a) protect existing paperprofits, (b) exploit unusual and temporary market movements,and (c) average down your basis in the stock.6. Long calls may also be used as a form of contingent purchase,but only for stocks you want to buy; it is one way to leveragecapital by locking in strike prices on numerous stocks.7. Writing short combinations or straddles is appropriate onlywhen the call side is covered and when all possible outcomeshave been evaluated and qualified to meet your conservativestandards.
The Importance of Taxes in the Option EquationEven when you have defined clear guidelines for using options in yourportfolio, you may yet face complications due to the tax rules, one ofthe most troubling aspects of including options as a strategy. Whileeveryone hopes for tax simplification, history shows that reforms in thefederal tax system have only made matters more complex.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
A seemingly innocent strategy, such as a short straddle, can cause complex tax problems. The least of these may be deferral of losses to afuture period when a second leg of a straddle closes.
Five Tax GuidelinesA more significant threat than deferral of losses is the loss of long-termstatus in exercised stock. Some tax guidelines worth rememberinginclude the following:1. Limit covered calls to out-of-the-money positions. Using out-ofthe-money calls avoids the complexities that arise when writingin-the-money calls. Additionally, the most conservative methodin the market involves out-of-the-money positions, so thismakes sense based on your risk profile as well.2. Accept exposure to loss of long-term capital gains only when youhave carryover losses. Most people are not happy to exchange alarge, long-term capital gain for the higher short-term rates. Oneexception is that if you have large carryover losses to absorb, youcan maximize options strategies by accepting short-term gainsand sheltering them by using up a part of the carryover loss.3. Be aware of how the tax rules affect any combination strategies,especially short straddles. This book emphasizes the strategicpossibilities of taking various options positions as well as maintaining a conservative risk profile while maximizing potentialprofits. However, you should also be aware of how a specificstrategy affects your tax liabilities.4. Remember that rolling out of one position and into another couldchange the status of taxation. If you begin with an out-of-themoney covered call and then roll forward to a later expiring inthe-money position, you could trigger the loss of long-termstatus for the underlying stock. Before picking a new position,be aware of the potential higher tax as a result.5. Check with a qualified tax expert before you enter into trades.The tax rules for options are complex and, in some cases,uncertain. For example, the anti-straddle rule is so vague that itChapter 9 Stock Selection and the Option Contract
239
may even be unclear when it applies. Make sure that you andyour tax expert understand the rules and the tax consequencesof your decisions before executing actual trades.
Option Volatility to Judge StocksTax rules are certainly a complication in your portfolio. Taxes alonemay prevent your entering specific types of transactions. However,knowing the tax outcome in advance provides you with better information and guidelines for proceeding. For most investors, managing market risk—usually measured by degrees of volatility—is a moreimmediate problem.Most investors agree that, as a technical indicator, changes in volatilitysignal changes in risk. High volatility in option premium is a warningsign. Although higher-than-average option premium (caused byimplied volatility) is attractive, it also tells you that buying shares ofstock is a high-risk idea. It contradicts your conservative risk profile.The temptation to buy highly volatile stocks specifically to sell coveredcalls is difficult to resist. But the greatest trap is to start out as a conservative investor and end up with a portfolio of inappropriate stocks. Itcan happen easily if your selection is based on option-specific valuationrather than on tried-and-true fundamental indicators. It is not necessary to stray from the conservative standard because it is not difficult toearn option-based returns using conservative strategies. This is possibleusing LEAPS options in short positions on conservative stocks withstrong fundamentals. A 16-percent annualized return using optionswith a conservative stock is far better than a 32-percent return fromcovered calls on a highly volatile stock. Compare the potential return towhat you earn on average rather than on what you could earn usingmore volatile stocks and higher risk strategies. That is the key.
Volatility as an Early IndicatorOption volatility itself may indicate emerging fundamental problemsin a company. The problems may be temporary or permanent. For
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
example, the current quarter’s earnings may be lower than expected,which creates momentary volatility. But in the long-term, bigger picture, the company’s fundamentals have not changed. In otherinstances, perhaps a corporation has peaked and is now beginning agradual downward earnings slide, loss of competitive position, or subtle changes in financial strength. If debt capitalization is inchingupward as a percentage of total capitalization, for example, it couldsignal a change in fundamental strength. This ultimately affects dividends and erodes working capital; recognizing such changes earlyhelps you to time decisions. Option volatility is not always an earlyindicator, but it could be. So, if option volatility changes suddenly, it isworth the effort to check fundamental changes, evaluate recent newsor earnings reports, and look for any confirming signs that the financial strength and position of the company have changed.Using the company’s fundamental indicators as a means for decidingwhether or not to buy stock is always the preferred place to start.Options should be viewed as alternative strategies that may augmentthe conservative portfolio strategy, provide alternatives to outright purchase, or enable you to protect or take paper profits without having tosell shares.Option volatility can help you to coordinate your fundamental analysiswith technical tests. Degrees of volatility provide potential confirminginformation or even signal coming changes. In addition to reviewingthe fundamentals, technical tests of various types can also be used—inconjunction with fundamental analysis—to augment your study oftrends. Technical and fundamental volatility are closely related. Forexample, when a company reports consistent growth in revenues andearnings over time, you are likely to also observe a gradual increase instock market value within a relatively narrow trading range. When thetrading range is broader or erratic compared to marketwide trends, itusually signals similar volatility in the fundamentals.With this in mind, it makes sense to test a limited number of technicalindicators along with your fundamentals. These may include optionpremium volatility as well as trading-range trends and the stock’s support and resistance levels. A comparison between fundamental andtechnical indicators improves your overall program and often provides
Chapter 9 Stock Selection and the Option Contract
241
greater insight than you can achieve with a program limited only to afew fundamental indicators.The time differences between financial reports and current trends limitthe isolated use of fundamentals. Because quarterly and annual reportsare outdated by the time they are released, it is difficult to equate thesereports to current price trends. However, you often see emerging trendsin price volatility as an indicator of pending financial changes, just ascurrent earnings reports have an immediate effect on the technical side.It makes perfect sense to consider option volatility within a coordinated fundamental plan; this is especially true if you incorporate technicalindicators in your study of a particular company. Options have no fundamentals of their own, which is why it is so important to limit youruse of options to well-selected stocks. A conservative portfolio’s overallreturn can be both protected and enhanced with options, and done soin a way that remains faithful to the risk profile that is so crucial. Youwant to avoid the mistake of using options in ways that expose yourportfolio to high risk. Thus, you want to isolate your options programto only those strategies that protect your portfolio or that provide premium returns without increasing market risk. As with any range ofstrategies, the appropriate range of possible uses of options is a shortlist, and it should be. Inexperienced investors are invariably surprisedwhen they experience losses. Wiser investors know that while somelosses are unavoidable, reducing the chances of loss is the key to success.Options can help achieve that while also improving overall rates ofreturn in your conservative portfolio.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
AppendixOPTION TRADINGSTRATEGIES
243
Following is a summary of the strategies presented in this book.1. Basic long calla. as a purely speculative positionb. used to take advantage of price declines in stockc. as a form of contingent purchase2. Basic long puta. as a purely speculative positionb. used to take advantage of price rise in stock (insurance forpaper profits)c. as a form of contingent sale of stock3. Basic uncovered calla. a highly speculative position with unlimited riskb. as part of a ratio write4. Basic uncovered puta. as a form of contingent purchaseb. as part of a rescue strategy5. Put insurance (buying long puts to insure current long-stockprofits)6. Contingent-purchase strategiesa. long calls purchased as alternative to buying stockb. puts sold to create a credit as well as contingent purchasec. the covered long call with higher strike price, shorter expiring short calls7. Rolling strategiesa. rolling forward to defer expiration while creating a creditb. rolling short calls forward and up to defer or avoid expiration and to increase potential exercise price
244
c. rolling short puts forward and down to defer or avoid expiration and to reduce potential exercise priced. rolling back—exchanging a current option position for oneexpiring sooner8. Ratio writea. creating partially covered positions with some degree of riskb. modified to eliminate all risk by buying high calls to offsetshort exposure9. Rescue strategiesa. short puts to create a credit and, if exercised, to reduce average basisb. covered calls to reduce paper lossc. two-part combination of short puts and, when exercised,converting to covered calls10. Forced exercise (intentional exercise using covered calls)11. Spread strategiesa. long spread, high risk requiring adequate price movementb. short spread with uncovered positions—high riskc. short spread involving covered call and uncovered put—conservative when fundamental criteria and assumptionsare present12. Straddle strategiesa. long straddle, high risk requiring substantial price movementb. short straddle with uncovered positions—extremely highriskc. short straddle combining covered call and uncovered put—ultimate conservative strategy with higher-than-averagereturns, assuming that basic fundamental criteria andassumptions are present
Appendix Option Trading Strategies
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GLOSSARYa calculation of return on an option strategy, adjustedto reflect that return as if the position had been open for one year.
annualized basis
the status of an option when its strike price is equal tothe stock’s current market value.
at the money
a technique for reducing net basis in stock as part of arescue strategy; by purchasing shares at current market price, theoverall basis in the stock is reduced so that option strategies can beemployed to create a net profitable outcome.
average down
call
an option providing the buyer with the right, but not the obligation, to purchase 100 shares of a specified stock, at a specified strikeprice and by an expiration date, and obligating a seller to deliver100 shares at a fixed strike price if and when the contract is exercised by the buyer.an order to close a short position throughpurchase at the current price or premium.
closing purchase transaction
an order to close a long position through saleat current price or premium.
closing sale transaction
any strategy involving option contracts on the sameunderlying stock, when terms (strike price, expiration, or call versus put) are not identical.
combination
the earnings of a corporation based on inclusion of revenue, costs, and expenses only related to its core business, andexcluding all noncore, extraordinary, or other nonrecurring items.
core earnings
a strategy in which one call is sold for every 100 sharesowned, considered a conservative strategy because it reduces market risk while offering exceptional return.
covered call
247
the value of stock or option based on what abuyer would pay or on what a seller would receive if a transactionwere executed now.
current market value
a condition in which an option is more than 5 points inor out of the money. A call is in the money when current marketvalue is higher than the strike price; a put is in the money whencurrent market value is lower than the strike price.
deep in or out
a reduction in cost or price, creating a lower basis in stockthrough selling options.
discount
the yield from dividends paid on stock, calculated bydividing annual dividends by current value (current yield) of stockor by original cost of the stock.
dividend yield
advantage gained using options to protect longpositions through the purchase of an insurance put or through thesale of covered calls.
downside protection
the purchase of stock under terms of a call, or the sale ofstock under terms of a put; exercise takes place at the fixed strikeprice of the option, regardless of the stock’s current market value.
exercise
expiration
the date on which an option becomes worthless.
the relative tendency of a company’s operatingresults to be consistent from one period to another or to be erratic.The higher the inconsistency of revenue and earnings results, thehigher the fundamental volatility.
fundamental volatility
the anticipated future value of an option based oncurrent market value of the stock and its proximity to strike price,time remaining until expiration, stock price volatility, and transaction volume in the option.
implied volatility
the condition in which the stock’s current market valueis higher than a call’s strike price or lower than a put’s strike price.
in the money
the portion of option premium equal to the number ofpoints, if any, that are in the money. When the option is at themoney or out of the money, there is no intrinsic value.
intrinsic value
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
a strategic utilization of capital to control more capital; forexample, a contingent purchase plan involving options is a form ofleverage because it locks the purchase price, but the buyer has theright to exercise or not exercise the option in the future.
leverage
an option available to the general public and throughpublic exchanges, which normally expires in 8 months or less.
listed option
the strike price of an option, which is the purchase or sellprice in the event of exercise.
lock-in price
a position in stock or option in which the first transaction is an opening purchase, followed later by a closing sale.
long position
an option whose lifelasts up to 36 months as opposed to a traditional listed option,whose life is limited to 8 months or less.
Long-term Equity Anticipation Securities (LEAPS)
any short call not covered by an offsetting stock position. A naked call is a short position in which the seller does notalso own 100 shares of stock for each option written.
naked position
an order to open a long position throughpurchase at the current price or premium.
opening purchase transaction
an order to open a short position through saleat current price or premium.
opening sale transaction
an intangible call or put contract providing certain rights tobuyers and obligations to sellers. A buyer pays a premium toacquire rights. The buyer of a call option has the right to purchase100 shares of stock at a specified strike price and by a specified datein the future. The buyer of a put option has the right to sell 100shares of stock at a specified strike price and by a specified date inthe future. An option seller receives a premium for accepting obligations. A call seller is required to sell 100 shares of stock at a specified strike price and by a specified date in the future if and whenthe buyer exercises the call (calls the stock from the seller). A putseller is required to buy 100 shares of stock at a specified strikeprice and by a specified date in the future if and when the buyerexercises the put (puts the stock to the seller). In all cases, optionsexist on a specific stock and cannot be transferred.
option
Glossary
249
a condition in which the current market value of stockis lower than a call’s strike price or higher than a put’s strike price.
out of the money
the current value of an option, which is paid by the buyer orto the seller for opening a position.
premiumput
an option providing the buyer with the right, but not the obligation, to sell 100 shares of a specified stock, at a specified strike priceand by an expiration date, and obligating a seller to purchase 100shares at a fixed strike price if and when the contract is exercised bythe buyer.an option strategy designed to offset a net decline invalue of stock, using options to average down basis or to offsetpaper losses with option profits.
rescue strategy
ratio write a variation on the covered call strategy involving the writing of a number of calls other than one call per 100 shares of stock.a calculation of overall return from a short-optionstrategy, based on exercise of the option and expressed on an annualized basis.
return if exercised
a calculation of return from a short-option strategy, based on expiration of the option and expressed on an annualized basis.
return if unchanged
replacement of one short put with another when the strikeprice of the replacement put is lower than the strike price of theoriginal put.
roll down
a replacement of one short call or put when the strikeprice remains the same but the current expiration date is replacedwith a later expiration date.
roll forward
a strategy in which an existing option isreplaced to avoid exercise, often also creating a net credit. An existing short call is closed and replaced with another whose strike priceis higher and whose expiration occurs later (roll up); an existingshort put is closed and replaced with another whose strike price islower and whose expiration occurs later (roll down).
roll forward and up/down
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
a replacement of one short call with another when the strikeprice of the replacement call is higher than the strike price of theoriginal call.
roll up
a position in stock or option in which the first transaction is an opening sale, followed later by a closing purchase.
short position
an investment profile accepting high risk in exchange forthe opportunity to earn exceptionally high short-term profits (or tosuffer high short-term losses). Speculators usually are not interested in long-term growth or in holding equity positions.
speculation
a strategy in which options are either purchased or sold on thesame stock, with varying strike prices, expiration dates, or both.
spread
a strategy in which an identical number of calls and puts,with identical expiration dates and strike prices, are either purchased (long straddle) or sold (short straddle).
straddle
the price at which options are exercised, regardless of current market value of the underlying stock.
strike price
the price or price range of a stock representing the lowest likely price that buyers and sellers agree upon.
support level
collectively, the contractual conditions and definitions of everyoption, including identification of the option as either a call or a put,the expiration date, the strike price, and the underlying security.
terms
the intangible option premium, equal to all out-of-themoney value and exceeding any intrinsic value.
time value
the combined return from option strategies, includingoption premium, capital gain, and dividend income, all net oftransaction costs.
total return
a short call when the seller does not own 100 sharesof stock for each call written, or any short put.
uncovered optionunderlying stock
the stock on which an option is bought or sold.
a measurement of safety, the degree of movement in currentmarket value of a stock’s price or of an option’s premium.
volatility
Glossary
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INDEXAannualized return, 113nanti-straddle rule, 203-204asset allocation, 88, 227-229
BBlack-Scholes Model, 37-38brand loyalty, 237-238
Ccapital gains, 45capitalization trends, 233-234carryover loss, 100-101, 190-192Chicago Board Options Exchange(CBOE), 36, 70Clorox Company, 5, 39, 69, 72-73, 109,111, 139-140, 143, 148, 150, 166, 207210, 218-219closing purchase transaction, 108Coca-Cola, 5, 39, 69, 72-73, 109, 111,139, 143, 145, 148, 150, 166, 207-210,218-219combination:spreads, 194-196straddles, 196-197, 217-222tax problems, 203-204conservative:approach, 119-123assumptions, 2-4, 205-206context for options, 58-59dilemma, 85-87goals, 76-78ground rules, 114-119, 170-172management, 98-100outcome scenarios, 214-217portfolio, 4-5profile, 227ratio write, 154-157returns, 172-175short straddles, 197-198, 217-222
standards, 232-236strategies, 41-42, 131-132theory, 200-203versus speculative, 164contingent purchase:applications, 137-138conditions, 134-137covered long call, 141-147, 159-160forced exercise, 159-160long call, 138-141, 151-156put, 26-27ratio write, 154-157rescue strategies, 151-158risks, 141rolling strategies, 145short put, 147-151, 156-158core earnings adjustments, 182, 235
Ddividends, 235-236downside protection, 123, 187-189
Eearnings trends, 232-233effective tax rate, 101-103Exxon Mobil, 5, 39, 69, 72-73, 109, 111,120, 139, 143-144, 148, 150, 166, 207210, 218-219
FFannie Mae, 5, 39, 69, 72-73, 93-97, 109,111, 139-140, 143, 148, 150, 166, 207212, 218-219, 222Federal Express, 5, 39, 69-70, 72-73,109-110, 111, 122, 130, 139-140, 143,148, 150-152, 155-156, 166, 173, 207212, 217-221fundamental analysis, 87-88, 163-164,236-238fundamental volatility, 55-57
253
G
stock risk, 53-55straddles, 196-197, 217-222strike price, 12tax rules, 45-47, 100-104, 123-128,203-204, 238-240terms, 18-19time value, 9-10, 12, 121-122timing, 59-60trading costs, 19-20, 43-45underlying stock, 19
General Dynamics, 5, 39, 69, 72-73, 109110, 111, 139, 143, 148, 150, 166, 207210, 218-219
JJ C Penney, 5, 39-40, 69, 72-73, 109, 110,111, 139-140, 148, 150, 166, 209-210,218-219
L
P
leverage, 134-137, 178-180
pattern day trader, 65Pepsico, 5, 39, 69, 72-73, 109-110, 111114, 139, 143, 148, 150, 165-167, 207210, 218-219PE ratio, 234-235put:contingent purchase, 26-27, 80guidelines, 25-26insurance, 24-25LEAPS, 30-31long, 28-30, 89, 165-169risk, 63-64short, 25-26, 169-176strategies, 22-23, 31-34value, 23-24
Mmargin rules, 65-67
Ooption:attributes, 9call, 16-18, 31-34, 61-62, 89, 176-180covered, 30-31, 106-108, 114, 119,123-128, 126-127deep in the money, 79-80down market benefits, 187-189exercise, 22-23, 45, 78-81, 128-130,131-132, 159-160expiration date, 19, 22intrinsic value, 9-10, 12, 121LEAPS, 10-11, 27-31, 38-41, 108,122, 124listed, 27-30long, 13, 28-30lost opportunity, 57margin, 65-67at the money, 20-22in the money, 20-22, 79-80out of the money, 20-22perceptions, 58-60pitfalls, 227-230planning 190-192positions, 15-16profits, 14quotes, 36risks, 16rolling, 54-55, 128-130, 145-147short, 12, 13, 16, 46, 61-64spreads, 194-196
254
Qquality of earnings, 43
Rratio write, 154-157return:annualized, 113ncalculations, 67-68comparisons, 172-175high rate, 197-198, 204-206if exercised, 67-68, 71-74if expired, 74-76revenue trends, 232-233risk:evaluation, 185-187lost opportunity, 57, 106market, 230nature of, 50-51option, 16profile, 186-187, 228-229
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
reality of, 89-90short, 63-64standards 237-238stock, 53-55volatility, 51-52, 55-57, 104, 134,181-183, 230-232, 240-242
Sspeculation, 164, 178-180spreads, 194-196stock:appreciated 119-120diversification, 138-141downside protection, 123evaluation, 180-184inertia, 97-100positions, 214-215price level, 62-63, 142-145, 157-158,165-169, 181-183profits, 87-90profit-taking, 90-92rescue strategies, 94-95, 175-176,180-181, 223-224sale, 183-184
selection, 225-226standards, 92-94volatility, 34-36, 51-57, 87-88, 104,134, 181-183, 230-232, 240-242straddles, 196-197, 203-204, 217-222
Vvolatility, 34-36, 51-57, 87-88, 134, 181183, 230-232, 240-242
Wwash sale, 45Washington Mutual, 5, 39, 69-70, 72-73,75, 109-111, 139, 143, 148, 150, 166,209-210, 218-219working capital, 233-234worst case analysis, 202-203
XXerox, 5, 39, 41, 69, 72-73, 75, 109-110,111, 139, 143, 148, 150, 166, 207-210,217-221
Index
255
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