1. © 2002 South-Western Publishing 1 Chapter 2 Review Basic Puts and Calls

2. 2 Buying a Call Option (cont’d) Breakeven = $87 020406080 100 Maximum loss = $7

3. 3 Buying A Call Option A bullish strategy Consider possible actions if: – stock declines and so has your option – stock stays the same and your option has declined (time value) – stock has advanced and your option increased in value

4. 4 Buying a Put Option (cont’d) $74.12 Breakeven = $74.12 020406080 100 $5.88

5. 5 Buying a Put Option Bearish Strategy Consider possible actions if: – stock declines and your option has increased in value – stock has stayed the same and your option has declined in value – stock has increased and your option has declined in value

6. 6 Writing a Call Option Breakeven = $87 Maximum Profit = $7 020406080 100

7. 7 Writing A Call Option A neutral to bearish strategy Possible actions if: – stock stays the same – stock declines – stock increases beyond the exercise price - risk of being ‘assigned’

8. 8 Writing a Put Option Breakeven = $74.12 $5.88 020406080 100 $74.12

9. 9 Writing a Put Option Neutral to bullish strategy Similar to a covered call Assume you wrote the put option as an alternative to placing an open buy order Possible actions if: – stock declines - possible assignment – stock stays the same - no action - realize the profit – stock increases - no action - realize the profit

10. © 2002 South-Western Publishing 10 Chapter 3 Basic Option Strategies: Covered Calls and Protective Puts

11. 11 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

12. 12 Using Options as A Hedge Protective puts Using calls to hedge a short position Writing covered calls to protect against market downturns

13. 13 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

14. 14 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

15. 15 Microsoft Example Assume you purchased Microsoft for $79.44 Stock price at option expiration Profit or loss ($) 0 79.44

16. 16 Microsoft Example (cont’d) Assume you purchased a Microsoft AUG 75 put for $1.81 Stock price at option expiration 0 1.81 73.19 75

17. 17 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the protective put: Stock Price at Option Expiration 030607590105 Buy stock @ $79.44 -79.44-49.44-19.44-4.4410.5625.56 Buy $75 put @ $1.81 73.1943.1913.19-1.81 Net -6.25 8.7523.75

18. 18 Microsoft Example (cont’d) The worksheet shows that – The maximum loss is $6.25 – The maximum loss occurs at all stock prices of $75 or below – The put breaks even somewhere between $75 and $90 (it is exactly $81.25) – 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

19. 19 Microsoft Example (cont’d) Protective put (vs unhedged position) Stock price at option expiration 0 - 6.25 75 81.25 unhedged 79.44 1.81

20. 20 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

21. 21 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

22. 22 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

23. 23 Microsoft - Synthetic Call Stock Price at Option Expiration 23.75 30-7.25 =22.75 8.75 15-7.25 =7.75 -6.25 -7.25 -6.25 -7.25 -6.25 -7.25 -6.25 -7.25 Net Call Option -1.81 13.1943.1973.19 Buy $75 put @ $1.81 25.5610.56-4.44-19.44-49.44-79.44 Buy stock @ $79.44 105907560300

24. 24 Using Calls to Hedge A Short Position Short sale Microsoft example

25. 25 Hedging 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

26. 26 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

27. 27 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

28. 28 Hedging a Short Position Assume you short sold Microsoft for $79 7/16 Stock price at option expiration Profit or loss ($) 0 79.44 Maximum loss = unlimited

29. 29 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 $3.38 in addition to the short sale – The potential for unlimited losses is eliminated

30. 30 Hedging a Short Position Construct a profit and loss worksheet to form the long put: Stock Price at Option Expiration 025507576.06100 Short stock @ $79.44 79.4454.4429.444.443.38-20.56 Long $90 call @ $3.38 -3.38 6.62 Net 76.0651.0626.061.060-13.94

31. 31 Hedging a Short Position Short sale with a long call creates the equivalent of a long put Stock price at option expiration 0 13.94 90 76.06 The potential for unlimited loss is gone

32. 32 Short sale with a long call creates the equivalent of a long put Stock price at option expiration 0 13.94 90 76.06 The potential for unlimited loss is gone Hedging a Short Position 93.38 unhedged

33. 33 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

34. 34 Writing Covered Calls An OCT 85 covered call on Microsoft @ $5; buy stock @ 79.44 Stock price at option expiration 0 74.44 85 10.56 74.44 unhedged..... not particularly effective as a hedge against losses, consider protective puts instead

35. 35 Using Options to Generate Income Writing calls (covered)to generate income Writing naked calls Naked vs. covered puts Put overwriting

36. 36 Writing Covered Calls to Generate Income Actually quite a conservative approach An attractive way to generate income for foundations, pension funds, and other portfolios A very popular activity with individual investors Attractive when investor expects stock to trade sideways

37. 37 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

38. 38 Writing Calls to Generate Income (cont’d) Writing a Microsoft Call Example It is now July 10, 2001. A year ago, you bought 300 shares of Microsoft at $46. Your broker suggests writing three OCT 90 calls @ $3.38, or $338.00 on 100 shares.

39. 39 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.

40. 40 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

41. 41 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 $.12  The July 95 MSFT call expires on July 21  Microsoft currently trades at $79.44

42. 42 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 $0.12 x 10,000 = $1,200 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.

43. 43 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

44. 44 Naked vs. Covered Puts (cont’d) A short stock position would cushion (only) losses from a short put: Short stock + short put short call Profit/ Loss Stock Price @ Expiration

45. 45 Naked or Short Put Long stock + short call =‘s short put (covered call) =‘s (approx) short put ……a strategy to consider!

46. 46 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 – Also a consideration in Corporate Share repurchase (buyback) situations - short put

47. 47 Microsoft Example An investor simultaneously: – Buys shares of MSFT at $79.44 – Writes an AUG 80 MSFT put for $4

48. 48 Microsoft Example (cont’d) Construct a profit and loss worksheet for put overwriting: Stock Price at Option Expiration 025507577.72100 Buy stock @ $79.44 -79.44-54.44-29.44-4.44-1.7220.56 Write $80 put @ $4 -76-51-261.724 Net -155.44-105.44-55.44-5.44024.56

49. 49 Microsoft Example (cont’d) Writing an AUG 80 put on MSFT @ $4; buy stock @ 79.44 Stock price at option expiration 0 155.44 80 4.56 Breakeven point = 77.72 Unhedged

50. 50 Profit and Loss Diagrams With Seasoned Stock Positions Adding a put (protective) to an existing stock position Writing a call against an existing stock position Other investment considerations: – sell stock - realize your profits! – Sell stock and replace it with a call option – Do nothing - continue to hold the stock expecting further gains

51. 51 Adding A Put to an Existing Stock Position Assume an investor – Bought MSFT @ $46 – Buys an AUG 75 MSFT put @ $1.81 Objective.........to lock in or ‘protect’ existing profit

52. 52 Adding A Put to an Existing Stock Position (cont’d) Stock Price at Option Expiration 025467579.44100 Buy stock @ $46 -46-2102933.4454 Buy $75 put @ $1.81 73.1948.1927.19-1.81 Net 27.19 31.6352.19

53. 53 Adding A Put to an Existing Stock Position (cont’d) Protective put with a seasoned position Stock price at option expiration 0 75 27.19 unhedged

54. 54 Writing A Call Against an Existing Stock Position Assume an investor – Buys MSFT @ $46 – Writes an OCT 85 call @ $5

55. 55 Writing A Call Against an Existing Stock Position (cont’d) Covered call with a seasoned equity position Stock price at option expiration 0 41 85 44 41

56. 56 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

57. 57 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 $79.44. AUG 60 call options are available @ $21. The institution could sell the stock outright for a total of $794,000. 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, $15,625 more than selling the stock outright.

58. 58 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 (option strategy less advantageous vs outright sale) – Bid/ask and liquidity/depth considerations Upside is essentially capturing time value associated with the option

59. 59 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 Risks to consider: – If the stock rises above the strike price and the put is not exercised, the stock has not been acquired – ‘opportunity loss’ if the stock price falls ie you would have done better simply buying the stock outright Trading range for the stock when this strategy is advantageous