CHAPTER SIXTEEN MANAGING THE EQUITY PORTFOLIO ( CONTINUED ) © 2001 South-Western College Publishing

2 Outline Using Derivatives in Portfolio Management  Overwriting  Writing Options to Generate Income  Improving on the Market  Portfolio Protection  Writing Covered Calls for Downside Protection  Protective Puts  Using Index Options  Using Index Futures Contracts

3  Option overwriting refers to the creation and sale of stock options in conjunction with a stock portfolio.  The most common purpose is to generate additional portfolio income.  The second motivation for writing options is to permit the purchase or sale of stock at a better-than-market price. Overwriting

 When investors write call options against stock they already own, the call is said to be covered. Writing Options to Generate Income Initial XYZ stock price = $116 $120 call premium = $6 Stock price at option expiration Profit Loss maximum loss = $110 maximum gain = $10 breakeven point = $110 4

5  Improving on the market involves writing deep-in-the-money put or call options that have “substantial” intrinsic value.  Selling stock: Current XYZ stock price = $116 Write $100 call $18 If option is exercised, total income = $100 + $18 = $118 > income without overwriting = $116 Overwriting : Improving on the Market

6  Buying stock: Current Intel stock price = $67 Write $75 put $9 If option is exercised, total cost = $75 - $9 = $66 < cost without overwriting = $67  Deep-in-the-money options can be used to improve a buying or selling price at the cost of a slight increase in risk.

7  Portfolio protection basically involves adding adding components to a portfolio such that a floor value is established below which the value of the portfolio will not fall.  Writing covered calls provide downside protection up to the amount of the premium.  If an investor owns shares of a particular stock (long stock position) and buys a put on that same stock (long put position), the put is called a protective put. Portfolio Protection

8  Using index options : An index put can protect a diversified stock portfolio against a market downturn. If market prices decline, a gain on the puts can largely offset the losses on the stock portfolio.  Using index futures contracts : A short futures position can help offset a long stock position. If the market falls, a gain in the futures market can largely offset the loss on the stock portfolio, and vice versa if the market rises. Portfolio Protection

9 Review  Structuring a Stock Portfolio  The Portfolio Objective  Asset Allocation  Active vs. Passive Management  Portfolio Rebalancing  What’s Wrong with Buy and Hold?  The Costs of Revision  Constant Proportion Rebalancing  Constant Beta Rebalancing  Indexing  Dollar Cost Averaging

10 Review  Overwriting  Writing Options to Generate Income  Improving on the Market  Portfolio Protection  Writing Covered Calls for Downside Protection  Protective Puts  Using Index Options  Using Index Futures Contracts