65 call:
$66$1.00–$1.10$2.10–$2.20
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The Options Strategist
The March option has 3 days until expiration, and the Apriloption has 31 days. A straight rollout consists in buying the 65 call(at $1.10) to cover the current short option and simultaneously writing the April 65 call (at $2.10), a roll that can presently be executedfor a $1 credit. Your obligation to sell your shares of JNJ at $65 wouldbe extended another four weeks and you would net $1 in the process. Does this trade make any sense?We start our analysis by assuming nothing is done, in which casethe calls will be assigned, you will be forced to sell your shares, andyou will end up with $65 in cash. You will probably start lookingfor a new investment opportunity for this sum. If you decide to rollout your short call position, you would be earning $1 over the nextfour weeks. Your return would therefore be: $1 ⫼ $65 ⫽ 1.54%,which can be annualized as follows: 1.54% ⫻ (365 / 28) ⫽ 20.0%.Some comments on the numbers used, and those not used, in ouranalysis. We use $1 because this is the extra return rolling out willgenerate. If JNJ went ex-dividend between the March and Aprilexpirations, we would add the dividend amount to the net optionpremium because it would increase our return. We use $65 as thedenominator in calculating our return for the simple reason that ifwe do nothing this is the amount of cash we will have to reinvest.By rolling out we generate an extra dollar on $65—not on the current stock price of $66 (as far as we are concerned it doesn’t matterby how much JNJ is above $65 since any price above our option’sexercise price will result in assignment). The number of days usedto annualize our rate of return is 28, which represents the length ofthe strategy’s extension, not the 31 days until the April optionsexpire since we are locked into the strategy for the next three days.Two numbers that did not enter into our analysis are the originalcost of the stock and the premium received from writing the March65 calls. Accountants refer to these as sunk costs. There is nothing wecan do to change our cost basis on the shares, and whatever wereceived from writing the March call was credited to our accountsome time ago and has probably been reinvested. Yes, we may becovering the March call at a price that is higher than the premiumoriginally received, thereby creating a “loss” on this individualoption, but it is necessary to look at the bigger picture. If the Marchcall was originally written for $0.60, covering it at $1.10 will createa $0.50 loss, but the effective selling price of our JNJ shares will have
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been raised from $65.60 (the 65 strike price plus the March optionpremium of $0.60) to $66.60 (the 65 strike price plus the March premium of $0.60 plus the $1.00 credit generated by rolling out). The“loss” on the March option will be compensated by a higher “proﬁt”on the sale of the stock, assuming the April calls are eventuallyassigned.Rolling our short March 65 calls to April is not without risks. Wewould not be earning a 20% annualized rate of return if this were aslam dunk. We will be holding the shares an additional month, during which time they could decline substantially. Our originalbuy/write presumed that we were comfortable holding shares ofJNJ, and our rolling out the option position is based on the sameassumption.In our example, JNJ was only $1 above the short calls’ exerciseprice. As the underlying stock moves further and further above thecalls’ strike price, the less attractive rolling out becomes. We can estimate the net credit of the March to April rollout to be $0.70 with JNJat $67, $0.40 at $68, and $0.20 at $69. At some point, an investor willdecide to let the stock go—i.e., wait for assignment and reinvest thecash obtained somewhere else, or look at an alternative strategysuch as rolling up and out, the topic of our next section.Rolling Up and OutLet’s look at the situation of an investor who wrote covered calls onher shares of General Dynamics (GD). She wrote the May 90s whenthe stock was trading around $87 and is now looking at the following situation on the Wednesday before May expiration:GD:May 90 call:June 90 call:June 95 call:July 95 call:
$94$4.00–$4.10$5.60–$5.70$2.90–$3.00$4.20–$4.30
Rolling from the May 90s to the June 90s would generate a $1.50credit, an excellent rate of return. Although our investor originallythought that selling her shares at $90 would represent a fair price,she is now wondering if she could raise her exit point.
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The Options Strategist
She considers rolling her May 90 calls up (to a higher strike price)and out (to a further expiration date) to the June 95 calls, but sherealizes that paying $4.10 to cover her May option and writing theJune 95s for $2.90 would leave her out of pocket $1.20. Lookingslightly further out, she notices the July 95 calls at $4.20; she couldpay $4.10 to cover her May option, write the July 95 call at $4.20, getcredited a dime (and use it to cover her transaction costs), not be outa penny, and have raised her GD selling price from $90 to $95.This textbook illustration of rolling up and out highlights the conditions necessary for the trade to make economic sense. First, GD isa somewhat more volatile stock than JNJ, and covered writers willquickly learn that it is difﬁcult to roll up and out with low-volatility stocks. Second, to be executed for even money (or a slight credit),the roll necessitated moving from an expiring option to one expiring two months later, not the next available month. One of the reasons a lot of investors are attracted to covered writing is the positivecash ﬂow the strategy generates. But if a covered writer is foreverrolling up and out for debits, the raison d’être of the strategy isnulliﬁed.By rolling up and out, our investor obtains an additional $5 ofpotential proﬁt from her covered write. But note the importance ofthe word potential. GD is currently at $94, and the additional $5 willbe realized only if the stock is trading at or above $95 in two months.Moreover, by moving her expiration date from May to July she musthold her shares an additional two months, during which time shehas to bear the full downside risk of this equity position. But underthe right circumstances, which we view as keeping the time commitment relatively short and being able to roll for even money or acredit, rolling up and out deﬁnitely should have a place in the covered writer’s arsenal.Rolling DownA few months ago an investor purchased shares of Liz Claiborne(LIZ) in the low 30s and wrote the 35 calls as part of his coveredwriting program. The stock has since retreated to $28 and the shortcalls expired worthless this past Saturday. This investor would liketo continue writing call options against his stock position, but aquick look at LIZ option quotes has revealed the four-month 35 call
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to be $0.10 bid. Writing options for a dime makes very little sense,and he is now wondering if he should consider writing a lowerstrike price call, such as the 30s, effectively rolling down.But wait, someone tells him, if you paid in the low 30s for thestock and write the 30 calls, you are committing yourself to sellingyour shares below their cost, effectively locking in a loss. Whywould anyone want to lock in a losing position?This is a recurring question, and we like to answer it with a question we asked a few pages back: do you ever sell stocks at a loss?Disciplined investors will tell you that it is imperative to sell losers:if you sell only your winning positions and keep all of your stocksthat have gone underwater, sooner or later you will end up with aportfolio made up entirely of your mistakes. Getting rid of yourerrors is the only way to keep moving forward.With those not so original comments in mind, let’s take anotherlook at LIZ. Our investor purchased shares in the low 30s and thestock is at $28, so the question becomes should he jettison the stockat the current price, or should he write the 30 calls hoping to sell theshares on a rally to $30? We have no objections to writing calls witha strike price below the cost of the underlying stock. We view thedisciplined covered writer as one who sticks to the game plan andone who also knows that absorbing losses is part of investing.In our LIZ example the decision should be based primarily on ourinvestor’s revised outlook for the stock. If the drop to $28 is seen asthe start of a downtrend, the shares should probably be sold immediately. If it is seen as a mere correction within a bull market, thenwriting the 30 calls will generate some immediate cash ﬂow, in addition to setting a selling target where one’s losses will be cut. Psychologically, this may not be the easiest position to establish, buttaking a loss rarely is.
Buying Protective PutsConceptually, the purchase of protective puts could be the most easily understood option strategy. An investor holds shares, is nervousabout an upcoming earnings announcement, and purchases putoptions as a form of insurance. For example, an investor holds 800shares of Cisco Systems (CSCO) trading at $18.60 in the ﬁrst week
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The Options Strategist
of February. The earnings are due the following week, and the February 17 1⁄2 puts (which expire one week after the earnings news) arequoted $0.55 to $0.60. This investor has seen the results of companies coming in a penny or two below street estimates but hesitatesto sell the stock because he sees good potential longer term. He buyseight of the February puts and sleeps well that night, knowing thatno matter how bad the earnings might be, he has the right to sell hisshares at $17.50 and has therefore limited his downside risk.The problem with purchasing puts as insurance is that in retrospect it is always the wrong decision. If CSCO beats the street andthe stock rallies, you may hear our investor grumble that he justwasted his money. If the stock gets clocked on bad news, he willchange his refrain, saying that he should have sold the stock and notbothered with these options. But can’t this same argument be madewhenever one purchases insurance? If the car isn’t wrecked or thehouse doesn’t burn down, hasn’t the money been wasted? Well, notquite. In fact, the insurance offered protection and, in most situations, insurance buyers would rather not have to make a claim.Investors also have a difﬁcult time getting their mind around thefact that the best thing that can happen to them when they buy protective puts is for them to expire worthless. For the investor whoowns CSCO and who has purchased the February puts, the optimaloutcome is for the corporation to blow away the estimates and forthe stock to rally to a new high.Strike and Expiration DecisionsThe two decisions the buyer of protective puts has to make are thesame ones before the insurance buyer: for how long a term and forwhat level of protection.In our CSCO example, short-term options were perfect for the situation. If the concern had been that inventories would be buildingup to needlessly high levels over the next three months, then purchasing three- or four-month options would have made sense. Theoption’s term should correspond to the period during which insurance is desired.The second decision relates to the level at which the coverage willkick in. With insurance this is known as the deductible; with optionsit’s the strike price. Back to CSCO. The nervous investor purchasedeight of the 17 1⁄2 puts at $0.60 each. At the same time, the 15 puts
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were offered at $0.15. If all he had wanted was disaster insurance,then paying $0.15 per share would have done the job, as he wouldhave traded a lower insurance cost for a higher deductible. (A couple of years ago we realized that no matter which deductible youchoose for your car insurance, it will turn out to be the wrong one.We had an accident-free year, after which we thought a higherdeductible and lower premium would have done just ﬁne. When acolleague’s son wrapped his dad’s car around a tree, the man realized he should have paid more for the lower deductible policy. Weboth bought insurance with the wrong deductible!)When to InsureIf you are like most of us, when the ﬁre insurance on your home isabout to expire you renew your policy. And you probably do thesame with your car insurance policy. Should you also insure yourstocks and automatically renew this insurance when it comes due?We don’t think so. If an investor is uncomfortable holding stocksfor the longer term without them being insured, then it is probablysafe to say that this investor’s risk tolerance does not stretch to holding equities. Buy bonds.Protective puts should be used as short-term hedges in front ofearnings reports or other announcements, or to lock in a proﬁt whilewaiting for a short-term capital gain to turn into a long-term one,or to help carry a position from one tax year to the next. But beforepurchasing puts as part of your tax planning, see Chapter 10.
Purchasing Call OptionsTo some, buying calls is a speculative trade, a strategy that investorsshould avoid. It’s true that most calls are bought as a trade, with thepurchaser having no intention of ever owning the underlying security. But there are two situations where an investor looking to adda stock to her portfolio may be well served by buying call options.Long Cash/Long Call StrategyTake the case of an investor who has become long-term bullish onthe shares of Bristol-Myers Squibb (BMY). She has between $25,000
46
The Options Strategist
and $30,000 to invest, enough to purchase 600 shares of the stock at$45.01. The stock has come down in price to a level she ﬁnds veryattractive, but she does have some shorter-term worries, such as thenext earnings report and some pending regulatory issues.She could wait, but then if all the stars line up and the stockrebounds quickly, she could also miss taking part in the initial phaseof that stock’s rally. A look at the BMY June options (with 20 weeksuntil expiration) reveals the following:BMY:June 40 call:June 45 call:June 50 call:
$45.01$6.00–$6.50$2.90–$3.10$1.00–$1.15
One possible solution to her dilemma is to purchase six BMY calloptions. This has the advantage of locking in the price at which shecould eventually purchase the shares, and it permits her to sit on thefence for the next couple of months to see how the earnings andother announcements turn out. She would also be risking a relatively small percentage of the capital she has to invest, leaving thebalance in her money market account.She chooses the June expiration because she believes that by thattime the dust will have settled. Her problem is choosing a strikeprice: 40, 45, or 50. This decision is a balancing act between theamount at risk and the effective purchase price of the stock uponexercise. For example, purchasing the 40 call results in an eventualstock purchase price of $46.50 (the $6.50 option premium plus the$40 paid when the call is exercised), a relatively small premium overthe current price of $45.01. But the 40 call also leaves $6.50 per shareat risk: if BMY is below $40 at the June expiration, these calls willexpire worthless.The 50 call, on the other hand, results in only $1.15 being at riskbut creates an effective purchase price of $51.15. There is no one correct answer as to which call our investor should purchase. If she isfairly conﬁdent the stock is now reaching bottom, she may be comfortable risking $6.50 per share to lock in an attractive purchaseprice. And this still represents a fraction of the amount she wouldhave at risk if she purchased the stock outright. If her risk toleranceisn’t so high, she may be more at ease risking $1.15 and accepting a
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higher entry point. She might reason that if the stock rallies backabove $50 this would be a positive signal, and she would at thatpoint be willing to pay a higher acquisition cost.She should also consider that middle road, the June 45 call. Byrisking $3.10 she would be locking in a $48.10 effective buying price,a compromise solution.Choosing among various option series always involves trade-offs.For this investor it will be between the amount at risk and the eventual buying price. The option series purchased will be chosen basedon the tug-of-war between the investor’s fear and greed, althoughyou will note that we did not consider options that were more thanone strike price in- or out-of-the-money. Options that are two ormore strike prices away from the stock’s price are usually not relevant. If they are too far in-the-money, the increased risk does notjustify the small reduction in effective buying price obtained. If theyare too far out-of-the-money, the odds of their ever being exercisedare virtually nil.One point to keep in mind during the option selection process isthat the investor’s goal is to eventually own BMY shares. That ultimate goal should be the driving factor in choosing the strike price.Buy Call/Start Saving StrategyThe preceding example assumed that the investor had the fundsnecessary to purchase the shares she wanted, but that’s not alwaysthe case. Take the situation of another investor who would like toadd 1,000 shares of Unocal (UCL) to his portfolio. With the stocktrading at $38.86 such an investment would require about $40,000,but our investor has immediate access to only $10,000.His ﬁrst alternative would be to purchase roughly one-quarter ofthe 1,000 shares he wants to own with his current cash, start saving,and add to his position as funds become available. One of the risksof such a plan is that if UCL starts to rally, his 1,000 shares could endup costing him more than $40,000.Turning to options, and more speciﬁcally to LEAPS, this investorﬁnds the 20-month UCL 30 call to be quoted at $10.40–$10.90. Purchasing 10 of these LEAPS would lock in an effective purchase priceof $40.90 (the 30 strike price plus the $10.90 LEAPS premium),would have an initial cost of $10,900 (slightly more than the cash
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The Options Strategist
available), and would give our investor 20 months to save up the$30,000 necessary to exercise the LEAPS calls.Assuming the savings are deposited into a money market accountyielding 3%, and assuming monthly compounding, our investorwould have to save $1,463 every month. With a 4% yield, themonthly savings required would be $1,451. Under the 3% assumption, the adjusted cost of the stock would be $40.16 per share($10,900 to purchase the LEAPS, plus 20 monthly installments of$1,463 totaling $29,260 for a grand total of $40,160). Note that thedifference between the $40.16 cost in this paragraph and the $40.90obtained in the previous paragraph represents the interest incomeearned.This buy calls/start saving strategy has two major advantages foran investor in this situation. First, the cost of the full 1,000 shares islocked in when the position is initiated: $10.90 per share needs tobe invested immediately and another $30 at option expiration in 20months. The investor will get the immediate upside appreciation ofa full 1,000-share position, although he will not get ancillary beneﬁts such as dividends and shareholders’ rights such as voting. Second, call buying is by deﬁnition a limited risk strategy. If ourinvestor’s forecast for UCL was off base and this stock is tradingbelow $30 in 20 months, our investor’s risk will be limited to theoption premium paid. Granted, in this example, the option premium paid represents a substantial percentage of the stock price,28% to be precise. Which then begs the question: is it possible forthe price of a stock to fall by more than 28% over a 20-month period?Only those investors who spent the ﬁrst two years of the new millennium on Mars will answer in the negative.Entering into the buy call/start saving strategy does not mean adecision is taken today and no further action is required during thenext 20 months. Someone who purchases these LEAPS calls shouldview his holding as he would a 1,000-share position. If there aredevelopments that would cause him to sell his shares, then heshould probably sell his calls. If the stock hits his target price beforeexpiration and he would be selling the shares, he should also sellhis calls. This investor has created a position that looks like and feelslike 1,000 shares; it should be treated as such.Should our investor hold his long LEAPS for the full 20 months,he will then have to come to a ﬁnal decision. Should he sell the
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LEAPS or exercise them? Assuming UCL is above $30 and the callsare not worthless, his sell or exercise decision should be based onhis reassessed outlook for UCL. Is this a stock he still wants to addto his portfolio, or has he found a more attractive investment alternative? In either case, he will have the funds available to take action.Yes, this strategy does imply a fair amount of discipline, as itrequires establishing a regular savings plan. But no more disciplinethan is required to participate in an automatic withdrawal plan thatfunnels a monthly contribution to a mutual fund.
Writing Equity Put OptionsThis strategy encompasses the best and the worst of options. If youhave not heard any horror stories about put writers, you probablydon’t go to cocktail parties. Everybody knows somebody, or at leastsomebody who knows somebody, who was writing put optionsand. . . . The magnitude of the ﬁnal disaster probably grows withevery retelling, but it remains a disaster nonetheless. Yet otherinvestors write equity puts year in and year out, love the strategy,and are comfortable knowing they will not end up as a topic of cocktail party conversation. Why these two extremes?Writing Puts Without and with LeverageA put writer assumes the obligation of purchasing a stock at a speciﬁed price. The risk of this strategy is easy to quantify: the put writercould become a stock owner and would have to bear the full risk ofstock ownership. If an investor is comfortable owning stocks, shouldshe be less comfortable writing puts?Take two people, both with roughly $20,000 to invest, and bothlooking to add Disney (DIS) to their portfolio. DIS is trading at$20.66 and Mr. Barrel instructs his broker to purchase 1,000 sharesat the market. Mr. Lock decides not to purchase DIS outright, but toassume the obligation to purchase 1,000 shares at $20. So he writes10 November 20 puts at $0.70. The options expire in six weeks.If the stock never dips to $20, Mr. Lock will never be assigned onhis puts. Should the options expire worthless, his return will be$0.70 on an investment of $20. That’s a yield of 3.5%, or 30% annu-
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The Options Strategist
alized. But did Mr. Lock make an investment of $20? Writing a putentails assuming an obligation, but it does not require investing anycash in the traditional sense of the word. Yes, his broker will requirehim to post sufﬁcient margin, but this would not be a problem if the$20,000 he has to invest is in his brokerage account, or if he holdssufﬁcient securities to margin the trade.This is where the psychology of the trade is as, if not more, important than its pure mechanics. We would like to see Mr. Lock segregate $20,000, if not physically, then at least mentally, and reserve thissum to purchase DIS if he is so obligated. When some put writerssee this sum sitting in their account, they consider it to be idle anddecide to invest it somewhere else. This cash is not idle. It is earning a 30% annualized rate of return in addition to the interest paidon the account’s cash balances.If history is any guide, here is how Mr. Lock gets into trouble. Hewrites 10 November puts at $0.70 and they expire worthless. “Thatwas easy,” he says. And he sells 10 more, maybe the January 20 puts.These also expire worthless. “Too bad I didn’t write more,” he concludes, and writes 15 of the March puts. They expire, and he writes20 of the May puts, then 30 of the July. But his winning streak ﬁnallycomes to an end. The stock heads south and before he knows it hisbroker is on the phone telling him he is the proud owner of 3,000shares of DIS, for which he just paid $20.Of course this happens when the stock is down, and maybe whenthe overall market is slumping. Mr. Lock gets nervous—or worse,gets a margin call—and liquidates part or all of his position as thestock is hitting a new 52-week low. He is now perfect material forcocktail party conversation.The problem with put writing is not put writing. It’s the extent towhich the option position is leveraged. When Mr. Lock wrote 10puts and had $20,000 in cash, his puts were cash-secured. He hadall of the funds required to pay for the stock. When he wrote 15 contracts he had $20,000 to pay for $30,000 worth of stock; a slightlyleveraged position, but one with which a lot of investors would becomfortable. By the time he got to 30 options he had $20,000 backing up a $60,000 obligation. It is easy to blame options for the messsome investors get into, but often the real culprit is overleveraging.Put writers should be aware of the risks of early assignment. SeeChapter 4.
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Rolling Short Put PositionsWe noted earlier that covered writers have a number of rolling alternatives available to them as their short options approach expiration.Put writers should also consider rolling out some of their positions.Consider an investor who a little while back wrote the ComputerAssociates (CA) April 20 puts for $1.25. Her goal was straightforward: she liked CA but was not willing to pay the current price of$22. By writing the 20 puts she took on the obligation of buyingshares at $20, and by receiving $1.25 in option premium she reducedher potential purchase price to $18.75, a buying target with whichshe was comfortable. One week before expiration Friday, CA hasdrifted down and she ﬁnds the following quotes:CA:April 20 put:May 20 put:
$19.05$1.40–$1.45$2.30–$2.40
If CA remains unchanged during the next week and if our investordoes not cover her puts, she will be assigned and end up owning CAat an adjusted price of $18.75. But she could also roll out her Apriloptions to May for an $0.85 credit (cover the April at $1.45, write theMay at $2.30). Adding this $0.85 to her original premium of $1.25totals $2.10, effectively bringing her potential purchase cost to below$18, an interesting proposition. If she rolls out to May and CA rallies sharply over the next ﬁve weeks, she could see the May optionsexpire worthless and not be assigned (and thus not have a positionin CA), which would leave her with a $2.10 proﬁt for her efforts.Rolling out can be analyzed from two perspectives. An investorcan look at the lower purchasing level the rolling strategy establishes. In the previous example, it reduced an effective buying priceof $18.75 to $17.90, although the probability of owning the stock wassomewhat diminished by pushing out the expiration date. Rollingcan also be analyzed from the perspective of a return on cash.Assume that our investor has $20 per share set aside in a moneymarket fund to pay for the CA shares she is looking to purchase. Byrolling her position out an additional four weeks she is earning $0.85on this $20 a 4.2% return that annualizes to 55%. This is a great rateof return, but it is also a message from the options market as to itsperception of the high risk inherent in CA shares.
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The Options Strategist
Other Rolling StrategiesRolling down (to a lower strike price) and out (to a deferred expiration date) is rarely done with puts. There are few circumstancesin which this trade can be done for even money or a small credit.And since put writers are usually looking either to purchase theunderlying stock or to capture some option time premium, doingso for a debit makes little sense. To be done for even money or better, rolling down and out will require one or more of the followingconditions to be met:■ The underlying stock is relatively volatile.■
The price of the stock is relatively high. Rolling down and outfrom an $80 strike to a 75 is much easier than from a $30 striketo a 25 because it represents a smaller percentage reduction inthe option’s strike.
■
The short position will have to be rolled out to one of the deferredexpirations (a two- or three-month put may have to be writteninstead of a one-month option).
Rolling up and out is technically not a roll, but a decision to moveto a higher strike price, usually after the options initially writtenhave expired. Assume that CA had rallied to the $24 area after ourinvestor wrote her April puts. At the April expiration she would seeher short puts expire worthless, and if she were still interested inadding these shares to her portfolio she would now have to decideif she wanted to raise her buying price to $22.50, one option strikeprice higher than her ﬁrst series. Stock investors will recognize thisas a version of “chasing a stock up”—something we prefer to avoid.When a stock we are looking to purchase gets away from us, weremind ourselves that it’s not the only ﬁsh in the sea and that theremay be other interesting opportunities elsewhere.Finally, when should investors roll out their short put positions?Looking back to the CA example, we see the April 20 put offered at$1.45 with the stock at $19.05. This put is in-the-money by $0.95, sopurchasing it at $1.45 means paying $0.50 in time premium, a halfdollar that will disappear over the next week, assuming anunchanged CA price. Our investor may feel it is a bit early to rollout her position because the April put will probably lose its time
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premium more rapidly than the May put over the next few tradingdays and the spread between the two options should widen, assuming an unchanged stock price. Our only note of caution is that putshave a t