© 2002 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

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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

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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

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Microsoft Example

Assume you purchased Microsoft for $79 7/16

Stock price at option expiration

Profit or loss ($)

0

79 7/16

79 7/16

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Microsoft Example (cont’d)

Assume you purchased a Microsoft AUG 75 put for $1 13/16

Stock price at option expiration

0

1 13/16

73 3/16

73 3/16 75

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Microsoft Example (cont’d)

Construct a profit and loss worksheet to form the protective put:

Stock Price at Option Expiration

0 30 60 75 90 105

Buy stock

@ $79 7/16

-79 7/16 -49 7/16 -19 7/16 -4 7/16 10 9/16 25 9/16

Buy $75 put

@ $1 13/16

73 3/16 43 3/16 13 3/16 -1 13/16 -1 13/16 -1 13/16

Net -6 1/4 -6 1/4 -6 1/4 -6 1/4 8 3/4 23 3/4

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Microsoft Example (cont’d)

The worksheet shows that

– The maximum loss is $6 ¼– 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 ¼)– The maximum gain is unlimited

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Microsoft Example (cont’d)

Protective put

Stock price at option expiration

0

6 1/4

75

81 1/4

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Logic Behind the Protective Put

A protective put is like an insurance policy

– You can choose how much protection you want

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Logic Behind the Protective Put (cont’d)

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

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Logic Behind the Protective Put (cont’d)

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

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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

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Using Calls to Hedge A Short Position

Introduction Short sale Microsoft example

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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

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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 (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

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Microsoft Example

Assume you short sold Microsoft for $79 7/16

Stock price at option expiration

Profit or loss ($)

0

79 7/16

79 7/16

Maximum loss = unlimited

21

Microsoft Example (cont’d)

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

22

Microsoft Example (cont’d)

Construct a profit and loss worksheet to form the long put:

Stock Price at Option Expiration

0 25 50 75 76 1/16 100

Short stock

@ $79 7/16

79 7/16 54 7/16 29 7/16 4 7/16 3 3/8 -20 9/16

Long $90 call

@ $3 3/8

-3 3/8 -3 3/8 -3 3/8 -3 3/8 -3 3/8 6 5/8

Net 76 1/16 51 1/16 26 1/16 1 1/16 0 -13 15/16

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Microsoft Example (cont’d)

Long put

Stock price at option expiration

0

13 15/16

90

76 1/16

76 1/16

The potential forunlimited loss is gone

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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 to Protect Against Market Downturns

An OCT 85 covered call on Microsoft @ $5; buy stock @ 79 7/16

Stock price at option expiration

0

74 7/16

90 (85)

15 9/16

74 7/16

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Using Options to Generate Income

Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting

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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

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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

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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 3/8, or $337.50 on 100 shares.

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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.

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Writing Naked Calls

Very risky due to the potential for unlimited losses

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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 $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(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 $0.125 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 naked put means a short put by itself

A covered put means the combination of a short put and a short stock position

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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

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Naked vs. Covered Puts (cont’d)

A short stock position would cushion losses from a short put:

Short stock + short put short call

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Put Overwriting: Introduction

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 (cont’d)

Construct a profit and loss worksheet for put overwriting:

Stock Price at Option Expiration

0 25 50 75 77 23/32 100

Buy stock

@ $79 7/16

-79 7/16 -54 7/16 -29 7/16 -4 7/16 -1 23/32 20 9/16

Write $80 put

@ $4

-76 -51 -26 -1 1 23/32 4

Net -155 7/16 -105 7/16 -55 7/16 -5 7/16 0 24 9/16

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Microsoft Example (cont’d)

Writing an AUG 80 put on MSFT @ $4; buy stock @ 79 7/16

Stock price at option expiration

0

155 7/16

80

4 9/16

Breakeven point = 77 23/32

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Profit and Loss Diagrams With Seasoned Stock Positions

Adding a put to an existing stock position Writing a call against an existing stock

position

42

Adding A Put to an Existing Stock Position

Assume an investor

– Bought MSFT @ $46– Buys an AUG 75 MSFT put @ $1 13/16

43

Adding A Put to an Existing Stock Position (cont’d)

Stock Price at Option Expiration

0 25 46 75 79 7/16 100

Buy stock

@ $46

-46 -21 0 29 33 7/16 54

Buy $75 put

@ $1 13/16

73 3/16 48 3/16 27 3/16 -1 13/16 -1 13/16 -1 13/16

Net 27 3/16 27 3/16 27 3/16 27 3/16 31 5/8 52 3/16

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Adding A Put to an Existing Stock Position (cont’d)

Protective put with a seasoned position

Stock price at option expiration

075

27 3/16

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Writing A Call Against an Existing Stock Position

Assume an investor

– Buys MSFT @ $46– Writes an OCT 85 call @ $5

46

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

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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

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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 7/16. AUG 60 call options are available @ $21.

The institution could sell the stock outright for a total of $794,375. 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, $16,625 more than selling the stock outright.

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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

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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