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

2 Outline Using options as a hedge Using options to generate income Profit and loss diagrams with seasoned stock positions Improving on the market

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

4 Introduction 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

5 Protective Puts Definition Microsoft example Logic behind the protective put Synthetic options

6 Definition 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

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

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

9 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the protective put: Stock Price at Option Expiration Long $ Long $25 $ Net

10 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 $29.61) – The maximum gain is unlimited

11 Microsoft Example (cont’d) Protective put Stock price at option expiration

12 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

13 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

14 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

15 Using Calls to Hedge A Short Position Introduction Short sale Microsoft example

16 Introduction Call options can be used to provide a hedge against losses resulting from rising security prices Call options are particularly useful in short sales

17 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

18 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

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

20 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

21 Microsoft Example (cont’d) Construct a profit and loss worksheet to form the long put: Stock Price at Option Expiration Short $ Long 35 $ Net

22 Microsoft Example (cont’d) Long put (short stock plus long call) Stock price at option expiration The potential for unlimited loss is gone

23 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

24 Writing Covered Calls to Protect Against Market Downturns A JAN 30 covered call on $1.20; buy Stock price at option expiration

25 Using Options to Generate Income Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting Microsoft example

26 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

27 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

28 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.

29 Writing Calls to Generate Income (cont’d) Writing a Microsoft Call Example (cont’d) 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.

30 Writing Naked Calls Very risky due to the potential for unlimited losses

31 Writing Naked Calls(cont’d) 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

32 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.

33 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

34 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

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

36 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

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

38 Microsoft Example (cont’d) Construct a profit and loss worksheet for put overwriting: Stock Price at Option Expiration Buy $ Write 30 $ Net

39 Microsoft Example (cont’d) Writing an OCT 30 put on $2; buy $28.51 Stock price at option expiration Breakeven point =

40 Profit and Loss Diagrams With Seasoned Stock Positions Adding a put to an existing stock position Writing a call against an existing stock position

41 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

42 Adding A Put to an Existing Stock Position (cont’d) Stock Price at Option Expiration Long $ Long 25 $ Net

43 Adding A Put to an Existing Stock Position (cont’d) Protective put with a seasoned position Stock price at option expiration

44 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

45 Writing A Call Against an Existing Stock Position (cont’d) Covered call with a seasoned equity position Stock price at option expiration

46 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

47 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.

48 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

49 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