1. © 2004 South-Western Publishing 1 Chapter 3 Basic Option Strategies: Covered Calls and Protective Puts

2. 2 Using Options as A Hedge Protective puts Using calls to hedge a short position Writing covered calls to protect against market downturns

3. 3 Protective Puts long stock position combined with a long put position Microsoft example Logic behind the protective put Synthetic options

4. 4 Microsoft Example Assume you purchased Microsoft for $28.51 Stock price at option expiration Profit or loss ($) 0 28.51

5. 5 Microsoft Example (cont’d) Assume you purchased a Microsoft APR 25 put for $1.10 Stock price at option expiration 0 1.10 23.90 25

6. 6 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the protective put: Stock Price at Option Expiration 0515253040 Long stock @ $28.51 -28.51-23.51-13.51-3.511.4911.49 Long $25 put @ $1.10 23.9018.908.90-1.10 Net -4.61 0.3910.39

7. 7 Microsoft Example (cont’d) Protective put Stock price at option expiration 0 4.61 25 29.61

8. 8 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

9. 9 Logic Behind the 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

10. 10 Synthetic Options The term synthetic option describes a collection of financial instruments that are equivalent to an option position – A protective put is an example of a synthetic call

11. 11 Using Calls to Hedge A Short Position Call options are particularly useful in short sales, providing a hedge against losses resulting from rising security prices Short sale, borrowing shares, later covering the short position Microsoft example

12. 12 Short Sale (cont’d) 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

13. 13 Short stock@31 and buy 30 call@3

14. 14 Short stock@31 and buy 25 call@7

15. 15 Microsoft Example Assume you short sold Microsoft for $28.51 Stock price at option expiration Profit or loss ($) 0 28.51 Maximum loss = unlimited

16. 16 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

17. 17 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the long put: Stock Price at Option Expiration 0152528.513540 Short stock @ $28.51 28.5113.513.510-6.49-11.49 Long 35 call @ $0.50 -0.50 4.50 Net 28.0113.013.01-0.50-6.99

18. 18 Microsoft Example (cont’d) Long put (short stock plus long call) Stock price at option expiration 0 6.99 35 28.01 The potential for unlimited loss is gone

19. 19 Using Options to Generate Income Writing calls to generate income Writing naked calls - very risky due to the potential for unlimited losses Naked vs. covered puts Put overwriting Microsoft example

20. 20 Covered Calls

21. 21 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

22. 22 Naked vs. Covered Puts (cont’d) 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

23. 23 Naked vs. Covered Puts (cont’d) A short stock position would cushion losses from a short put: Short stock + short put short call

24. 24 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

25. 25 Microsoft Example An investor simultaneously: – Buys shares of MSFT at $28.51 – Writes an OCT 30 MSFT put for $2

26. 26 Microsoft Example (cont’d) Construct a profit and loss worksheet for put overwriting: Stock Price at Option Expiration 0152528.2553035 Buy stock @ $28.51 -28.51-13.51-3.51-0.2551.496.49 Write 30 put @ $2 -28.00-13.00-3.000.2552.00 Net -56.51-26.51-6.510.003.498.49

27. 27 Microsoft Example (cont’d) Writing an OCT 30 put on MSFT @ $2; buy stock @ $28.51 Stock price at option expiration 0 56.51 30 3.49 Breakeven point = 28.255