Basic Option Strategies: Covered Calls & Protective Puts Chapter 3 Basic Option Strategies: Covered Calls & Protective Puts Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady Outline Using options as a hedge Using options to generate income Profit and loss diagrams with seasoned stock positions Improving on the market Dr. Hassan Mounir El-Sady

Using Options as A Hedge Introduction Protective puts Using calls to hedge a short position Writing covered calls to protect against market downturns Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady Introduction Hedgers transfer unwanted risk to speculators who are willing to bear it E.g., insuring a home Home owner Hedges by buying the insurance, the insurance company Speculates that the house will not burn. It is important to note that neither party wants the house to catch fire. Insurance that expires without a claim does not constitute a waste of money Money spent on reducing risk is not wasted, it provides peace of mind to the insurer. Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady Protective Puts It is not special type of put options, 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, mainly because of the tax preference of the stock owner. Notice that the term “Long” has nothing to do with the time span, it means that you own something. Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady Microsoft Example Assume you purchased Microsoft for $28.51 Profit or loss ($) Stock price at option expiration 28.51 28.51 Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Assume you purchased a Microsoft APR 25 put for $1.10 23.90 23.90 25 Stock price at option expiration 1.10 Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Construct a profit and loss worksheet to form the protective put: Stock Price at Option Expiration 5 15 25 30 40 Long stock @ $28.51 = 0 – 28.51 = - 28.51 = 5 – 28.51 = - 23.51 = 15 – 28.51 = - 13.51 = 25 – 28.51 = - 3.51 = 30 – 28.51 = 1.49 =30– 28.51 = 11.49 Long $25 put @ $1.10 = 25 - 0 - 1.1 = 23.90 = 25 - 5 - 1.1 = 18.90 = 25 - 15 - 1.1 = 8.90 = 25 - 25 - 1.1 = - 1.10 -1.10 Net - 4.61 0.39 10.39 Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) The worksheet shows that The maximum loss is $4.61 The maximum loss occurs at all stock prices of $25 or below The put breaks even somewhere between $25 and $30 (it is exactly $29.62 = $28.51 + $1.1) The maximum gain is unlimited Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Protective put 25 Stock price at option expiration 29.62 - 4.61 Dr. Hassan Mounir El-Sady

Logic Behind the Protective Put A protective put is like an insurance policy You can choose how much protection you want The put premium is what you pay to make large losses impossible 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 Dr. Hassan Mounir El-Sady

Logic Behind the Protective Put Insurance Policy Put Option Premium Time Premium Value of Asset Price of Stock Face Value Strike Price Deductible Stock Price Less Strike Price Duration Time Until Expiration Likelihood of Loss Volatility of Stock Dr. Hassan Mounir El-Sady

Using Calls to Hedge A Short Position Call options can be used to provide a hedge against losses resulting from rising security prices Call options are particularly useful in short sales Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady 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 A short sale is like buying a put Many investors prefer the put The loss is limited to the option premium Buying a put requires less capital than margin requirements Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady Microsoft Example Assume you short sold Microsoft for $28.51 Profit or loss ($) 28.51 Stock price at option expiration 28.51 Maximum loss = unlimited Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Combining a short stock with a long call results in a long put Assume the purchase of an APR 35 call at $0.50 in addition to the short sale The potential for unlimited losses is eliminated Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Construct a profit and loss worksheet to form the long put: Stock Price at Option Expiration 15 25 28.51 35 40 Short stock @ $28.51 13.51 3.51 -6.49 -11.49 Long 35 call @ $0.50 -0.50 4.50 Net 28.01 13.01 3.01 -6.99 Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Long put (short stock plus long call) 28.01 35 Stock price at option expiration 28.01 6.99 The potential for unlimited loss is gone Dr. Hassan Mounir El-Sady

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 Dr. Hassan Mounir El-Sady

Writing Covered Calls to Protect Against Market Downturns A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51 2.69 Stock price at option expiration 30 27.31 27.31 Dr. Hassan Mounir El-Sady

Using Options to Generate Income Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting Microsoft example Dr. Hassan Mounir El-Sady

Writing Calls to Generate Income Can be very conservative or very risky, depending on the remainder of the portfolio An attractive way to generate income with foundations, pension funds, and other portfolios A very popular activity with individual investors Writing calls may not be appropriate when Option premiums are very low The option is very long-term Dr. Hassan Mounir El-Sady

Writing Calls to Generate Income (cont’d) Writing a Microsoft Call Example It is now September 15, 2005. A year ago, you bought 300 shares of Microsoft at $22. Your broker suggests writing three JAN 30 calls @ $1.20, or $120.00 on 100 shares. If prices advance above the striking price of $30, your stock will be called away and you must sell it to the owner of the call option for $30 per share, despite the current stock price. If Microsoft trades for $30, you will have made a good profit, since the stock price has risen substantially. Additionally, you retain the option premium. Dr. Hassan Mounir El-Sady

Writing a Naked Microsoft Call Example Dr. Hassan Mounir El-Sady Writing Naked Calls Very risky due to the potential for unlimited losses Writing a Naked Microsoft Call Example The following information is available: It is now September 15 A SEP 35 MSFT call exists with a premium of $0.05 The SEP 35 MSFT call expires on September 19 Microsoft currently trades at $28.51 Dr. Hassan Mounir El-Sady

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 $35 per share in ten days. The firm decides to write 100 SEP 35 calls. The firm receives $0.05 x 10,000 = $500 now. If the stock price stays below $35, nothing else happens. If the stock were to rise dramatically, the firm could sustain a large loss. Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady 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 A special short put is a fiduciary put Refers to the situation in which someone writes a put option and simultaneously deposits the striking price into a special escrow account Ensures that the funds are present to buy the stock if the put owner exercises it A short stock position would cushion losses from a short put: Short stock + short put = short call Dr. Hassan Mounir El-Sady

Dr. Hassan Mounir El-Sady 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 Dr. Hassan Mounir El-Sady

Stock Price at Option Expiration Dr. Hassan Mounir El-Sady Microsoft Example An investor simultaneously: Buys shares of MSFT at $28.51 Writes an OCT 30 MSFT put for $2 Construct a profit and loss worksheet for put overwriting: Stock Price at Option Expiration 15 25 28.255 30 35 Buy stock @ $28.51 -28.51 -13.51 -3.51 -0.255 1.49 6.49 Write 30 put @ $2 -28.00 -13.00 -3.00 0.255 2.00 Net -56.51 -26.51 -6.51 0.00 3.49 8.49 Dr. Hassan Mounir El-Sady

Microsoft Example (cont’d) Writing an OCT 30 put on MSFT @ $2; buy stock @ $28.51 3.49 Stock price at option expiration 30 56.51 Breakeven point = 28.255 Dr. Hassan Mounir El-Sady

Profit and Loss Diagrams With Seasoned Stock Positions Adding a put to an existing stock position Writing a call against an existing stock position Dr. Hassan Mounir El-Sady

1. Adding A Put to an Existing Stock Position Assume an investor Bought MSFT @ $22 Buys an APR 25 MSFT put @ $1.10 The stock price is currently $28.51 Stock Price at Option Expiration 10 25 30 35 40 Long stock @ $22 -22 -12 +3 +8 +13 +18 Long 25 put @ $1.10 +23.90 +13.90 -1.10 Net 1.90 6.90 11.90 16.90 Dr. Hassan Mounir El-Sady

Adding A Put to an Existing Stock Position (cont’d) Protective put with a seasoned position 1.90 Stock price at option expiration 25 Dr. Hassan Mounir El-Sady

2. Writing A Call Against an Existing Stock Position Assume an investor Bought MSFT @ $22 Writes a JAN 30 call @ $1.20 The stock price is currently $28.51 Dr. Hassan Mounir El-Sady

Writing A Call Against an Existing Stock Position (cont’d) Covered call with a seasoned equity position 9.20 Stock price at option expiration 30 20.80 20.80 Dr. Hassan Mounir El-Sady

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 Dr. Hassan Mounir El-Sady

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 $28.51. OCT 20 call options are available @ $8.62. The institution could sell the stock outright for a total of $285,100. Alternatively, the portfolio manager could write 100 OCT 20 calls on MSFT, resulting in total premium of $86,200. If the calls are exercised on expiration Friday, the institution would have to sell MSFT stock for a total of $200,000. Thus, the total received by writing the calls is $286,200, $1,100 more than selling the stock outright. Dr. Hassan Mounir El-Sady

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 Dr. Hassan Mounir El-Sady

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 Dr. Hassan Mounir El-Sady