Option Strategies.....
Buying Calls
A call option contract gives its holder the right to buy a specified number of shares of the
underlying stock at the given strike price on or before the expiration date of the contract.
I. Buying calls to participate in upward price movements
Buying an XYZ July 50 call option gives you the right to purchase 100 shares of XYZ common
stock at a cost of $50 per share at any time before the option expires in July. The right to
buy stock at a fixed price becomes more valuable as the price of the underlying stock
increases.
Assume that the price of the underlying shares was $50 at the time you bought your option
and the premium you paid was 3 1/2 (or $350). If the price of XYZ stock climbs to $55 before
your option expires and the premium rises to 5 1/2, you have two choices in disposing of your
in-the-money option:
You can exercise your option and buy the underlying XYZ stock for $50 a share for a
total cost of $5,350 (including the Option premium) and simultaneously sell the shares
on the stock market for $5,500 yielding a net profit of $ 150.
You can close out your position by selling the option contract For $550, collecting the
difference between the premium received and paid, $200. In this case, you make a
profit of 57% (200/350), whereas your profit on an outright stock purchase, given the
same price movement, would be only 10% (55-50/50).
The profitability of similar examples will depend on how the time remaining until expiration
affects the premium. Remember, time value declines sharply as an option nears its expiration
date. Also influencing your decision will be your desire to own the stock.
If the price of XYZ instead fell to $45 and the option premium fell to 7/8, you could sell your
option to partially offset the premium you paid. Otherwise, the option would expire worthless
and your loss would be the total amount of the premium paid or $350. In most cases, the loss
on the option would be less than what you would have lost had you bought the underlying
shares outright, $262.50 versus $500 in this example.
II. Buying calls as part of an investment plan
A popular use of options known as "the 90/10 strategy" involves placing 10% of your
investment funds in long (purchased) calls and the other 90% in a money market instrument
(in our examples we use T-bills) held until the option's expiration. This strategy provides both
leverage (from the options) and limited risk (from the T-bills), allowing the investor to benefit
from a favorable stock price move while limiting the downside risk to the call premium minus
any interest earned on the T-bills.
Assume XYZ is trading at $60 per share. To purchase 100 shares of XYZ would require an
investment of $6,000, all of which would be exposed to the risk of a price decline. To employ
the 90/10 strategy, you would buy a six-month XYZ 60 call. Assuming a premium of 6, the
cost of the option would be $600. This purchase leaves you with $5,400 to invest in T-bills for
six months. Assuming an interest rate of 10% and that the T-bill is held until maturity, the
$5,400 would earn interest of $270 over the six month period. The interest earned would
effectively reduce the cost of the option to $330 ($600 premium minus $270 interest).
If the price of XYZ rises by more than $3.30 per share, your long call will realize the dollar
appreciation at expiration of a long position in 100 shares of XYZ stock but with less capital
invested in the option than would have been invested in the 100 shares of stock. As a result,
you will realize a higher return on your capital with the option than with the stock.
If the stock price instead increases by less than $3.30 or falls, your loss will be limited to the
price you paid for the option ($600) and this loss will be at least partially offset by the earned
interest on your T-bill plus the premium you receive from closing out your position by selling the
option, if you choose to do so.
III. Buying calls to lock in a stock purchase price
An investor who sees an attractive stock price but does not have sufficient cash flow to buy
at the present time can use call options to lock in the purchase price for as far as eight
months into the future.
Assume that XYZ is currently trading at $55 per share and that you would like to purchase
100 shares of XYZ at this price; however, you do not have the funds available at this time. You
know that you will have the necessary funds in six months but you fear that the stock price
will increase during this period of time. One solution is to purchase a six-month XYZ 55 call
option, thereby establishing the maximum price ($55 per share) you will have to pay for the
stock. Assume the premium on this option is 4 1/4.
If in six months the stock price has risen to $70 and you have sufficient funds available, the
call can be exercised and you will own 100 shares of XYZ at the option's strike price of $55.
For a cost of $425 in option premium, you are able to buy your stock at $5,500 rather than
$7,000. Your total cost is thus $5,925 ($5,500 plus $425 premium), a savings of $1075
($7,000 minus $5,925) when compared to what you would have paid to buy the stock without
your call option. If in six months the stock price has instead declined to $50, you may not want
to exercise your call to buy at $55 because you can buy XYZ stock on the stock market at
$50. Your out-of-the-money call will either expire worthless or can be sold for whatever time
value it has remaining to recoup a portion of its cost. Your maximum loss with this strategy is
the cost of the call option you bought or $425.
IV. Buying calls to hedge short stock sales
An investor who has sold stock short in anticipation of a price decline can limit a possible loss
by purchasing call options. Remember that shorting stock requires a margin account and margin
calls may force you to liquidate your position prematurely. Although a call option may be used
to offset a short stock position's upside risk, it does not protect the option holder against
additional margin calls or premature liquidation of the short stock position.
Assume you sold short 100 shares of XYZ stock at $40 per share. If you buy an XYZ 40 call
at a premium of 3 1/2, you establish a maximum share price of $40 that you will have to pay
if the stock price rises and you are forced to cover the short stock position. For instance, if the
stock price increases to $50 per share, you can exercise your option to buy XYZ at $40 per
share and cover your short stock position at a net cost of $350 ($4,000 proceeds from short
stock sale less $4,000 to exercise the Option and $350 cost of the option) assuming you can
affect settlement of your exercise in time. This is significantly less than the $ 1,000 ($4,000
proceeds from short stock sale less $5,000 to cover short) that you would have lost had you
not hedged your short stock position.
The maximum potential loss in this strategy is limited to the cost of the call plus the difference,
if any, between the call strike price and the short stock price. In this case, the maximum loss is
equal to the cost of the call or $350. Profits will result if the decline in the stock price exceeds
the cost of the call.
Buying puts
A put option contract gives its holder the right to sell a specified number of shares of the
underlying stock at the given strike price on or before the expiration date of the contract.
I. Buying puts to participate in downward price movements
Put options may provide a more attractive method than shorting stock for profiting on stock
price declines, in that, with purchased puts, you have a known and predetermined risk. The
most you can lose is the cost of the option. If you short stock, the potential loss, in the event
of a price upturn, is unlimited.
Another advantage of buying puts results from your paying the full purchase price in cash at
the time the put is bought. Shorting stock requires a margin account, and margin calls on a
short sale might force you to cover your position prematurely, even though the position still may
have profit potential. As a put buyer, you can hold your position through the option's expiration
without incurring any additional risk.
Buying an XYZ July 50 put gives you the right to sell 100 shares of XYZ stock at $50 per
share at any time before the option expires in July. This right to sell stock at a fixed price
becomes more valuable as the stock price declines.
Assume that the price of the underlying shares was $50 at the time you bought your option
and the premium you paid was 4 (or $400). If the price of XYZ falls to $45 before July and
the premium rises to 6, you have two choices in disposing of your in-the-money put option:
1) You can buy 100 shares of XYZ stock at $45 per share and simultaneously exercise your
put option to sell XYZ at $50 per share, netting a profit of $100 ($500 profit on the stock less
the $400 option premium).
2) You can sell your put option contract, collecting the difference between the premium paid
and the premium received, $200 in this case.
If, however, the holder has chosen not to act, his maximum loss using this strategy would be
the total cost of the put option or $400. The profitability of similar examples depends on how
the time remaining until expiration affects the premium. Remember, time value declines sharply
as an option nears its expiration date.
If XYZ prices instead had climbed to $55 prior to expiration and the premium fell to 1 1/2, your
put option would be out-of-the-money. You could still sell your option for $150, partially
offsetting its original price. In most cases, the cost of this strategy will be less than what you
would have lost had you shorted XYZ stock instead of purchasing the put option, $250 versus
$500 in this case.
This strategy allows you to benefit from downward price movements while limiting losses to
the premium paid if prices increase.
II. Buying puts to protect a long stock position
You can limit the risk of stock ownership by simultaneously buying a put on that stock, a
hedging strategy commonly referred to as a "married put." This strategy establishes a minimum
selling price for the stock during the life of the put and limits your loss to the cost of the put
plus the difference, if any, between the purchase price of the stock and the strike price of the
put, no matter how far the stock price declines. This strategy will yield a profit if the stock
appreciation is greater than the cost of the put option.
Assume you buy 100 shares of XYZ stock at $40 per share and, at the same time, buy an
XYZ July 40 put at a premium of 2. By purchasing this put option for the $200 in premium,
you have ensured that no matter what happens to the price of the stock, you will be able to
sell 100 shares for $40 per share, or $4,000.
If the price of XYZ stock increases to $50 per share and the premium of your option drops to
7/8, your stock position is now worth $5,000 but your put is out-of-the-money. Your profit, if
you sell your stock, is $800 ($1,000 profit on the stock less the amount you paid for the put
option, $200). However, if the price increase occurs before expiration, you may reduce the loss
on the put by selling it for whatever time value remains, $87.50 in this case if the July 40 put
can be sold for 7/8.
If the price of XYZ stock instead had fallen to $30 per share, your stock position would only be
worth $3,000 (an unrealized loss of $1,000) but you could exercise your put, selling your stock
for $40 per share to break even on your stock position at a cost of $200 (the premium you
paid for your put).
This strategy is significant as a method for hedging a long stock position. While you are limiting
your downside risk to the $200 in premium, you have not put a ceiling on your upside profit
potential.
III. Buying puts to protect unrealized profit in long stock
If you have an established profitable long stock position, you can buy puts to protect this
position against short-term stock price declines. If the price of the stock declines by more than
the cost of the put, the put can be sold or exercised to offset this decline. If you decide to
exercise, you may sell your stock at the put option's strike price, no matter how far the stock
price has declined.
Assume you bought XYZ stock at $60 per share and the stock price is currently $75 per
share. By buying an XYZ put option with a strike price of $70 for a premium of 1 1/2, you are
assured of being able to sell your stock at $70 per share during the life of the option. Your
profit, of course, would be reduced by the $150 you paid for the put. The $150 in premium
represents the maximum loss from this strategy.
For example, if the stock price were to drop to $65 and the premium increased to 6, you could
exercise your put and sell your XYZ stock for $70 per share. Your $1,000 profit on your stock
position or $150 would be offset by the cost of your put option resulting in a profit of $850
($1,000 - $150). Alternatively, if you wished to maintain your position in XYZ stock, you could
sell your in-the-money put for $600 and collect the difference between the premiums received
and paid, $450 ($600 - $150) in this case, which might offset some or all of the lost stock
value.
If the stock price were to climb, there would be no limit to the potential profit from the stock's
increase in price. This gain on the stock, however, would be reduced by the cost of the put or
$150.
Selling calls
As a call writer, you obligate yourself to sell, at the strike price, the underlying shares of stock
upon being assigned an exercise notice. For assuming this obligation, you are paid a premium at
the time you sell the call.
Covered Call Writing
The most common strategy is writing calls against a long position in the underlying stock,
referred to as covered call writing. Investors write covered calls primarily for the following two
reasons:
to realize additional return on their underlying stock by earning premium income; and
to gain some protection (limited to the amount of the premium) from a decline in the
stock price.
Covered call writing is considered to be a more conservative strategy than outright stock
ownership because the investor's downside risk is slightly offset by the premium he receives
for selling the call.
As a covered call writer, you own the underlying stock but are willing to forsake price
increases in excess of the option strike price in return for the premium. You should be prepared
to deliver the necessary shares of the underlying stock (if assigned) at any time during the life
of the option. Of course, you may cancel your obligation at any time prior to being assigned an
exercise notice by executing a closing transaction, that is, buying a call in the same series.
A covered call writer's potential profits and losses are influenced by the strike price of the call
he chooses to sell. In all cases, the writer's maximum net gain (i.e., including the gain or loss on
the long stock from the date the option was written) will be realized if the stock price is at or
above the strike price of the option at expiration or at assignment. Assuming the stock
purchase price is equal to the stock's current price:
If he writes an at-the-money call (strike price equal to the current price of the long
stock), his maximum net gain is the premium he receives for selling the option;
If he writes an in-the-money call (strike price less than the current price of the long
stock), his maximum net gain is the premium minus the difference between the stock
purchase price and the strike price;
If he writes an out-of-the-money call (strike price greater than the current price of the
stock), his maximum net gain is the premium plus the difference between the strike
price and the stock purchase price should the stock price increase above the strike
price.
If the writer is assigned, his profit or loss is determined by the amount of the premium plus the
difference, if any, between the strike price and the original stock price. If the stock price rises
above the strike price of the option and the writer has his stock called away from him (i.e., is
assigned), he forgoes the opportunity to profit from further increases in the stock price. If,
however, the stock price decreases, his potential for loss on the stock position may be
substantial; the hedging benefit is limited only to the amount of the premium income received.
Assume you write an XYZ July 50 call at a premium of 4 covered by 100 shares of XYZ
stock which you bought at $50 per share. The premium you receive helps to fulfill one of the
objectives of a call writer: additional income from your investments. In this example, a $4 per
share premium represents an 8% yield on your $50 per share stock investment. This covered
call (long stock/short call) position will begin to show a loss if the stock price declines by an
amount greater than the call premium received or $4 per share.
If the stock price subsequently declines to $40, your long stock position will decrease in value
by $ 1,000. This unrealized loss will be partially offset by the $400 in premium you received for
writing the call. In other words, if you actually sell the stock at $40, your loss will be only $600.
On the other hand, if the stock price rises to $60 and you are assigned, you must sell your 100
shares of stock for $5,000. By writing a call option, you have forgone the opportunity to profit
from an increase in value of your stock position in excess of the strike price of your option.
The $400 in premium you keep, however, results in a net selling price of $5,400. The $6 per
share difference between this net selling price ($54) and the current market value ($60) of the
stock represents the "opportunity cost" of writing this call option.
Of course, you are not limited to writing an option with a strike price equal to the price at
which you bought the stock. You might choose a strike price that is below the current market
price of your stock (i.e., an in-the-money option). Since the option buyer is already getting part
of the desired benefit, appreciation above the strike price, he will be willing to pay a larger
premium, which will provide you with a greater measure of downside protection. However, you
will also have assumed a greater chance that the call will be exercised.
On the other hand, you could opt for writing a call option with a strike price that is above the
current market price of your stock (i.e., on out-oœ the-money option). Since this lowers the
buyer's chances of benefiting from the investment, your premium will be lower, as will the
chances that your stock will be called away from you.
In short, the writer of a covered call option, in return for the premium he receives, forgoes the
opportunity to benefit from an increase in the stock price which exceeds the strike price of his
option, but continues to bear the risk of a sharp decline in the value of his stock which will only
be slightly offset by the premium he received for selling the option.
Uncovered Call Writing
A call option writer is uncovered if he does not own the shares of the underlying security
represented by the option. As an uncovered call writer, your objective is to realize income from
the writing transaction without committing capital to the ownership of the underlying shares of
stock. An uncovered option is also referred to as a naked option. An uncovered call writer
must deposit and maintain sufficient margin with his broker to assure that the stock can be
purchased for delivery if and when he is assigned.
The potential loss of uncovered call writing is unlimited. However, writing uncovered calls can
be profitable during periods of declining or generally stable stock prices, but investors
considering this strategy should recognize the significant risks involved:
If the market price of the stock rises sharply, the calls could be exercised. To satisfy
your delivery obligation, you may have to acquire stock in the market for more than the
option's strike price. This could result in a substantial loss.
The risk of writing uncovered calls is similar to that of selling stock short, although, as
an option writer, your risk is cushioned somewhat by the amount of premium received.
As an example, if you write an XYZ July 65 call for a premium of 6, you will receive $600 in
premium income. If the stock price remains at or below $65, you may not be assigned on your
option and, if you are not assigned because you have no stock position, the price decline has no
effect on your $600 profit. On the other hand, if the stock price subsequently climbs to $75
per share, you likely will be assigned and will have to cover your position at a net loss of $400
($1000 loss on covering the call assignment off-set by $600 in premium income). The call
writer's losses will continue to increase with subsequent increases in the stock price.
As with any option transaction, an uncovered call writer may cancel his obligation at any time
prior to being assigned by executing a closing purchase transaction. An uncovered call writer
also can mitigate his risk at any time during the life of the option by purchasing the underlying
shares of stock, thereby becoming a covered writer.
Selling Puts
Selling a put obligates you to buy the underlying shares of stock at the option's strike price
upon assignment of an exercise notice. You are paid a premium when the put is written to
partially compensate you for assuming this risk. As a put writer, you must be prepared to buy
the underlying stock at any time during the life of the option.
Covered Put Writing
A put writer is considered to be covered if he has a corresponding short stock position. For
purposes of cash account transactions, a put writer is also considered to be covered if he
deposits cash or cash equivalents equal to the exercise value of the Option with his broker. A
covered put writer s profit potential is limited to the premium received plus the difference
between the strike price of the put and the original share price of the short position. The
potential loss on this position, however, is substantial if the price of the stock increases
significantly above the original share price of the short position. In this case, the short stock will
accrue losses while the offsetting profit on the put sale is limited to the premium received.
Uncovered Put Writing
A put writer is considered to be uncovered if he does not have a corresponding short stock
position or has not deposited cash equal to the exercise value of the put. Like uncovered call
writing, uncovered put writing has limited rewads (the premium received) and potentially
substantial risk (if prices fall and you are assigned). The primary motivations for most put
writers are:
receive premium income; and
acquire stock at a net cost below the current market value.
If the stock price declines below the strike price of the put and the put is exercised, you will be
obligated to buy the stock at the strike price. Your cost will, of course, be offset at least
partially by the premium you received for writing the option. You will begin to suffer a loss if
the stock price declines by an amount greater than the put premium received or $5 per share.
As with writing uncovered calls, the risks of writing uncovered put options are substantial. If
instead the stock price rises, your put will most likely expire.
Assume you write an XYZ July 55 put for a premium of 5 and the market price of XYZ
stock subsequently drops from $55 to $45 per share. If you are assigned, you must buy 100
shares of XYZ for a cost of $5,000 ($5,500 to purchase the stock at the strike price minus
$500 premium income received).
If the price of XYZ had dropped by less than the premium amount, say to $52 per share, you
might still have been assigned but your cost of $5,000 would have been less than the current
market value of $5,200. In this case, you could have then sold your newly acquired (as a result
of your put being assigned) 100 shares of XYZ on the stock market with a profit of $200.
Had the market price of XYZ remained at or above $55, it is highly unlikely that you would be
assigned and the $500 premium would be your profit.
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