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Basic Chapter Option Strategies: Covered Calls and Protective Puts
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2002 South-Western Publishing
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
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Using Options as A Hedge
Protective
puts Using calls to hedge a short position Writing covered calls to protect against market downturns
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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
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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
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Microsoft Example
Assume you purchased Microsoft for $79 7/16
Profit or loss ($)
0 79 7/16 79 7/16
Stock price at option expiration
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Microsoft Example (contd)
Assume you purchased a Microsoft AUG 75 put for $1 13/16
73 3/16 73 3/16 0 75 Stock price at option expiration
1 13/16
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Microsoft Example (contd)
Construct a profit and loss worksheet to form the protective put:
Stock Price at Option Expiration 0 30
-49 7/16
60
-19 7/16
75
-4 7/16
90
10 9/16
105
25 9/16
Buy stock @ $79 7/16 Buy $75 put @ $1 13/16
-79 7/16
73 3/16
43 3/16
13 3/16
-1 13/16
-1 13/16
-1 13/16
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Net
-6 1/4
-6 1/4
-6 1/4
-6 1/4
8 3/4
23 3/4
Microsoft Example (contd)
The
worksheet shows that
The maximum loss is $6 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 ) 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
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Microsoft Example (contd)
Protective
put (vs unhedged position)
unhedged
1 13/16
0
75 81 1/4
79 7/16
Stock price at option expiration
- 6 1/4
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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
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The more protection you want, the higher the premium you are going to pay
Protective Put (contd)
Insurance Policy
Premium Value of Asset Face Value Deductible Duration Likelihood of Loss
Put Option
Time Premium Price of Stock Strike Price Stock Price Less Strike Price Time Until Expiration Volatility of Stock
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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
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Microsoft - Synthetic Call
Stock Price at Option Expiration 0 Buy stock @ $79 7/16 Buy $75 put @ $1 13/16 Net Call Option
-79 7/16
30
-49 7/16
60
-19 7/16
75
-4 7/16
90
10 9/16
105
25 9/16
73 3/16
43 3/16
13 3/16
-1 13/16
-1 13/16
-1 13/16
-6 1/4
-6 1/4
-6 1/4
-6 1/4
8 3/4 15-71/4 =7 3/4
23 3/4 30-71/4 =22 3/4
-7 1/4
-71/4
-71/4
-71/4
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Using Calls to Hedge A Short Position
Short
sale Microsoft example
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Hedging a Short Postion
Call
options can be used to provide a hedge against losses resulting from rising security prices options are particularly useful in short sales
Call
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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
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Short Sale (contd)
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 The put has a limited life or time frame The cost of the put needs to be considered
However:
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Hedging a Short Position
Assume you short sold Microsoft for $79 7/16
Profit or loss ($) 79 7/16 Stock price at option expiration 79 7/16 Maximum loss = unlimited
0
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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 3/8 in addition to the short sale The potential for unlimited losses is eliminated
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Hedging a Short Position
Construct a profit and loss worksheet to form the long put:
Stock Price at Option Expiration 0 25
54 7/16
50
29 7/16
75
4 7/16
76 1/16
3 3/8
100
-20 9/16
Short stock @ $79 7/16 Long $90 call @ $3 3/8
79 7/16
-3 3/8
-3 3/8
-3 3/8
-3 3/8
-3 3/8
6 5/8
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Net
76 1/16
51 1/16
26 1/16
1 1/16
0
-13 15/16
Hedging a Short Position
Short sale with a long call creates the equivalent of a long put
76 1/16 90 76 1/16 13 15/16 The potential for unlimited loss is gone Stock price at option expiration
0
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Hedging a Short Position
Short sale with a long call creates the equivalent of a long put
76 1/16
unhedged
0 76 1/16 13 15/16
90 Stock price at option expiration The potential for unlimited loss is gone
93 3/8
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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
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Writing Covered Calls
An OCT 85 covered call on Microsoft @ $5; buy unhedged stock @ 79 7/16
15 9/16 74 7/16 90 Stock price at option expiration
0 74 7/16
.....not particularly effective as a hedge against losses,
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consider protective puts instead
Using Options to Generate Income
Writing
calls to generate income Writing naked calls Naked vs. covered puts Put Covered overwriting
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Writing Calls to Generate Income
Acutally
quite a conservative approach An attractive way to generate income with foundations, pension funds, and other portfolios A very popular activity with individual investors Attractive when investor expects stock to trade sideways
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Writing Calls to Generate Income (contd)
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
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Writing Calls to Generate Income (contd)
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 3/8, or $337.50 on 100 shares.
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Writing Calls to Generate Income (contd)
Writing a Microsoft Call Example (contd) 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.
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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
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Writing Naked Calls(contd)
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 $1/8 The July 95 MSFT call expires on July 21 Microsoft currently trades at $79 7/16
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Writing Naked Calls(contd)
Writing a Naked Microsoft Call Example (contd)
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 $0.125 x 10,000 = $1,250 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.
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Naked vs. Covered Puts
A A
naked put means a short put by itself
covered put means the combination of a short put and a short stock position
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Naked vs. Covered Puts (contd)
A
short stock position would cushion losses from a short put:
Short stock + short put
Profit/ Loss
short call
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Stock Price @ Expiration
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
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Microsoft Example
An
investor simultaneously:
Buys shares of MSFT at $79 7/16 Writes an AUG 80 MSFT put for $4
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Microsoft Example (contd)
Construct a profit and loss worksheet for put overwriting:
Stock Price at Option Expiration 0 25
-54 7/16
50
-29 7/16
75
-4 7/16
77 23/32
-1 23/32
100
20 9/16
Buy stock @ $79 7/16 Write $80 put @ $4 Net
-79 7/16
-76
-51
-26
-1
1 23/32
4
-155 7/16
-105 7/16
-55 7/16
-5 7/16
0
24 9/16
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Microsoft Example (contd)
Writing an AUG 80 put on MSFT @ $4; buy stock @ 79 7/16
Unhedged
4 9/16 0 80
Stock price at option expiration
155 7/16
Br...