Post on 28-Dec-2015
Dr. Hassan Mounir El-Sady 1
Chapter 3
Basic Option Strategies: Covered Calls &Protective Puts
Dr. Hassan Mounir El-Sady2
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-Sady3
Using Options as A Hedge
Introduction Protective puts Using calls to hedge a short position Writing covered calls to protect
against market downturns
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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-Sady5
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-Sady6
Microsoft Example
Assume you purchased Microsoft for $28.51
Stock price at option expiration
Profit or loss ($)
0
28.51
28.51
Dr. Hassan Mounir El-Sady7
Microsoft Example (cont’d)
Assume you purchased a Microsoft APR 25 put for $1.10
Stock price at option expiration
0
1.10
23.90
23.90 25
Dr. Hassan Mounir El-Sady8
Microsoft Example (cont’d)
Construct a profit and loss worksheet to form the protective put:
Stock Price at Option Expiration
0 5 15 25 30 40
Long stock @ $28.51
= 0 – 28.51
= - 28.51
= 5 – 28.51
= - 23.51
= 15 – 28.51
= - 13.51
= 25 – 28.51
= - 3.51
= 30 – 28.51
= 1.49
=30– 28.51
= 11.49
Long $25 put @ $1.10
= 25 - 0 - 1.1 = 23.90
= 25 - 5 - 1.1 = 18.90
= 25 - 15 - 1.1 = 8.90
= 25 - 25 - 1.1 = - 1.10
-1.10 -1.10
Net - 4.61 - 4.61 - 4.61 - 4.61 0.39 10.39
Dr. Hassan Mounir El-Sady9
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 = $28.51 + $1.1)
– The maximum gain is unlimited
Dr. Hassan Mounir El-Sady10
Microsoft Example (cont’d)
Protective put
Stock price at option expiration
0
- 4.61
25
29.62
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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
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-Sady12
Logic Behind the Protective Put
Insurance Policy Put Option
Premium Time PremiumValue of Asset Price of StockFace Value Strike PriceDeductible Stock Price Less
Strike PriceDuration Time Until ExpirationLikelihood of Loss Volatility of
Stock
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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
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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
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 $28.51
Stock price at option expiration
Profit or loss ($)
0
28.51
28.51
Maximum loss = unlimited
Dr. Hassan Mounir El-Sady16
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-Sady17
Microsoft Example (cont’d)
Construct a profit and loss worksheet to form the long put:
Stock Price at Option Expiration
0 15 25 28.51 35 40
Short stock @ $28.51
28.51 13.51 3.51 0 -6.49 -11.49
Long 35 call @ $0.50
-0.50 -0.50 -0.50 -0.50 -0.50 4.50
Net 28.01 13.01 3.01 -0.50 -6.99 -6.99
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Microsoft Example (cont’d)
Long put (short stock plus long call)
Stock price at option expiration
0
6.99
35
28.01
28.01
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
A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51
Stock price at option expiration
0
27.31
30
2.69
27.31
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Using Options to Generate Income
Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting Microsoft example
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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
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 ExampleIt is now September 15, 2005. A year ago, you bought 300 shares of Microsoft at $22. Your broker suggests writing three JAN 30 calls @ $1.20, or $120.00 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-Sady24
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
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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 $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.
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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
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
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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 $28.51– Writes an OCT 30 MSFT put for $2
Construct a profit and loss worksheet for put overwriting:
Stock Price at Option Expiration
0 15 25 28.255
30 35
Buy stock @ $28.51
-28.51 -13.51 -3.51 -0.255 1.49 6.49
Write 30 put @ $2
-28.00 -13.00 -3.00 0.255 2.00 2.00
Net -56.51 -26.51 -6.51 0.00 3.49 8.49
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Microsoft Example (cont’d)
Writing an OCT 30 put on MSFT @ $2; buy stock @ $28.51
Stock price at option expiration
0
56.51
30
3.49
Breakeven point = 28.255
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Profit and Loss Diagrams With Seasoned Stock Positions
1. Adding a put to an existing stock position
2. Writing a call against an existing stock position
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1. Adding A Put to an Existing Stock Position
Assume an investor– Bought MSFT @ $22– Buys an APR 25 MSFT put @ $1.10
The stock price is currently $28.51
Stock Price at Option Expiration
0 10 25 30 35 40
Long stock @ $22 -22 -12 +3 +8 +13 +18
Long 25 put @ $1.10
+23.90
+13.90
-1.10 -1.10 -1.10 -1.10
Net 1.90 1.90 1.90 6.90 11.90 16.90
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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
025
1.90
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2. Writing A Call Against an Existing Stock Position
Assume an investor– Bought MSFT @ $22– Writes a JAN 30 call @ $1.20
The stock price is currently $28.51
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Writing A Call Against an Existing Stock Position (cont’d)
Covered call with a seasoned equity position
Stock price at option expiration
0
20.80
30
9.20
20.80
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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 Deep-in-the-Money Microsoft Calls Example
Assume an institution holds 10,000 shares of MSFT. The current market price is $28.51. OCT 20 call options are available @ $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.
Writing Calls to Improve on the Market (cont’d)
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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