b) the price change is corrected immediately and prices returnto previously established trading ranges, and (c) the adjustedtrading range appears to correspond to fundamental volatilitylevels. This adjustment is statistically sensible and can confirmfundamental trends.Market risk—the tendency for stock prices to rise and fall and thevolatility those price levels demonstrate—is manageable in a number ofways involving options. The most obvious is writing covered calls toreduce basis and take paper profits. Timing covered calls for price peaksis the most advantageous. If you expect overbuying short-term trendsto correct in the near future, writing a call can produce fast option profits; this is a form of profit taking that does not require you to sell shares.Another way to manage market risk is to time option strategies for astock’s pricing trends. For example, when prices rise much more quickly than you expect, you may buy puts in anticipation of a reversal inthat trend. Buying puts is normally considered speculative, but whenyou buy relatively cheap puts to protect stock profits, it is a form ofinsurance. A “cheap” put is one without a lot of time value and that isseveral points out of the money. For example, your stock has risen fromthe mid-30s to $50 per share; you expect a price retreat. The 3-month45 put is available for 0.75 ($75). Considering the potential retreat of 10points or more that you expect within the coming few weeks, buyinginsurance through the put makes more sense than selling the stock totake profits now. Your conservative sensibilities encourage you toignore short-term price gyrations, but you are watching the market too,and you know that this price trend could be an advantage to you.Whether you sell a call or buy a put, you take advantage of that pricetrend and protect the short-term paper profits.As yet another alternative, you do not have to take any action. Youcould listen to the conservative voice and decide to simply wait outthe short-term trends, reminding yourself that the fundamentals ofthe company continue to indicate a hold policy. In fact, you may waituntil the stock’s volatility has settled down before even considering
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
using options in any way. You may return to the conservative policy ofemploying covered call writes on appreciated stock; that strategymight not be well suited to an environment in which the stock’s priceis changing rapidly—even though call premium may be attractive atthe moment.
Lost Opportunity Risk and OptionsIf you do decide to write covered calls on appreciated stock—whetherin high-volatility times or otherwise—handsome yields are a realisticpossibility. There is no market risk involved when the various outcomesare considered. The only existing market risk—that the stock’s pricewill decline—exists whether you write calls or not. In fact, writing callsreduces that risk by lowering your basis in the stock. There is anotherform of risk to consider, however: the lost opportunity risk. If thestock’s price soars far above the strike price of the covered call, you maylose shares through exercise. Your stock may have to be sold at the fixedstrike price when that strike price is below the current market value.Is writing covered calls worth the lost opportunity risk? When youremember that your stocks tend to be conservative selections in the firstplace, how many of your issues are likely to soar in price? It certainlyhappens. But when you compare the certainty of short-term returnsfrom writing covered calls to the risk of losing appreciated price in thestock, you realize that the consistency in writing covered calls produceshigher overall profits. You will probably have calls exercised periodically, and you will wish you had waited so that you could have benefitedfrom the higher stock price. But your portfolio profits will be higherfrom writing covered calls on appreciated stock than they will be fromsimply keeping your long positions without any options activity. Thelost opportunity is the exception rather than the rule because, by definition, a conservative selection of stocks requires consistent pricetrends (low volatility) and less likelihood of sudden and unexpectedprice changes. You can further mitigate or even eliminate the risk ofexercise using rolling techniques once you have shorted options.
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Perceptions About OptionsNot only do options have a place in your conservative strategy; properlyemployed, options can strengthen your portfolio and provide greater protection than well-selected stocks. Because prices tend to move in cycles,short-term and intermediate-term pricing may be erratic, and even thebest-chosen stocks go through reversal and consolidation patterns.One argument concerning long-term planning is that such changes inprice are of no concern. As long as long-term fundamental signals continue to show strength, the conservative philosophy is to hold, accumulate, and wait out the market. This traditional approach observescorrectly that short-term pricing is unpredictable as an indicator, abelief held by followers of both the Dow theory and the random-walkhypothesis. Short-term price movement is not useful for any sort oflong-term predictive use. However, it remains possible to (a) protectpaper profits and even take those profits without selling shares, (b)exploit market price overreactions, and (c) generate current returns—all without taking on added market risks. As previously noted, the lostopportunity risk associated with committing shares of stock to a fixedstrike price should be evaluated along with the rates of return, the valueof downside protection, and the yield diversification we achieve withthe use of options in a conservative manner.
Finding the Conservative Context for Options TradingOptions are high-risk, exotic, specialized, and very complex productswhen used in certain ways. To some extent, the technician enjoys thecomplexity of the high-risk, high-return options strategy. This does notmean that you, as a conservative investor, have to shun options; youonly have to use them in the proper context. An individual who watches a high-speed stock car race does not stop using the automobilebecause of the dangers of driving 200 miles per hour; instead, theobserver understands that prudent speeds, obeying traffic laws, anddriving defensively are conservative policies. Such policies prevent accidents and injuries.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
The same comparison applies to options. They are intangible and oftenhave the character of a market “side bet.” Those who believe strongly inacquiring and holding equity (a highly conservative point of view) arelikely to view options as belonging solely to the short-term thinking ofthe speculator. This does not have to be the case. A side bet using anintangible product like an option is not always a high-risk approach tothe market. It comes down to a question of how you use options. Itwould be reckless to write uncovered calls or to place large amounts ofcapital in long option positions. Those strategies are inappropriate foryou, so they are out of the question. But there does exist an intelligentcontext for using options within your conservative risk profile. It is limited. You are likely to write covered calls or buy puts for insurance as theprimary strategies. As we move to Chapter 6, “Alternatives to StockPurchase,” Chapter 7, “Option Strategies in Down Markets,” andChapter 8, “Combination Conservative Techniques,” some moreadvanced variations of options are introduced—but all within the conservative game plan.It is a mistake to make a blanket statement. For example, “Speculatingin option long positions is always high risk” is an unfair characterization. Not only are you likely to use puts to protect paper profits; thereare specific market conditions in which using calls simply makessense, even with a conservative risk profile. For example, at thosetimes when the “market” (as measured by the Dow Jones IndustrialAverage index, for example) falls by several hundred points, severalchanges occur in the market, all short-term. The most important isinvestor emotion. Everyone is fearful of further price drops. As a consequence, the idea of picking up cheap shares is appealing, but mostpeople do not take that opportunity.
Strategic Timing and Short-Term Price ChangesConsider the possibilities at such times. Most of your capital may be tiedup in long stock positions that would produce losses if sold when market prices are low. You recognize that this is the time to buy more stock,but you are uncertain, and you do not have capital available to make abold move even if you wanted to. This is the perfect opportunity—using
Chapter 3 Options in Context
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a limited amount of capital, of course—to buy cheap calls. You knowthat sharp market drops usually rebound very quickly. You also recognize the stocks whose fundamental strength supports the probability ofa healthy return to the normal trading range. So, picking the bargains isnot difficult; the decision to put money into the market at thesemoments is the difficult part.In this scenario, even a conservative investor may use long calls to takeadvantage of the temporary depression in stock prices. The point isthis: being conservative does not mean that you have the same attitudein all market conditions. Flexibility is an essential tool in your portfoliomanagement arsenal. When opportunities present themselves, it is prudent to take them. If you lack the capital to buy shares, or you are fearful of further price declines, options present the perfect compromise.You can limit your risk by investing only a small amount of capital; andthe timing can work to your advantage given the likely price patterns inbig-number changes.This does not suggest that you should speculate in long calls under anycircumstances. But every conservative investor has survived throughbig price swings and seen the results—a big drop followed by a few daysof uncertainty and then a rapid return to previous levels. Just as suddenprice declines can be exploited with the selective purchase of calls, sudden price rallies invariably lead to corrections, a time when you can usecalls to (a) protect paper profits and (b) speculate in the price correction itself. Even if you do not own stock, when you observe a big runup in a stock’s price and you conclude the price trend is anoverreaction, buying puts can be a well-timed strategy.In addition to unexpected stock price movements, investors are concerned about what happens to open option positions when stocks aresplit. Does it change the ratio between stock and option? No. When astock splits, options are split in the same manner. For example, in a 2for-1 split, you end up with twice as many shares at half the previousshare value; you double the number of options, and the strike price iscut in half. If a stock is split and you have open options with strike pricesof 45, you end up with twice as many options, each with strike prices of22.50. A stock split keeps the values the same; only the numbers change.The same rule is applied to all open option contracts in that situation.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Short Positions, Naked or CoveredThe concept of speculating on long calls or puts is contrary to the generally understood definition of conservative. As shown in the precedingdiscussion, there may be moments when you want to use long calls orlong puts to take advantage of price changes. It is appropriate, given thetiming, and may conform to your conservative standards. For example,if you bought stock and currently have a large paper loss, buying calls isone way to average down your basis. If you can acquire additionalshares of stock at a strike price below your original basis, it could bringthe collective value up high enough to eliminate those paper losses.This is the opposite side of the coin in which you would buy puts toprotect paper profits. If the stock were to decline in value, you could sellthe puts, creating a profit to offset stock losses; or you could exercise theputs and sell shares of stock at a price higher than current market value.Some strategies involving short calls and puts may also conform toyour conservative risk profile based on prevailing market conditionsand your portfolio positions. The basic covered calls strategy is themost obvious example. When you sell a call, you are taking paper profits and reducing your basis in the stock; you expose yourself to the possibility of losing future price gains in exchange for the certainty ofpremium income today.
The Uncovered Call—A Violation of the ConservativeTheme, UsuallyIs it ever justified to sell uncovered calls? In the conservative philosophy, it is not. Uncovered calls have to be viewed as one of the highestrisk strategies possible. Chapter 6 contains an example of one situationin which writing uncovered calls can work for a conservative portfolio:the ratio write. In this strategy, more calls are written than sharesowned. For example, you may write six short calls when you own 500shares of stock. With the proper structuring of ratio writes, you minimize risks and produce profits with short calls; the plan works in somesituations. The risks are simply too great, and the strategy is not a goodfit in your conservative portfolio without modification.
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One exception involves topping off a ratio write with one long call. Ineffect, this eliminates the uncovered portion of the ratio write. Forexample, if you own 300 shares, full coverage involves selling three calls.If you sell four calls, you have a ratio write. This can also be viewed asthe combination of three covered calls and one uncovered call.However, you can further modify this position by purchasing a singlecall with a higher strike price. In effect, this creates a different kind ofcombination: a covered call strategy on 300 shares accompanied by aspread (a strategy in which the benefits of one side of the position areoffset by the risk in the other). As long as the modified ratio write canbe accomplished with a net credit (money coming in rather than goingout), the risk is limited. The difference in strike prices between thefourth short call and the long call is a risk if and when the stock movesabout the highest short call strike price. Chapter 6 examines this modified strategy in greater detail.Short calls are related to ownership of stock, so exercise risk is easilycontrolled. Short puts are a different matter. There are many instancesin which writing puts makes sense. Because puts cannot be covered inthe same way as calls, it is easy to overlook the potential of writinguncovered puts. The risks of short puts are far more limited than thoseof short calls, because the potential decline in value is finite. An initialanalysis makes it clear that a stock can decline only to the value of zero,so it is easy to limit short puts to low-priced shares. But that standard isnot always necessary. The real likely decline in value is somewhere higher than zero.
A Stock’s Likely Lowest Theoretical Price LevelTangible book value per share is assumed to be a corporation’s liquidation value, or the net value of all assets if the company simply went outof business and paid off stockholders. It is more likely that companieswill cease to exist through merger or acquisition, and at a price somewhere at or above tangible book value. Does the worst-case liquidationvalue of the company also provide a reliable low market price level forthe stock? In practice, your true support level may have little or nothingto do with the fundamental and tangible value of the corporation’sassets. Some technicians prefer to identify a chart-based price-support
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
level, but that is also unreliable; the history of trading patterns in anygiven stock is the history of support and resistance levels being brokenthrough and new trading patterns established. In evaluating the likelybottom for a stock, you may want to rely partly on fundamental andpartly on technical indicators. However, your analysis should be basedon the original criteria you employed when selecting the stock.Remembering the rule that option activity should be restricted to optionson stocks that you have prequalified on a conservative standard, considerwhat, in your opinion, is a realistic bottom price range. With this analysis in hand, compare the difference between strike price and the probably lowest price level to the premium you receive upon selling the put.If the gap between a particular strike price and lowest likely price levelis 3 points and you can sell a put for 5 points, then even given your perceived worst-case scenario for the stock, you will be ahead. This riskfree description, the worst case, allows for the possibility that the stockwould be put to you upon exercise at a price above current marketvalue. So, if the market value of shares were to fall below the put’s strikeprice, you would be required to buy inflated-value stock.Establishing the lowest likely price range may not be easy; it is a matterof opinion. A study of recent price trends may help, but determiningthe level is far from an exact science. This is why comparisons betweenprice trends and tangible book value per share are useful. If you areuncertain about the reliability of price-support level, then tangiblebook value per share may provide a more comfortable “drop-deadprice” and fundamental support level. This is especially true for thededicated fundamental analyst. Because tangible book value per shareis a fundamental indicator, it may be viewed as more reliable than thetechnical concept of price support level for judging risk.
Short Put Risks—Not as Drastic as Short Call RisksThe true risk to writing short puts is the difference between currentmarket value and strike price, minus the premium you received for selling the put. This brings us to the conservative standard for sellinguncovered puts: if the premium discounts the risk level to a price thatyou consider a fair price for the stock, then it is conservative to selluncovered puts—but only if you are willing to buy shares at that price.Chapter 3 Options in Context
63
Once the short put is assigned, you can simply hold the shares andawait a price rebound or recapture the paper loss through writing covered calls. The point is, in some situations, you may want to sell uncovered puts even though you are a conservative investor.Consider the case in which prices of the stock have fallen as part of amarketwide price decline. You are fairly certain that prices will reboundin the near future; but current price levels are bargains given the company’s fundamentals, earnings per share, dividend history, and tangiblebook value per share. In this situation, you may not want to buy sharesoutright, so you have two choices involving options. You can speculatein calls, expecting to profit from the price rebound, but that requires anoutlay of money. Or you can sell uncovered puts for which you receivea premium. It is always better to have cash coming in than going out,but in exchange for the credit, you also accept the risk of exercise.However, if you are confident that prices will rise in the near future,selling uncovered puts presents less risk than in other circumstances.For example, when prices for the stock have risen sharply, selling puts isa reckless and ill-timed decision, just as buying calls is. We expect pricesto act in a particular way, and it is reliable to time option decisionswhen we can recognize overbought and oversold conditions. Thoseconditions present opportunities for the timing of option trades, anduncovered puts can be structured to present great opportunity with relatively little risk.The well-understood correlation between risk and opportunity is thenormal situation. However, changes in a stock’s market value may signal that a short-term correction is imminent. To average out yourbasis or to protect paper profits, you can use long or short calls atsuch moments. This is not the same thing as contrarian speculation, astrategy in which the speculator seeks out long shots offering greatprofit potential—and the likelihood of large losses. The wise timingstrategy that suits your conservative standards involves careful timingof option trades with price aberrations in the stock. Such a strategy isconsidered conservative when you have qualified the fundamentalstrength of the company and when you would be happy to buy sharesat the strike price.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Margin Requirements and Trading RestrictionsThere are two areas in which option investors have to live with specialrules: taxes and trading rules. The tax rules are covered later; a moreimmediate concern involves the special rules that apply once youmove beyond the status of stockholder and begin to make actualoption trades.The first rule to be aware of involves the very basic qualifications totrade. You are required to complete a questionnaire and to advise yourbrokerage firm that, in fact, you know enough about options and theirrisks to enter into trades. The brokerage firm is required to establishyour qualifications. So, you probably could not begin trading tomorrowfor the first time. Because options can involve considerable risks, youhave to go through a special screening process by the brokerage firm.The second restriction is intended to limit the volume of tradingundertaken by investors with limited capital. The Securities andExchange Commission (SEC) defines a pattern day trader as any individual who makes four or more day trades within five business days. Aday trade is opening and closing a position within a single day. Onceyou make the fourth day trade within a five-day period, you arerequired to maintain at least $25,000 equity in your account (in cashand securities). For many options traders, the restriction certainlyapplies. So, unless you can limit activity to three or fewer, you will betreated as a pattern day trader.
Other Margin RulesAll investors must be concerned with the initial margin (the amount ofvalue required at the time a position is opened) and with maintenancemargin requirements (additional margin that is required if and whenprices change in the securities involved).Options traders must be aware of these margin requirements. Thestrategies involving options may look good on paper but, given marginrequirements, limited capital could make combinations of positionsimpractical. Table 3–1 gives an overview of the basic margin requirements related to options trading.
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Table 3–1 Margin Requirements, Option Trades
TYPE OF TRADE
INITIALMARGIN
MAINTENANCE
Long call or put
100% of cost.
Same as initial.
Short uncoveredcall
Proceeds receivedplus 20% of theunderlying stockmarket value(when out of themoney) plusadditional marginwhen stock marketvalue exceeds thecall’s strike price.
Additional margin ifstock’s market valueexceeds strike price andcontinues upward;potentially unlimited.
Short uncoveredput
Proceeds receivedplus 20% of theunderlying stockmarket value(when out of themoney) plusadditional marginwhen stock marketvalue falls belowthe call’s strikeprice.
Additional margin ifstock’s market valuefalls below strike priceand continuesdownward; limited tothe range of price downto zero.
Covered call
Standard stockmarginrequirement (50%of cost of thestock) plus 100%of option valuewhen in themoney.
100% of stock purchaseprice.
The margin rules become much more complex for advanced tradingstrategies and combinations. To see a complete summary of a typicalbroker’s margin requirements, check the Interactive Brokers Web site atwww.interactivebrokers.com and follow links for (a) trading to (b) margin,and then to (c) US options.
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Given the limitation on pattern day trading and the capital requirements, it would be very difficult for an investor to become active inoptions without placing substantial capital at risk. With options, it isrealistic to believe that the threshold of four trades would be crossedquickly and easily within a few days, at least occasionally; it is the natureof option trading to execute a number of trades in a short period oftime because market conditions present immediate opportunities.
Return Calculations—Seeking ValidComparisonsMargin limitations certainly inhibit investor activity if only a smallamount of capital is available. An equally complex problem is the calculation of returns from option activity. In attempting to measure andcompare option trades—whether employing timing strategies or thesafer and more reliable covered call—you face a problem. How do youmeasure your profits? Consider the problem of the covered call trade.You have three possible outcomes: exercise, expiration, or close of theposition. In the first instance, you combine a capital gain with profitsfrom selling a covered call; in the second two, you realize a level of profit, but you still own the stock. So, comparing possible returns cannot bedone on a like-kind basis.We have to look at potential returns as possible scenarios and judge thecovered call if any of the three outcomes occur. Comparative returnanalysis is a wise move, and as a conservative investor, you want toknow the best-case and worst-case range of outcomes before proceeding; but remember that the time a position is open and the actual outcome make comparisons elusive. The purpose in return analysis has tobe to judge the strategy in all of its outcome permutations, and not toarrive at comparable outcomes.The return if exercised is calculated as a percentage of the stock’s valueat the time the strategy is entered into. For example, if you were to writea 45 call at the time the stock was at $43 per share and you received premium of 7 ($700), the return if exercised would be 16.3 percent (7 ÷43). Your capital gain on stock would depend on your basis in that
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stock and would be calculated separately. As long as you purchased thestock at a price below the short call’s strike price, you can ensure a highcapital gain in the event of exercise.Limiting our discussion to the option-only return allows us to comparethe various option outcomes. While return if exercised (also termed ifcalled rate of return) appears to be the best possible return on a shortstrategy, it is not always the case. To make return comparisons trulyvalid, they have to be viewed on an annualized basis. When you consider the possibility of a short call simply expiring worthless (or beingclosed at a profit), you can repeat the strategy over and over. The ability to sell covered calls repeatedly turns stock into a combined longterm growth instrument and current cash cow. The combined annualincome from dividends and call premiums can make nonexercisedreturns far more advantageous than the exercised rate of return.To begin analyzing various options and their potential returns, we use aside-by-side comparison between stocks, and for each stock, we presentpotential outcome (exercise, expiration, or close). Table 3–2 summarizes the market data for the companies in our model portfolio.In these examples, companies are shown with selected options at themoney or at the next increment above. We included the option premium as a percentage of the current stock price. This is a good startingpoint because you may want to limit your study to covered calls thatwill yield a minimum return of some level. Because all options in thisexample expire 27 months from the study date, the percentages shownare comparable. If we were using dissimilar expiration periods, wewould also need to annualize these returns.The likely return you can expect to earn on a particular option dependson the premium’s relationship to current price and may also includedividend yield on the stock. Clearly, the calculation of option returnshas to also consider the ramifications of exercise. While we do not complicate our analysis by including this factor, it is clear that differencewill occur. For example, the General Dynamics option is at the money,so exercise would include no capital gain above the value as of theanalysis date. The Clorox call is more than 4 points above current shareprice, so in the event of exercise, you would keep the premium and earna capital gain.
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 3–2 Market Data for Covered Call Writing: Comparisons
27-Month Calls**Name ofCompany
StockSymbol
SharePrice*
Strike
Premium
%
CloroxCompany
CLX
$55.91
60
5.10
9.1
Coca-Cola
KO
38.90
40
4.00
10.3
Exxon Mobil
XOM
48.70
50
4.50
9.2
Fannie Mae
FNM
67.65
70
8.30
12.3
FederalExpress
FDX
87.78
90
12.30
14.0
GeneralDynamics
GD
100.01
100
9.90
9.9
J.C. Penney
JCP
38.20
40
5.70
14.9
Pepsico(Pepsi-Cola)
PEP
48.48
50
4.30
8.9
WashingtonMutual
WM
38.43
40
3.10
8.1
Xerox
XRX
14.32
15
2.55
17.8
* Closing stock prices as of October 22, 2004.** Current option premium value bid at the close, October 22, 2004; source:Chicago Board Options Exchange, http://quote.cboe.com/QuoteTable.asp.
A second factor to remember is the dividend yield. For example,Federal Express (which, in our example, yields 14.0 percent fromoption premium) pays only 0.3 percent in annual dividend as of theanalysis date. However, Washington Mutual yields only 8.1 percentfrom option premium but pays annual dividend yielding 4.7 percent.The consideration of capital gains upon exercise, and dividends, are notincluded in the comparison between call premiums. However, in the selection and comparison between stocks, and in the selection of a strike price,you must also consider which stocks would yield overall higher returnsthrough covered calls. This is especially true in the case of dividends. The
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CBOE includes dividends in overall return. Investors may actually determine which stocks to buy based on fundamental analysis and on the dividend yield, so dividends cannot be ignored altogether.For example, let’s assume that you had prequalified both FederalExpress and Washington Mutual as stocks you would like to own andthat the decision is based on the combination of (a) dividend yield and(b) 27-month option premium available through writing covered calls.If we annualize the 27-month returns on each company, we get theannualized option yield (divide return by 27, and then multiply by 12);we then add current dividend yield to find the overall potential:
Option Premium ReturnStock
27-Month
Annualized
DividendYield
TotalReturn
FederalExpress
14.0%
6.2%
0.3%
6.5%
WashingtonMutual
8.1
3.6
4.7
8.3
This calculation demonstrates that it is not reliable to simply comparepotential returns on calls. You have to also consider dividend yield, especially if you are going to select one stock over another as the stock to buy.This also assumes that all other analyses are equal and that you would behappy to own either stock. When you add in the dividend yield to theannualized return, the relative outcome changes completely.All of the options shown in Table 3–2 are at or out of the money, so theentire premium is time value. This simplifies the analysis. In fact, as a conservative standard, you may set a rule for yourself concerning coveredcalls: consider only those options that are at or out of the money. Thisstandard makes sense for two reasons. First, writing covered calls is amethod for trading on time value. The speculative nature of writing inthe-money calls—which may also invite exercise at any time—contradicts
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
your conservative policies. Second, writing in-the-money calls may jeopardize the long-term capital gains status of stock in the event of exerciseand, in situations where you have owned stock for less than one year, mayalso toll the time counting toward achieving long-term status. Chapter 5explains tax rules for covered call writing in more detail. The point here isthat restricting your activity to time value premium trades makes senseunder the definition of conservative investing.With the information in hand from Table 3–2, we can compare outcomes in the event of exercise, expiration, and close. To ensure thosecomparisons are realistic, we also annualize potential returns.In the case of closing a position, the return depends on timing as well asprice. For example, if you close out short calls when their value decreases by one-half, then your yield before calculating trading costs is 50 percent. You then want to annualize that. If you hold the position open for6 months, the annualized yield is 100 percent; and if you hold the shortoption open for 18 months, the yield is 33 1/3%(50% ÷ 18 × 12).We make no further calculations to compare the “if-closed” calculation,since actual returns depend on the level at which you decide to closeand the total number of months positions are left open. “If-exercised”and “if-expired” comparisons, however, are necessary.
Return If ExercisedWe assume that exercise occurs at the very last day of the option’s life.While exercise could occur at any time the call is in the money, we cannot accurately compare the yield unless we make such a broad assumption. Dividend yield would vary based on the time the option is leftopen; we assume that dividend yield is more properly treated as stockspecific and not as part of the comparative option return analysis, so weexclude it in our comparative analysis. If you decide which stocks topurchase based on dividend yield, then it becomes quite important.However, in the following example, we assume that you already ownthe model portfolio, and we exclude dividends from our calculation.Return if exercised is shown in Table 3–3, including