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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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 =
= 5 – 28.51 =
= 15 – 28.51 =
= 25 – 28.51 =
= 30 – 28.51
= 1.49
=30– 28.51
= 11.49
Long $25 $1.10 =
= 23.90 =
= 18.90 =
= 8.90 = =
-1.10
Net
- 4.61
0.39
10.39
Dr. Hassan Mounir El-Sady

9. 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 = $ $1.1)
The maximum gain is unlimited
Dr. Hassan Mounir El-Sady

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

11. 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

12. 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

13. 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

14. 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

15. 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

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
Dr. Hassan Mounir El-Sady

17. 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

18. 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

19. 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

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

21. 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

22. 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

23. Writing Calls to Generate Income (cont’d)
Writing a Microsoft Call Example
It is now September 15, A year ago, you bought 300 shares of Microsoft at $22. Your broker suggests writing three JAN 30 $1.20, or $ 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

24. 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

25. 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

26. 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

27. 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

28. 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 $28.51
-28.51
-13.51
-3.51
-0.255
1.49
6.49
Write 30 $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

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

30. 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

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

32. 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

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

34. 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

35. 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

36. 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 $ OCT 20 call options are $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

37. 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

38. 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