© 2002 South-Western Publishing 1 Chapter 3 Basic Option Strategies: Covered Calls and Protective Puts

2 Outline Equity Options Using options as a hedge Using options to generate income Profit and loss diagrams with seasoned stock positions Improving on the market

3 Using Options as A Hedge Protective puts Using calls to hedge a short position Writing covered calls to protect against market downturns

4 Options as a Hedge Hedgers transfer unwanted risk to speculators who are willing to bear it – E.g., insuring a home Insurance that expires without a claim does not constitute a waste of money Hedging a stock or commodity price position - clarity on the objective is important

5 Protective Puts A protective put is a descriptive term given to a long stock position combined with a long put position – Investors may anticipate a decline in the value of an investment but cannot conveniently sell the security or choose not to for some reason

6 Microsoft Example Assume you purchased Microsoft for $79 7/16 Stock price at option expiration Profit or loss ($) /16

7 Microsoft Example (cont’d) Assume you purchased a Microsoft AUG 75 put for $1 13/16 Stock price at option expiration / /16 75

8 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the protective put: Stock Price at Option Expiration Buy $79 7/ / / /16-4 7/1610 9/1625 9/16 Buy $75 $1 13/ /1643 3/1613 3/ /16 Net -6 1/4 8 3/423 3/4

9 Microsoft Example (cont’d) The worksheet shows that – The maximum loss is $6 ¼ – The maximum loss occurs at all stock prices of $75 or below – The put breaks even somewhere between $75 and $90 (it is exactly $81 ¼) – The maximum gain is unlimited but it will always be reduced by the cost of the ‘insurance’ - this is what needs to be clearly understood

10 Microsoft Example (cont’d) Protective put (vs unhedged position) Stock price at option expiration / /4 unhedged 79 7/ /16

11 Protective Put Logic: A protective put is like an insurance policy – You can choose how much protection you want The put premium is what you pay to transfer the risk of large losses – The striking price puts a lower limit on your maximum possible loss Like the deductible in car insurance – The more protection you want, the higher the premium you are going to pay

12 Protective Put (cont’d) Insurance PolicyPut Option PremiumTime Premium Value of AssetPrice of Stock Face ValueStrike Price DeductibleStock Price Less Strike Price DurationTime Until Expiration Likelihood of LossVolatility of Stock

13 Synthetic Options The term synthetic option describes a collection of financial instruments that are equivalent to an option position – look at the shape of the protective put - similar appearance to a call option position – A protective put is an example of a synthetic call

14 Microsoft - Synthetic Call Stock Price at Option Expiration 23 3/ /4 =22 3/4 8 3/ /4 =7 3/4 -6 1/4 -71/4 -6 1/4 -71/4 -6 1/4 -71/4 -6 1/4 -7 1/4 Net Call Option -1 13/ /1643 3/1673 3/16 Buy $75 $1 13/ /1610 9/16-4 7/ / / /16 Buy $79 7/

15 Using Calls to Hedge A Short Position Short sale Microsoft example

16 Hedging a Short Postion Call options can be used to provide a hedge against losses resulting from rising security prices Call options are particularly useful in short sales

17 Short Sale Investors can make a short sale – The opening transaction is a sale – The closing transaction is a purchase Short sellers borrow shares from their brokers Closing out a short position is called covering the short position

18 Short Sale (cont’d) A short sale is like buying a put - you profit from a decline in the price of the security Many investors prefer the put – The loss is limited to the option premium – Buying a put requires less capital than margin requirements However: – The put has a limited life or time frame – The cost of the put needs to be considered

19 Hedging a Short Position Assume you short sold Microsoft for $79 7/16 Stock price at option expiration Profit or loss ($) /16 Maximum loss = unlimited

20 Hedging a Short Position Combining a short stock with a call results in a long put – Assume the purchase of an OCT 90 call at $3 3/8 in addition to the short sale – The potential for unlimited losses is eliminated

21 Hedging a Short Position Construct a profit and loss worksheet to form the long put: Stock Price at Option Expiration / Short $79 7/ / / /16 4 7/16 3 3/ /16 Long $90 $3 3/8 -3 3/8 6 5/8 Net 76 1/ / /16 1 1/ /16

22 Hedging a Short Position Short sale with a long call creates the equivalent of a long put Stock price at option expiration / /16 The potential for unlimited loss is gone

23 Short sale with a long call creates the equivalent of a long put Stock price at option expiration / /16 The potential for unlimited loss is gone Hedging a Short Position 93 3/8 unhedged

24 Writing Covered Calls to Protect Against Market Downturns A call where the investor owns the stock and writes a call against it is called a covered call – The call premium cushions the loss – Useful for investors anticipating a drop in the market but unwilling to sell the shares now

25 Writing Covered Calls An OCT 85 covered call on $5; buy 79 7/16 Stock price at option expiration / / /16 unhedged..... not particularly effective as a hedge against losses, consider protective puts instead

26 Using Options to Generate Income Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting

27 Writing Covered Calls to Generate Income Acutally quite a conservative approach An attractive way to generate income with foundations, pension funds, and other portfolios A very popular activity with individual investors Attractive when investor expects stock to trade sideways

28 Writing Calls to Generate Income (cont’d) Writing calls may not be appropriate when – Option premiums are very low – The option is very long-term may be able to generate more income by writing a series of shorter term call options give away upside opportunity for long term

29 Writing Calls to Generate Income (cont’d) Writing a Microsoft Call Example It is now July 10, A year ago, you bought 300 shares of Microsoft at $46. Your broker suggests writing three OCT 90 $3 3/8, or $ on 100 shares.

30 Writing Calls to Generate Income (cont’d) Writing a Microsoft Call Example (cont’d) If prices advance above the striking price of $90, your stock will be called away and you must sell it to the owner of the call option for $90 per share, despite the current stock price. If Microsoft trades for $90, you will have made a good profit, since the stock price has risen substantially. Additionally, you retain the option premium.

31 Writing Naked Options A naked option position is one where you do not have another related security position that can cushion losses from price movements that are adversely impacting your short option position – long stock position cushions losses from a short call option position - ‘covered call’ – short stock position cushions losses from a short put option position Very risky due to the potential for unlimited losses - no offset or cushion

32 Writing Naked Calls(cont’d) Writing a Naked Microsoft Call Example The following information is available:  It is now July 11  A July 95 MSFT call exists with a premium of $1/8  The July 95 MSFT call expires on July 21  Microsoft currently trades at $79 7/16

33 Writing Naked Calls(cont’d) Writing a Naked Microsoft Call Example (cont’d) A brokerage firm feels it is extremely unlikely that MSFT stock will rise to $95 per share in ten days. The firm decides to write 100 July 95 calls. The firm receives $0.125 x 10,000 = $1,250 now. If the stock price stays below $95, nothing else happens. If the stock were to rise dramatically, the firm could sustain a large loss.

34 Naked vs. Covered Puts A naked put means a short put by itself A covered put means the combination of a short put and a short stock position

35 Naked vs. Covered Puts (cont’d) A short stock position would cushion losses from a short put: Short stock + short put short call Profit/ Loss Stock Expiration

36 Put Overwriting: Put overwriting involves owning shares of stock and simultaneously writing put options against these shares – Both positions are bullish – Appropriate for a portfolio manager who needs to generate additional income but does not want to write calls for fear of opportunity losses in a bull market

37 Microsoft Example An investor simultaneously: – Buys shares of MSFT at $79 7/16 – Writes an AUG 80 MSFT put for $4

38 Microsoft Example (cont’d) Construct a profit and loss worksheet for put overwriting: Stock Price at Option Expiration / Buy $79 7/ / / / / / /16 Write $80 $ /32 4 Net / / / / /16

39 Microsoft Example (cont’d) Writing an AUG 80 put on $4; buy 79 7/16 Stock price at option expiration / /16 Breakeven point = 77 23/32 Unhedged

40 Profit and Loss Diagrams With Seasoned Stock Positions Adding a put to an existing stock position Writing a call against an existing stock position

41 Adding A Put to an Existing Stock Position Assume an investor – Bought $46 – Buys an AUG 75 MSFT $1 13/16 Objective to lock in existing profit

42 Adding A Put to an Existing Stock Position (cont’d) Stock Price at Option Expiration / Buy $ /16 54 Buy $75 $1 13/ / / / /16 Net 27 3/ /8 52 3/16

43 Adding A Put to an Existing Stock Position (cont’d) Protective put with a seasoned position Stock price at option expiration /16 unhedged

44 Writing A Call Against an Existing Stock Position Assume an investor – Buys $46 – Writes an OCT 85 $5

45 Writing A Call Against an Existing Stock Position (cont’d) Covered call with a seasoned equity position Stock price at option expiration

46 Improving on the Market Writing calls to improve on the market – Investors owning stock may be able to increase the amount they receive from the sale of their stock by writing deep-in-the-money calls against their stock position

47 Writing Calls to Improve on the Market (cont’d) Writing Deep-in-the-Money Microsoft Calls Example Assume an institution holds 10,000 shares of MSFT. The current market price is $79 7/16. AUG 60 call options are $21. The institution could sell the stock outright for a total of $794,375. Alternatively, the portfolio manager could write 100 AUG 60 calls on MSFT, resulting in total premium of $210,000. If the calls are exercised on expiration Friday, the institution would have to sell MSFT stock for a total of $600,000. Thus, the total received by writing the calls is $810,000, $16,625 more than selling the stock outright.

48 Writing Calls to Improve on the Market (cont’d) There is risk associated with writing deep- in-the-money calls – It is possible that Microsoft could fall below the striking price – It may not be possible to actually trade the options listed in the financial pages

49 Writing Puts to Improve on the Market Writing puts to improve on the market – An institution could write deep-in-the-money puts when it wishes to buy stock to reduce the purchase price