Option Strategies 1

Basic Option Strategies: Covered Calls and Protective Puts

Outline
Using

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

Protective Puts
Definition Microsoft

example Logic behind the protective put Synthetic options

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

Microsoft Example

Assume you purchased Microsoft for $28.51

Profit or loss ($)

0 28.51 28.51

Stock price at option expiration

Microsoft Example (contd)

Assume

you purchased a Microsoft APR 25 put for $1.10

23.90 23.90 0 25 Stock price at option expiration

1.10

Microsoft Example (contd)

Construct

a profit and loss worksheet to form the protective put:

Stock Price at Option Expiration 0 5
-23.51 18.90 -4.61

15
-13.51 8.90 -4.61

25
-3.51 -1.10 -4.61

30
1.49 -1.10 0.39

40
11.49 -1.10 10.39

Long stock @ $28.51 Long $25 put @ $1.10 Net

-28.51 23.90 -4.61

Microsoft Example (contd)

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

Microsoft Example (contd)

Protective

put

25 29.61 Stock price at option expiration

4.61

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

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

Using Calls to Hedge A Short Position

Introduction Short

sale Microsoft example

Introduction
Call

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

Call

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

Microsoft Example
Assume

you short sold Microsoft for $28.51

Profit or loss ($) 28.51 Stock price at option expiration 28.51 Maximum loss = unlimited

Microsoft Example (contd)

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

Microsoft Example (contd)

Construct a profit and loss worksheet to form the long put:= (Short Stock + Long Call)

Stock Price at Option Expiration 0

Short stock @ $28.51 Long 35 call @ $0.50 Net
28.51 -0.50 28.01

15
13.51 -0.50 13.01

25
3.51 -0.50 3.01

28.51 35
0 -0.50 -0.50 -6.49 -0.50 -6.99

40
-11.49 4.50 -6.99

Microsoft Example (contd)

Long

put (short stock plus long call)

28.01 35 28.01 6.99 The potential for unlimited loss is gone Stock price at option expiration

Writing Covered Calls to Protect Against Market Downturns

When

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

Using Options to Generate Income

Writing

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

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 to Generate Income (contd)

Writing

calls may not be appropriate when

Option premiums are very low The option is very long-term

Writing Calls to Generate Income (contd)

Writing a Microsoft Call Example It is now September 15, 2003. 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.

Writing Calls to Generate Income (contd)

Writing a Microsoft Call Example (contd) 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.

Writing Naked Calls

Very

risky due to the potential for unlimited losses

Writing Naked Calls(contd)

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

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 $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.

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

Naked vs. Covered Puts (contd)

A

short stock position would cushion losses from a short put:

Short stock + short put short call