.50
$0
$0
($0.10)
($0.10)
front spread by purchasing one of the September 40 calls at $3.90and writing two of the 42 1⁄2 calls at $1.90, for an initial debit of $0.10.Table 6.14 calculates the value and proﬁtability of this front spreadat option expiration.The proﬁt-and-loss numbers are illustrated in Figure 6.9.Figure 6.9 provides a quick summary of the features of a call frontspread. Like the short straddle, it is a strategy with limited proﬁtpotential, which is realized only if the underlying stock closes at theshort options’ strike price. Unlike the short straddle, the call frontspread has virtually no risk if the price of the underlying stock$4
Profit/(Loss)
$2$0($2)($4)($6)($8)$37.50
$40.00
$42.50
$45.00
XOM Price at Expiration
Figure 6.9 XOM: Call Front Spread
$47.50
$50.00
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The Options Strategist
moves sharply lower (in our example this risk is limited to $0.10).But like the straddle, the call front spread is net short one calloption, which means there is theoretically unlimited risk to theupside.Another minor point is that unless a stock is trading exactly at astrike price, a call front spread will require a trader to give his position a slight bias. With XOM at $43.41, the 40–42 1⁄2 front spread inour example had a slightly bearish bias as its maximum proﬁt isrealized at $42.50, nearly $1 below the current stock price. A slightlybullish spread could have been created by purchasing the 42 1⁄2 calland writing the 45s.Put Front SpreadFinally, take the case of a trader who is very neutral on Illinois ToolWorks (ITW), trading at $71.22, expecting it to remain in a narrowtrading range over the next few months. If this trader sees anyvolatility risk in ITW, it is to the upside; in other words, the trader’sforecast is for “nothing to happen,” but a surprise would more thanlikely see ITW rallying. She initiates a put front spread by buyingone June 75 put at $5.80 and writing two of the June 70 puts at $3each, for an initial credit of $0.20. Table 6.15 summarizes her optionposition and its proﬁtability at expiration.Once again we present the results in Figure 6.10.
Table 6.15ITW atExpiration
Value ofLong 75 Put
Value ofShort 70 Puts
InitialCredit
Proﬁt/(Loss)
$85
$0
$0
$0.20
$0.20
$80
$0
$0
$0.20
$0.20
$75
$0
$0
$0.20
$0.20
$70
$5
$0
$0.20
$5.20
$65
$10
2 ⫻ ($5.00)
$0.20
$0.20
$60
$15
2 ⫻ ($10.00)
$0.20
($4.80)
$55
$20
2 ⫻ ($15.00)
$0.20
($9.80)
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$6
Profit/(Loss)
$4$2$0($2)($4)($6)($8)($10)$55
$60
$65
$70
$75
$80
$85
ITW Price at Expiration
Figure 6.10 ITW: Put Front Spread
We now have the mirror image of the call front spread: limitedproﬁt potential, realized only if ITW closes at $70 at expiration, noupside risk, and all of the stock’s downside risk.Both front spreads have half the risk of a short straddle and itshould not come as a surprise that their proﬁt potential is somewhatlower. Before entering into any of the strategies in this section we recommend reading the discussion of risk management in Chapter 10.
SyntheticsSometimes traders have no use for options. They simply want toown a stock for the short term without calculating deltas and coping with time decay. And if they are like a lot of other traders, they’llbe buying these shares with borrowed funds since they are alreadyfully invested. Take the situation of a trader who has turned bullishon the shares on Invidia (NVDA) but has no cash left in his tradingaccount. If he has sufﬁcient securities he could purchase sharesusing borrowed funds, but he should also take a look at the optionsmarket, such as the following quotes:NVDA:June 40 call:June 40 put:
$42.86$7.60–$7.80$4.60–$4.80
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The Options Strategist
The trader considers the options too pricey and refuses to paynearly $8 for a call with less than three months until expiration. Ifhe purchased the 40 call and at the same time wrote the 40 put, hewould be entering into a strategy that replicates a long stock position, known as long synthetic stock.Buying the 40 call at $7.80 and writing the 40 put at $4.60 meansthat the option position is established for a $3.20 debit. At optionexpiration, NVDA will either be above $40 or below $40. In the ﬁrstinstance, the 40 call would be in-the-money and could be exercised.The adjusted cost of the stock would then be $43.20—the $40 paidupon exercise of the call plus the initial debit of $3.20. If NVDA isbelow $40, the put will be in-the-money, and if it is not covered itwill be assigned, forcing the trader to buy shares at $40. Once again,the adjusted cost on the stock will be $43.20—the $40 paid uponassignment of the put plus the initial debit of $3.20. Yes, there is athird possibility, that of NVDA closing at exactly $40 on expirationFriday. In this case the trader would probably not want to exercisehis call because the possibility of being assigned on the puts willstill exist. To eliminate the risk of being assigned on his short optionthe trader would have to buy it back for some nominal amount.Of course, a trader will not have to exercise or be assigned on hissynthetic stock position: he’ll be able to trade out of his options anytime prior to expiration.The position and its proﬁtability at option expiration are summarized in Table 6.16 below.
Table 6.16NVDA atExpiration
NVDA $Change
Value of40 Call
Value of40 Put
InitialDebit
OptionProﬁt/(Loss)
$50
$7.14
$10
$0
($3.20)
$6.80
$47.50
$4.64
$7.50
$0
($3.20)
$4.30
$45
$2.14
$5
$0
($3.20)
$1.80
$42.50
($0.36)
$2.50
$0
($3.20)
($0.70)
$40
($2.86)
$0
$0
($3.20)
($3.20)
$37.50
($5.36)
$0
($2.50)
($3.20)
($5.70)
$35
($7.86)
$0
($5.00)
($3.20)
($8.20)
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The proﬁt or loss realized on the option position is equal to thedollar change in NVDA less $0.34. So why not simply buy the stocksince the options leave us $0.34 poorer? Because the numbers abovedo not reﬂect the cost of capital. If the trader has enough cash to buythe stock, his opportunity cost is $0.21 per share for the next threemonths. This represents the forgone interest on $42.86 invested at2% for three months. On the other hand, if the trader plans to borrow the funds to buy the stock, then his interest cost would be $0.64per share, assuming he borrows $42.86 at 6% for the next threemonths.In the end, the difference between the real stock and the syntheticstock will boil down to two minor factors: the fact that establishingthe position with options involves two bid-ask spreads versus onlyone with the stock, and the trader’s opportunity or borrowing costversus the carrying cost imbedded in the price of the options.Remember that options are usually priced using the risk-free interest rate, and the theoretical value of a long synthetic stock will tendto reﬂect this cost of money.Choosing Strike PricesA trader looking to establish a long synthetic position on HomeDepot (HD) ﬁnds the following quotes:HD:May 45 call:May 45 put:May 50 call:May 50 put:
$48.43$4.10–$4.30$0.65–$0.70$1.05–$1.10$2.55–$2.65
With HD trading between exercise prices the trader must choosebetween the 45 or 50 strikes. Establishing the long synthetic usingthe 45 strike would entail buying the 45 call at $4.30 and writing the45 put at $0.65 for a net debit of $3.65. The effective purchase priceof HD would be $48.65 (the 45 strike plus the $3.65 debit). Using the50 strike options would mean purchasing the 50 call at $1.10 andwriting the 50 put at $2.55 for a net credit of $1.45 and an effectivepurchase price of $48.55 (the 50 strike less the $1.45 credit).At ﬁrst glance there are two advantages to using the 50 strikeoptions. First, the effective purchase price is $0.10 lower, probably
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The Options Strategist
because of the wider bid-ask spread on the 45 call. And second, the50 strike synthetic can be established for a credit rather than a debit,and isn’t getting paid better than paying?Yes, but these two advantages must be balanced against the factthat using the 50 strike price involves writing an in-the-money put.Both synthetic positions carry the risk of early assignment on theshort puts, but the 50 put is already in-the-money and so carries ahigher risk of having to purchase the stock on assignment beforeoption expiration.Personally, we would probably rather pay up and use the 45 striketo reduce the risk of early assignment. This is not an immediateissue, even with the 50 puts, as they are in-the-money by a littlemore than $1.50 and are trading with an additional dollar of timepremium, but we prefer our short puts to be out-of-the-money.Another possible solution is to create what is known as a splitstrike synthetic: purchase the out-of-the-money 50 call at $1.10 andwrite the out-of-the-money 45 put for $0.65 for an initial debit of$0.45. This position will behave like stock above 50 and below 45but not in between the strike prices. If HD is inside the strikes atexpiration, both options will expire worthless and the split-strikesynthetic will show a loss of $0.45, the initial debit.Even though long synthetic positions can be initiated for little orno up-front cash, they all incorporate a short put option that mustbe adequately margined. This is not the illusive free ride.Short SyntheticsIt should come as no surprise that an option position that fully replicates the risk and proﬁt potential of a short stock can be created synthetically. By buying a put a trader obtains all of the downside proﬁtpotential of a short stock position, and by writing a call he mustassume all of the upside risk. Look at the following quotes on Procter & Gamble (PG):PG:July 90 call:July 90 put:
$89.12$3.30–$3.50$4.40–$4.60
Purchasing the 90 put at $4.60 and writing the 90 call at $3.30would establish a synthetic short position for a $1.30 debit, effec-
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163
tively shorting the stock at $88.70. Is the synthetic short short-changing us by $0.42? This difference is partly explained by the bid-askon the options (we did not factor in the bid-ask on the stock) andpartly by the $0.36 dividend that is expected between the trade dateand the options’ expiration date. A trader who shorts the stockwould have to pay this $0.36 dividend to the brokerage ﬁrm fromwhich he borrowed the shares (and it in turn would pay this dividend to the client from whom it borrowed the shares). The syntheticshort position does not incur this liability. So the net results arepretty even.Traders know that certain stocks are difﬁcult to borrow and thusto sell short, so they reason, “If I can’t borrow shares of a stock Iwant to short, why not simply create a synthetic short position?”There is nothing to prevent them from trying to short a stock synthetically, but when traders can’t borrow a stock this penury is usually felt streetwide. The market makers or specialists in this optionclass are probably aware that the stock is difﬁcult (or impossible) toborrow, and since this limits their hedging possibilities, they will bereluctant to take on option positions in which they would have toshort the underlying stock to hedge themselves.In brief, if a trader shorts a stock synthetically, the option’s market makers end up buying the stock synthetically and would normally hedge this option position by shorting the underlying stock.If it’s impossible to borrow shares, the options market may be rathershallow and the bid-ask spreads wider than normal, imposing anadditional cost to option traders.
Buying Calls to Hedge a Short StockSome traders have the experience, the capital, and, let’s admit it, thestomach to short stocks they believe are about to head south. Buying a call to protect a short stock position appears as a natural optionstrategy—either to let traders with short stock positions sleep better at night or to let someone who could never assume the risk of ashort stock position dip her toes into this bearish strategy.The logic is straightforward: the risk of a short stock position isseeing the underlying rally on good news, takeover speculation, ora plain vanilla bull market. Buying a call locks in the buying priceof the shorted stock, limiting the amount of pain that a runaway
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The Options Strategist
stock can inﬂict. Yes, the buyer of the call option has to pay up, butisn’t the option premium a relatively small price to pay for theknowledge that if this one gets away, the risk is limited to so manydollars and not a penny more?Yes, and no. We are ambivalent about this strategy, but let’s startwith where we believe it has a role to play. A trader has been shorta stock for the last four weeks, waiting for the bad news to hit or, ashe sees it, for the market to come to its senses. He realizes that earnings will be released next Tuesday. This could be the catalyst he hasbeen waiting for, or it could sound his death knell. The day beforethe earnings come out he buys call options to hedge his short stockposition. He will hold these options for less than a week, just to seehow the market reacts to the company’s earnings, or lack thereof. Ifhis bearish outlook remains unchanged after this news hits the tape,he will sell his calls to recoup part of the option premium paid andwill maintain his short stock position. This, we believe, is how callscan be effectively purchased to hedge a short stock position.The Married CallLet’s now turn to another trader who has just turned bearish onMcDonald’s (MCD). She has never shorted shares and, given herrisk tolerance, would probably never do so, but marrying a shortstock to a long call would reduce her overall risk to a more comfortable level. MCD is trading at $27.34 and the February 27 1⁄2 call isoffered at $0.85. Her reasoning is straightforward: she can shortMCD at the current price, pay $0.85 for the eight-week call, and beable to maintain her short stock position for the next two months,knowing her ultimate risk. Table 6.17 looks at the proﬁtability of hershort stock/long call position at option expiration in eight weeks.Table 6.17 clearly shows how the long call hedges the short stockposition: if MCD rallies above $27.50, any losses accruing on theshort stock are made up by the increased value of the call option.Of course, our investor will have to absorb the loss of the option premium, but she considers this a small price to pay. The numbers inTable 6.17 are illustrated in Figure 6.11.Figure 6.11 illustrates the limited upside risk of the position andthe substantial proﬁt potential to the downside. This graph bears astriking resemblance to one of the basic strategy graphs presented
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165
Table 6.17MCD atOptionExpiration
Proﬁt/(Loss)on Short MCD
Value of27 1⁄2 Call
Cost of27 1⁄2 Call
TotalProﬁt/(Loss)
$32.50
($5.16)
$5
($0.85)
($1.01)
$30
($2.66)
$2.50
($0.85)
($1.01)
$27.50
($0.16)
$0
($0.85)
($1.01)
$25
$2.34
$0
($0.85)
$1.49
$22.50
$4.84
$0
($0.85)
$3.99
$20
$7.34
$0
($0.85)
$6.49
in Chapter 1. Look at Figure 1.2, which illustrates a long AVP putposition. Both a long call/short stock and a long put position havelimited risk if the underlying rallies, and substantial proﬁt potentialto the downside. The put buyer’s risk is limited to the option premium paid. The risk to the trader who is short stock/long call isequal to the option premium paid plus any out-of-the-moneyamount, if there is any.In fact, by shorting MCD and purchasing a call option, our traderhas simply purchased a put option. The difference is that her tradeis more complicated and carries higher transaction costs. It also addsmore layers of risk, such as being forced to cover her short position
Profit/(Loss)
$7$6$5$4$3$2$1$0($1)($2)$20.00
$22.50
$25.00
$27.50
MCD Price at Expiration
Figure 6.11 Short MCD, Long Call
$30.00
$32.50
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The Options Strategist
if her broker can no longer borrow MCD shares, or being liable forany dividends declared by MCD. If she wanted to establish a bearish position with limited risk to the upside and good downsidepotential, she could have simply purchased the February 27 1⁄2 putthat was offered at $0.90. Her risk would have been $0.90 (versus$1.01 for the short stock/long call position), she would have effectively been short MCD at $27.50 (versus $27.34), and her cost ofinsurance would have been $0.90 (versus $0.85). Most important,she could have initiated her position with one trade and would havepaid one commission instead of two. Getting approval from her broker to purchase puts probably entails much less paperwork than setting up a short stock account.Although it initially sounds good, the short stock/long call strategy is nothing but a roundabout way of purchasing a put option.Just as we were able to create a synthetic stock position, we can create a synthetic put option (although, in this case, we prefer the 100%natural put). Traders who like the limited risk and substantial downside proﬁt potential of the short stock/long call position will savethemselves a lot of trouble (and some transaction costs) by simplypurchasing put options. Keep in mind, though, that for the twostrategies to be equivalent the expiration dates and strike prices ofthe options must be identical. When hedging a short stock, tradershave a tendency to purchase out-of-the-money calls, which is equivalent to purchasing an in-the-money put. If an out-of-the-money putis purchased to replace a short stock/long out-of-the-money callposition, the risk-reward proﬁle will be different—not because thestrategies are different, but because of the choice of strike prices.
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OPTIONS ONEXCHANGETRADED FUNDSAND ON INDICESOptions on Exchange-Traded FundsOptions on exchange-traded funds (ETFs) could arguably belumped with equity options. The main difference between the twois that the underlying of equity options is 100 shares of a speciﬁcstock and the underlying of ETF options is 100 shares of a fund.Think of an index mutual fund. The fund manager purchases thecomponent shares in proportions that are appropriate to the indexthe fund is designed to track. Investors can buy or sell shares of this167Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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The Options Strategist
fund once a day based on the fund’s closing net asset value. Nowtake a fund, also holding all of the component stocks of an index,and list it on an exchange, giving investors and traders the opportunity to buy it and sell it at any point during the trading day. Younow understand the basics of ETFs.The ﬁrst ETF to catch investors’ attention was the Standard &Poor’s Depositary Receipt®, SPDR®, better known as “Spiders”(ticker symbol: SPY), a fund that tracks the Standard & Poor’s 500Index. Today, ETFs are well established, as can be seen by the special section they occupy in the Wall Street Journal. The universe ofoptions on ETFs is still small, but these instruments present uniqueinvestment opportunities.
Investment Strategies with Options on ETFsAlthough options on ETFs can be used for trading purposes, weprefer to use them in an investment context. Traders, especiallythose who are looking to establish more complex strategies, shouldprobably favor index options, which are discussed later in thischapter.Writing Puts to Go Long the MarketSay an investor is ambivalent about moving some of his cash intoequities. He likes the market, but not enough to stick his neck out,at least at the current levels. He would be more comfortable committing himself to a position in the overall market on a slight pullback. Given the amount he is looking to invest, around $50,000, heis reluctant to purchase individual stocks because it would be difﬁcult for him to attain the level of diversiﬁcation he feels is necessaryfor his risk tolerance. He would, however, purchase the Standardand Poor’s 100® iSharesSM (OEF), currently trading at $56.72 (note:the OEF are structured to be valued at one-tenth the level of theStandard and Poor’s 100 Index, which is at 567.21). Looking at theeight-week options on OEF he ﬁnds the following:OEF:April 53 puts:
$56.72$0.65–$0.85
Options on Exchange-Traded Funds and on Indices
April 54 puts:April 56 puts:
169
$0.85–$1.05$1.55–$1.75
Sharpening his pencil, he comes up with the data presented inTable 7.1.Taking the 54 puts, here is how to interpret these numbers. If theinvestor writes the 54 put for $0.85 and is assigned, he will effectively be purchasing OEF shares at $53.15 ($54 less the $0.85 premium). This price is 6.3% below the current value of OEF at $56.72.If the investor is not assigned on the puts, he will keep the optionpremium of $0.85. Remember that he is currently sitting on cash, sothe option premium generates an incremental return of 1.57%,which is 10.2% annualized. ($0.85 is earned on every $54 that is setaside to purchase OEF shares if assigned; the return is therefore$0.85 ⫼ $54 ⫽ 1.57%.)So which put should this investor write? This is another questionthat doesn’t have just one correct answer. Would a 4% discount tothe current market level be an acceptable entry point? If so, writingthe 56 puts looks quite attractive and provides an excellent incremental return if not assigned. But this investor should also remember that the higher the put’s strike price, the greater the odds ofbeing assigned. So the probability of getting assigned on the 56 putsis signiﬁcantly higher than the probability of being assigned on the53 puts. There is therefore less chance of earning the higher incremental return on cash.For those who like more precision when it comes to probabilities,the probability of being assigned on a put is roughly equal to theabsolute value of the put’s delta. So a put with a ⫺0.40 delta wouldhave roughly a 40% chance of being in-the-money at expiration andTable 7.1
Percent BelowCurrent Level
IncrementalReturn on Cash(Not Assigned)
Premium
EffectivePurchase Price
53 Put
$0.65
$52.35
7.7%
7.9%
54 Put
$0.85
$53.15
6.3%
10.2%
56 Put
$1.55
$54.45
4.0%
18.0%
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The Options Strategist
being assigned. Note that this method of estimating probabilitiesloses precision the further out the expiration date; so it is fairly accurate for one- or two-month options, but not so accurate for sixmonth options and LEAPS. The deltas of the options in our exampleare ⫺0.42 (56 put), ⫺0.28 (54 put), and ⫺0.23 (53 put). Our investorhas to balance the probability of being assigned (and going long themarket at the discount associated with the put written) and that ofnot being assigned (and earning the incremental return on his cash).Writing Covered Calls to Ease Out of a PositionAn investor is currently long 1,000 of the Nasdaq-100 TrackingStockSM, better known as the “triple Qs” (ticker: QQQ). The QQQare currently at $34.70, one-fortieth the Nasdaq-100® level of 1388.02.She purchased these shares at a lower price and would not be averseto selling half her position on a rally. Looking at the QQQ optionsshe ﬁnds the following three-month calls:QQQ:May 35 call:May 36 call:May 37 call:May 38 call:May 39 call:
$34.70$2.40–$2.50$1.90–$2.00$1.50–$1.60$1.15–$1.25$0.90–$0.95
Putting two and two together, she comes up with the data inTable 7.2.Table 7.2OptionPremium
Upside
Return fromPremium
Total Return(If Called)
35 Call
$2.40
0.9%
6.9%
7.8%
36 Call
$1.90
3.7%
5.5%
9.2%
37 Call
$1.50
6.6%
4.3%
10.9%
38 Call
$1.15
9.5%
3.3%
12.8%
39 Call
$0.90
12.4%
2.6%
15.0%
Options on Exchange-Traded Funds and on Indices
171
The upside is the amount by which the call is out-of-the-moneyand represents the possible appreciation from the ETF’s currentprice to the options’ strike price. The return from premium is thepercentage of the ETF’s price represented by the option premium.If the QQQ price remains unchanged over the life of the option, thiswould represent her static return (note: these numbers have notbeen annualized). And ﬁnally, the total return is the best-case scenario: her return if the shares rise to or above the options’ strikeprice and she is assigned.The give and take here is quite simple: a higher total return(which requires the shares to rise to the selected strike price) or ahigher return if the shares remain unchanged (which only requiresQQQ to remain stable). We can gather that our investor is relativelybullish over the longer term since she only wants to reduce her position by half, not eliminate it. Writing the at-the-moneys (the 35 or36 calls) probably does not ﬁt in with her overall assessment. Sheshould be looking instead at the 37 or 38 calls, which both providemore than 10% of potential total return over the next three months.You may have a different opinion, and we would not want to changeit, as long as you have factored in all the relevant data and weighedthe trade-offs.Other Strategies Using ETF OptionsThe two preceding strategies are a repeat of the basic investmentstrategies with equity options. The mindset remains the same, theobjectives are similar—only the underlying has changed. It standsto reason that the other investment strategies built around equityoptions will easily translate to ETFs: the buy/write, the purchase ofprotective puts, the buying of calls, the repair strategy, coveredstraddles, and covered combinations. We invite you to review someof the strategies presented in Chapter 5, replacing the equities withETFs. You should ﬁnd new investing opportunities.
Index Options: Special FeaturesBefore proceeding with index options strategies we must underscore some of their special features.
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The Options Strategist
Cash SettlementThink of your car insurance policy. This is a type of option: you paida ﬁxed premium, the policy has an expiration date, and you havethe right to make a claim if this option goes in-the-money. The inthe-money amount is determined by the extent of the damage toyour car (the more severe, the deeper in-the-money), and how farout-of-the-money the option (determined by the deductible) is. Notethat the right to exercise is completely yours. You may decide not tomake a claim if you deem the in-the-money amount to be too small.(You know that making a claim will impact the pricing of futureoptions because the market will view you as a “volatile” driver.)Now assume that you