
$3
$0
$3
$34
$4
$0
$4
$35
$5
$0
$5
$36
$6
($1)
$5
$37
$7
($2)
$5
from writing the 35 call, $3.20). The risk of this spread is limited tothe initial debit because the worst-case scenario has SEBL at orbelow $30 at option expiration, making both options worthless. Thebest-case scenario has SEBL at or above $35 at expiration, in whichcase the spread will be worth its maximum theoretical value of $5(think of it as exercising the 30 call to buy SEBL at $30, beingassigned on the short 35 call, and being forced to sell your shares at$