net basis. Exercise can be subsequently avoided in a risingmarket by rolling forward and up.An example shows how this strategy may work. Table 7–2 summarizesthe annualized returns you would earn by writing several different putson Federal Express. The annualized yield is calculated by first calculating the simple rate of return between option premium and strike price,then reflecting that return as if the position were open for 12 months.
Comparing Rates of Return for Dissimilar Strike PricesThe comparison between different strike prices and expiration dates iscomplex, even when the returns are annualized. When you consider theramifications of different strike prices with the potential for exercise in
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Table 7–2 Short-Put Annualized Rates of Return
FederalExpressExpirationand StrikePrices*January 20058580757065April 20058580757065January 20068580757065January 20078580757065
(B)SimpleReturn
(C)Months toExpiration
AnnualizedReturn**
2.150.950.400.150.05
2.5%1.20.50.20.1
33333
10.0%4.82.00.80.4
3.301.901.000.550.25
3.9%2.41.30.80.4
66666
7.8%4.82.61.60.8
6.304.50—2.25—
7.4%5.6—3.2—
1515151515
5.9%4.5—2.6—
8.606.705.103.902.90
10.1%8.46.85.64.5
2727272727
4.5%3.73.02.52.0
(A)Premium
* Stock prices and option premium values based on prices as of October 22, 2004.Source: Chicago Board of Exchange (CBOE).** The calculation to annualize involves the following two steps:Divide premium (Col. A) by strike price to arrive at simple return (Col. B)Annualize with the following formula to reflect return on a 12-month basis:[col. B ÷ col. C]  12
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mind, it changes the comparison completely; for example, if the stockcontinued to decline, you would prefer to take exercise at the lowestpossible strike price, given the desired rate of return. The comparisonbetween returns at various strike prices provides a valuable analyticaltool for making an informed, conservative decision. For example, withFederal Express at $87.78 per share, the exercise risk of an 85 strike isconsiderably greater than the same risk for an 80 put. The 3-month 85put yields annualized 10.0 percent; the comparable 80 put yields 4.8percent, but also contains 5 points less market risk (the differencebetween strikes of 85 and 80).Table 7–2 can be useful in limiting risks and establishing your own standards for which puts to sell. The table demonstrates that spreading therisk out to longer expirations does increase the dollar amount of premium; but on an annualized return basis, shorter term options yield farbetter returns. Consider the case of the 80 puts. The 3-month optionyields the same annualized rate as the 6-month option. Yield for 15months is only slightly lower. In this comparison, the risk of the 3month option is less because the exposure period is shorter. Thus, theturnover of short positions could be entered more frequently. This represents a lower risk for another reason: if the market value of the stockwere to change in either direction in the next 3 months, you could selectdifferent options in future short strategies based on the desirability ofmaintaining a gap between current market price and strike price thatmeets your standards. In our example, we compare returns for strikes of80, which is 7.78 points below current market value. So, for example, inselecting options with the short-put strategy in mind, you could limityour exposure to puts with strike prices between 5 and 10 points belowcurrent market value and with 3 to 6 months until expiration.When you consider the alternative—buying shares at today’s price toaverage down your basis—you immediately realize that selling the putis more profitable but requires less capital (limited to margin requirement minus premium).When selecting short puts, plan an exit or roll strategy and also identify a rescue strategy in the event the stock declines in value. To addressthese two contingencies, you may sell the 80 put and decide that if andwhen the stock’s market value declines to $79 per share or below, you
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will roll forward and down—replacing the short put with a later expiring put. That would extend the proximity of market value and strikeprice, and build in a margin of safety. You will likely be able to roll forward and down at a credit (or perhaps at a small cost when tradingexpenses are considered). The value of rolling is not based on theexchange of premium cost or benefit, but more on the reduction ofpotential exercise price by 5 points.
Three Types of Rescue StrategiesA sensible strategy is to develop a contingency plan to rescue the stockif and when your put is exercised. (This is comparable to an exit strategy or other contingency plan you employ in managing your portfolioeven if you don’t use options.) If the short put is exercised, it will meancurrent market value is below the strike price, so you would end upwith more shares at a reduced basis off your original cost but at a basisabove current market value. Your rescue strategy in this case may takethree forms:1. Take no further action. You can wait out the market in the beliefthat while the downward price movement is lasting longer thanyou thought, the stock’s value will rebound. Because you continue to believe the stock is a quality investment, there is nolong-term problem with waiting out the market. Having soldthe put, you have reduced the overall basis in stock, and itsvalue will eventually rise. Because you averaged down yourbasis, it will take less time to return your investment tobreakeven or profitable status.2. Sell short puts again. You can repeat the strategy in the beliefthat the price level is lower than the stock’s long-term support.In severe marketwide price declines, this situation can occur,but it does not necessarily signal a disaster. It can be viewed asyet another opportunity to average down your basis. However,you also need to decide when to stop shorting puts. A conservative standard may dictate that you not continue to buy stock asprices fall, regardless of where you believe the stock’s lowestlikely level resides.
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3. Sell covered calls. You have acquired additional shares, and thisprovides the potential to revert to a covered call strategy. Yourtrue basis in stock is the average share price of all shares youown, minus put premium you received. Can you sell coveredcalls on those shares and—in the event of exercise—produce anet profit? That is an important first question because if it isnot possible, then it makes no sense to invite a net loss uponexercise. Second, you must select calls on the same basis as yourselection of puts: for example, limiting your positions to a predetermined minimum annualized yield and number of pointsout of the money.
Using Calls in Down MarketsUsing puts to average down your basis and acquire more shares—or toincrease income when those short puts are not exercised—is one way tomanage your portfolio in a down market. You can also use calls basedon the same arguments.Long calls can be used to maximize your position as long as youremember these guidelines:1. Buy calls on stocks already qualified or owned. The conservativeuse of long calls has to be based on the fundamental value ofthe underlying stock, so limit your call-buying activity to stocksyou already own and intend to hold for the long term or tostocks you have already qualified based on your risk profile andconservative investing standards. If you intend to exercise thecalls when the stock’s price rises, do so to increase your holdings while averaging down your basis.2. Buy calls only when the stock’s price is low. Timing is everything with options. Speculators often pay little if any attentionto the underlying stock; they are concerned solely with optionvalues and potential for short-term gain. However, because allof your decisions are related to your long-stock portfolio (andperhaps to its potential expansion), you should buy calls onlywhen the underlying stock’s price has declined dramatically.
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The “normal” trading range for the stock should be well abovecurrent market price, increasing the probability that thedecline is a spike, a reaction to a marketwide decline or to atemporary decline in the sector. In those cases, a reversal willoccur in the short term, so timing your call purchase to suchmoments is essential.3. Identify and define an exit strategy. When will you close thelong-call position? In some cases, your purpose will be strictlyto exploit a short-term price decline in a stock you have qualified, so you will want to know exactly when to sell the positionand take your profit. For example, you may decide to sell if andwhen premium values will produce a post-trading-expensedoubling of your investment; or you may also identify a specificpremium price level. If you intend to exercise the call (again,assuming the stock’s price rises above the call’s strike price), atwhat level will you exercise? While you might decide you wantmore shares today, you could change your mind in the futurebased on emerging fundamentals.4. Select strike prices with your intent in mind. You should select astrike price you consider an attractive price for the stock basedon the trading range prior to the price decline. This is premisedon your belief that the stock’s market value will return to thatlevel, so strike price has to be selected with exercise in mind. Ifyou decide later to just sell the call instead of exercising it, thatis a subsequent decision. At the onset of the position, you wantto pick a strike price that will average down your basis whenyou exercise. For example, if you bought 200 shares at $84, andtoday’s price is $72, which strike price is most appealing? If youbuy one 75 call and later exercise it, your average basis is $81. Ifyou buy two 75 calls, your average is $79.50. Another way toaverage down involves dramatically increasing your holdingsusing long calls. For example, if you originally bought 100shares at $84 and today sold two 75 calls, your exercised averagebasis would be $78. So, if the stock’s market value at the time ofexercise was $78 or above, then you would have recaptured allof the paper losses associated with the price decline.
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The combination of long puts and short calls in this situationcan be quite interesting. Consider the possible outcomes: thecost of the long call may be covered by the premium you receivefor the put. If the market price rises, the call grows in value andthe put becomes worthless, so you benefit for no cost or lowcost. If the market price declines further, the put may be exercised (or rolled forward and down) and the call expires worthless. However, even though the call becomes worthless, the zerocost (or close to zero cost) of the position provides increasedupside potential with no more downside risk than you wouldexperience by simply selling puts.5. Coordinate cost and expiration so that the strategy is logical. Inpicking long calls in down markets, limit the premium cost,since all of the premium is in time value, and allow enoughtime until expiration that the stock can rebound to its previously established trading range. This suggestion assumes thatyou limit your long-call positions to out-of-the-money callsand that you have a sense of how long it may take for prices toreturn to normal levels. If you have survived through previousmarket-price changes, you know that short-term movement isusually an overreaction to current economic news and that thesituation tends to correct itself in a very short period. However,you also know that investors are cautious during volatile periods, and a reversal of a price decline can take more time. So,picking the right call is a matter of judgment.
Calls Used for Leverage, but Not for SpeculationThe selection of calls in your conservative portfolio is a matter of leverage rather than speculation. The difference is based on ownership of thestock or on restricting the activity to the short list of stocks you haveanalyzed and qualified. It makes sense to have a list of stocks you wouldpurchase if given the chance, and a price decline is the perfect opportunity to buy shares—assuming you are right about the timing and extentof the decline itself. Given this uncertainty, using long calls is more conservative than putting a large sum of capital into the purchase of shares.With calls, your potential loss is limited to call premium, and the poten-
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tial profit is theoretically unlimited. When you buy stock, the same profit potential exists, but you risk further price decline if you time marketvolatility incorrectly.The question of using long calls is a problem when you consider howtime value affects price movement. If you have only a few months to gobefore expiration, you need the stock to appreciate enough to both create intrinsic value and offset time value. Consider the case of buying acall 4 points out of the money and paying a premium of 3. By expiration, the stock must increase 4 points just to reach zero and another 3points just to break even. In addition, you pay trading costs when youbuy and again when you sell. If you use the average of a half point forthe complete two-part trade, you need the stock to rise 7.5 points justto break even. If you want to double your premium investment, thestock must rise 10.5 points by expiration. With listed options, this is aproblem; but with LEAPS, the potential use of long calls gives youmuch greater flexibility.Rather than limiting your selection of calls to the next 8 months or so,you can also consider using LEAPS calls of up to 36 months. The longerthe time until expiration, the more you pay, but if the stock’s price isdepressed and you’re not sure how long it will take for prices to returnto normal levels, LEAPS calls can provide flexibility by allowing moretime for strategies to season. An analysis of a range of prices, as done inChapter 6, reveals this flexibility. In Chapter 6, Table 6–1 lists a series oflong calls with contingent purchase in mind. The same list demonstrates the potential for long calls as part of a rescue strategy duringdown markets. It shows that for relatively small risk, you can lock in theshare price in anticipation of a change in market price. LEAPS callsextend your period significantly.You can also employ the ratio-writing technique in down markets tospeed up your recovery and to close the gap between net basis and current market value. For example, if you own 400 shares and you write fivecalls, your ratio will produce more income than strict one-to-one coverage provides. (You eliminate the uncovered call risk by purchasing ahigher long call.) While ratio writing is one method to rescue paper losspositions, with well-chosen stocks your premise for holding them is abelief that prices will recover in the near future. Other rescue techniques
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are more prudent and contain less market risk; a ratio write may turnout to be a poor strategy if the stock’s market value rises more rapidlythan you expected and you end up exiting the position through exerciseof stock you would rather keep.
Evaluating Your Stock PositionsWhenever a stock’s price falls, you have to ask whether the decline ispart of a short-term technical correction that will reverse in the future.If so, then the buying opportunities should not be ignored. However,there is also the chance that the stock’s volatility and technical safetyhave changed. Why?Changes in volatility can be caused by a number of company-specificreasons. Marketwide volatility is better understood because investorstend, as a whole, to think of the market singularly. This can be a deceptive point of view, because a long-term quality investment may demonstrate short-term volatility, so it may appear higher risk than youthought it was. A temporary problem can be ignored or exploited withthe well-timed use of options.
Rescue Strategies and OpportunityA conservative options strategy makes sense as part of a rescue strategyor as a way to take advantage of down-market buying opportunities.Such opportunities are often best dealt with using options because thatis a safer and more conservative approach than buying more stock.Timing, in all investment strategies, is both the key to profits and thepotential gateway to losses. However, conservative investors, referringfaithfully to in-depth analysis of the fundamentals, are less likely to fallvictim to short-term price changes. Your decisions, if based on conservative investing standards and well-established fundamental indicators,will likely be more successful than the average technical investor’s,because you do not buy into short-term trends: you prefer to exploitthose trends to find real bargains in market pricing.
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Another question has to be asked, however: Have the fundamentalschanged? Among the many causes of stock-specific volatility, a plateauof a growth trend is one of many signals that a growth period is slowingdown or even stopping. All trends eventually flatten out; nothing continues in the same direction forever. If you look back over stock markethistory, you realize that companies like Polaroid—with heavy dependence on now-obsolete photo technology—lost its market leadershipposition because its products did not evolve with the times. Someexperts believe the same problem may be happening to Kodak in thedigital camera industry. Similar changes have happened to many industries due to either exhaustion of markets or technological change.Railroads, steel, public utilities, dotcom companies, and retail sectorshave all changed drastically over the last 50 years. New technology andthe Internet, new modes of travel, energy efficiency, and changing methods of consumer shopping are examples of how the past growth companies have been replaced or forced to evolve. Today’s leaders must changewith ever-emerging technology or they too will become obsolete.
Examining the Causes of Price VolatilityFundamentals do change, often for reasons beyond anyone’s control, sowhen stock market volatility changes, the related volatility in conservative investments cannot be automatically blamed on the marketwidetrend. The fundamentals deserve another look. Among the possiblecauses for individual stock volatility are the following:1. Cyclical movement. Many sectors have predictable cycles, and atvarious points in those cycles, price volatility is predictablyhigher than at others. As one of the many factors worth reviewing, even the most dedicated fundamental investor will benefitby studying cyclical price trends. Coordinated review of fundamental cyclical change with those price and volume trends mayreveal a correlation that explains the change in volatility andperhaps even signals immediate buying (or selling) opportunities in that stock.2. Economic and political developments. Some sectors are moresensitive than others to outside changes. Beyond marketwide
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cycles, also consider the cause and effect of economic and political situations. For example, a slight change in interest ratesaffects utility stock values, and world events can drasticallyimpact the value of airline stocks.3. Basic revenue and earnings changes. A strong growth curve usually combines a consistent rate of growth in revenues, wellcontrolled ratios to cost and expense levels, and growing dollaramounts of earnings with a consistent net return. These fundamental indicators are perhaps the most popular for spottinglong-term trends and, of equal importance, a slow-down orreversal in those trends. Assuming that you have faith in theaccuracy of reported operating results, you probably rely heavily on these trends.4. High core earnings adjustments. Core earnings—the revenueand expenses related specifically to a company’s primary product or service—are not always the only items reported on operating statements. Noncore items may include proceeds from thesale of an operating subsidiary or fixed assets; one-time adjustments due to accounting changes and other extraordinaryitems; and pro forma profits from invested assets such as pension plan assets. Some expenses are properly a part of coreearnings but may be excluded, such as the exercise value ofemployee stock options granted during the year.You may notice a direct relationship between core-earnings adjustments (a fundamental indicator) and price volatility (a technical indicator). This important relationship has been documented.2 As a generalobservation, the greater year-to-year core-earnings adjustments, thegreater the tendency for market price to fluctuate, and vice versa.Investigating the possibility that a company’s fundamentals havechanged is crucial, even when short-term market volatility is the obvious cause. It is often the case that market volatility reflects economic or
2 The author’s book, Stock Profits: Getting to The Core, Financial Times Prentice Hall, 2005, pp.
245–46, demonstrates the direct relationship between technical and fundamental volatility(the latter being attributed largely to core-earnings adjustments).
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sectorwide changes, so volatility itself may be a symptom of fundamental change. It is, at the very least, a possibility worth looking into. Yourconservative risk profile requires that once the conservative investingstandards in your portfolio change, you must change from hold to sell.It is unrealistic to expect that stocks you own today will continue indefinitely to offer all the features you require in your portfolio. It is morerealistic to select stocks that have those attributes today but to continually monitor each stock you own and, if and when changes occur, replacethose stocks with other issues that better suit your requirements.
Deciding When to Sell and Replace StockWhen you decide it is time to dispose of stock, it is fairly simple to selland replace if you are holding stock at a profitable position. As a matterof policy, you may wish to employ options in various ways to turnpaper losses into paper profits on all stocks you intend to keep and onall stocks in which you would like to increase your holdings. If you canachieve this goal, then your portfolio will always be in good shape. Butthere is also a strong likelihood that once it is time to sell a particularstock, its price will be depressed. There is a tendency to want to keepstocks as long as their price is higher than original basis and to take asecond look only when the price falls. In that situation, do you acceptthe loss or use options to recapture your basis before you sell? Thedilemma is that you decide you want to sell the stock, but to do so willcreate an immediate loss.If the stock’s attributes have changed significantly, you are probablybetter off to wisely accept the loss and put your money elsewhere,preferably in shares of stock you can use for covered call writing. Thatis a far more profitable strategy than hoping for a price recovery, especially if you have already noted a decline in fundamental value. It is lesslikely than ever that you will recapture your full basis under these circumstances. As difficult as it is to accept losses, that may be the mostconservative decision.One alternative is to use options in a combination strategy to providepotential recapture of value, along with protection against further pricedecline. When you combine a long put with a strike price immediately
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below current market value with a covered call above current value, youmay be able to recapture your paper loss without additional risk—assuming some conditions are present:1. The net cost of the position should be as close to zero as possible. Thisis a rescue strategy combined with a desired exit from the longstock position. The cost of opening the long put should be offsetby the premium you earn from selling the short call. This is notthe time to spend more money on options; it is a time to providedownside protection against further price decline (long put) whilebeing able and willing to sell shares through exercise (short call).2. The call’s strike price should be adequate to produce a net profitupon exercise or to yield a desirable exit price. The call’s strikeprice may be high enough to produce an overall net profit onthe total position. That is the most desirable outcome, ofcourse, but it will create a net loss. Your alternative—simplyselling shares at today’s market price—would not be as profitable as long as your short call’s strike price is higher. So, selling the call may be the preferred position, even though it stillproduces a loss.3. The exposure time should be limited; you want to exit this position.Given that you want to exit this position, you do not want to becommitted to a long-term covered call position. The premiumlevels have to be high enough to justify the exposure, but withexpiration occurring soon enough that you are willing to wait.4. The long put should expire at or after the short call, but notbefore. As part of your exit strategy, you cannot risk furtherprice decline. If the net cost of the long put and short call areclose to zero, you are protected against any downside movement. If the stock moves below the put’s strike price, each pointis protected (since your combined option cost is at or nearzero). However, be sure that the long put will expire at the sametime as the short call or later. Otherwise, your stock position isvulnerable to further price decline, thus additional losses. If theput were to expire first, you would own long stock and be shorta call. If the stock’s value declined at that point, you would havea bigger loss than you face today.
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Stock Positions and Risk EvaluationIf you want to coordinate your various portfolio management requirements by using options, you must first classify risks and keep them inperspective. Inexperienced options traders commonly forget to payattention to stock fundamentals, picking options in isolation. Even if aspeculator uses only long-option positions and never buys or sellsstock, fundamental analysis invariably affects (a) the success of anoption trade; (b) pricing trends based on support, resistance, and overbought or oversold conditions; and (c) timing of purchase and selldecisions for options.Risk evaluation of stock based on both price volatility and fundamental volatility (levels of period-to-period changes in revenue and earnings trends) are at the heart of risk analysis. The two types ofanalysis—technical and fundamental—are directly related and have acause and effect on one another. The tendency to look at only one set ofindicators is a mistake because to truly understand the causes of markettrends, you need both.
The Relationship Between Stock Safety and OptionsThe better the fundamentals for a company, the safer your selection ofoptions. A stock whose price volatility makes it high-risk is invariablyalso a high fundamental risk. Companies are unlikely to have safe fundamentals but high-risk technical indicators, or vice versa. The two gohand in hand. The same point applies to option strategies. If yourstocks are selected based on corporate strength, excellence of management, strong revenue and earnings trends, dividend history, and competitive stance within a sector, then the option choices will match thestock’s fundamental strength.Some observers counter that safe stocks do not offer great potential inoption trades. In other words, time value is not as strong in safe stocksas it is in highly volatile stocks, and the real short-term option opportunities are found in highly volatile situations. That is all true. However,the program in your conservative portfolio is not to maximize optionincome at the risk of your long-term portfolio; the purpose is to manage
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portfolio positions in a variety of strategies using options: puts to insurepaper profits, basic covered call writing, contingent purchase using longputs or short calls, and rescue strategies in down markets. You do notwant to expose yourself to high-risk situations because option income islikely to be better; in fact, income levels of short-term option positionsare indicative of higher risk levels if and when those strategies requirethat you take long positions in high-volatility stocks. No matter whichstrategies you employ, the essential safety of your long stock positions isthe highest priority.That is why some down-market conditions indicate your best course ofaction is simply to sell. Cut your losses and invest capital in other companies whose value is greater and whose long-term growth prospectsare more promising. Accepting losses is part of investing in the market,and few people will suggest that any line of strategies can make yourportfolio foolproof. You will continue to have losses in the future, justas you have in the past. However, well-selected option strategies canprotect you against losses, help you solidify paper profits, improveshort-term income, and reduce your basis in stock positions—all without having to assume higher levels of risk and, in many cases, withoutany added market risk whatsoever.
Examining Your Risk ProfileEven when you have defined yourself as conservative, it can be instructive to review your attitude toward long positions in stocks. There arethree likely points of view, and you may even hold these views in different ways for different issues in your portfolio:1. Long-term hold for conservative stock growth. The traditionalconservative view is that stocks should be selected based onlong-term value, growth potential, dividend record, and capitalstrength; kept for the long term; and used to build wealth overmany years. This ideal continues to provide an intelligentinvesting method for many individuals.2. A vehicle for current income via covered calls. Many investorsselect stocks using sound conservative principles, but with theprimary idea of earning consistent current income from writ-
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ing covered calls. This is also a sound investment program. It isentirely possible to earn option-generated current income withno added market risk, as demonstrated in Chapter 5, “Optionsas Cash Generators.” This strategy works best when stocks havebeen picked using sound fundamental analysis associated withconservative investing.3. A combination, the best of both worlds: long-term value investingwith potentially high current returns. You can have it both ways. Ifyour portfolio consists of carefully picked stocks of value thatoffer long-term growth potential, you can also generate currentreturns with covered call writing. Exercise is avoided with rollingtechniques. When exercise does occur, you can reinvest capital inother stocks offering strong growth potential, wait for appreciation, and then include those stocks in your covered call program.
Options and Downside RiskAn essential element of using calls in down markets is the reduction oflosses caused by further downside movement. Premium earned forwriting short calls reduces net basis in stock, which also helps close thegap between basis and current market value. Long puts or long callsprovide profitable outcomes as long as stock prices move enough in thedesired direction; the problem with long-option positions is twofold.First, time works against you when you buy options. Second, time valuedeclines as expiration approaches, requiring far more price movementin the stock to justify the decision to go long in the option.
The Down-Market Benefits of OptionsConsider the four primary down-market benefits of options in determining when to use them to manage your portfolio:1. Short positions reduce basis. The first benefit worth analysis isthat writing short options produces income, which reducesyour basis in stock. This rescues a part of the paper loss duringthe down market; in some cases, writing short positions can
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completely eliminate a marginal loss position. A short positionmay not be exercised due to lack of movement in the stockprice; or, if the position moves in the money, exercise can beavoided with rolling techniques, further reducing the paper lossand the potential effects of eventual exercise.The short position can be repeated if the option expires or losesenough value so that it can be closed profitably. In either event,you are then free to write new short positions with richer premium. Ultimately, you recover the paper loss through the combination of improving market price levels and ongoingshort-option strategies. A short position, when properly timedand when strike prices are properly selected, is programmed toensure net profit positions and/or reduced overall long-stockbasis. If short puts are exercised, the overall, lower basis positionin stock can be advanced to a secondary rescue phase, writingcovered calls, and if short covered calls are exercised, the resulting sale of stock will either produce a net profit or mitigate losses, freeing you to reinvest funds in more promising stocks.2. Short-put premium