Chapter 2 Review
Basic Puts and Calls
1
© 2002 South-Western Publishing
Buying a Call Option (cont’d)
Breakeven = $87
0
Maximum
loss = $7
2
20
40
60
80
100
Buying A Call Option


A bullish strategy
Consider possible actions if:
–
–
–
3
stock declines and so has your option
stock stays the same and your option has declined
(time value)
stock has advanced and your option increased in
value
Buying a Put Option (cont’d)
$74 1/8
Breakeven = $74 1/8
0
$5 7/8
4
20
40
60
80
100
Buying a Put Option


Bearish Strategy
Consider possible actions if:
–
–
–
5
stock declines and your option has increased in
value
stock has stayed the same and your option has
declined in value
stock has increased and your option has declined in
value
Writing a Call Option
Breakeven = $87
Maximum
Profit = $7
0
6
20
40
60
80
100
Writing A Call Option


A neutral to bearish strategy
Possible actions if:
–
–
–
7
stock stays the same
stock declines
stock increases beyond the exercise price - risk of
being ‘assigned’
Writing a Put Option
Breakeven = $74 1/8
$5 7/8
0
$74 1/8
8
20
40
60
80
100
Writing a Put Option




Neutral to bullish strategy
Similar to a covered call
Assume you wrote the put option as an
alternative to placing an open buy order
Possible actions if:
–
–
–
9
stock declines - possible assignment
stock stays the same - no action - realize the profit
stock increases - no action - realize the profit
Chapter 3
Basic Option
Strategies: Covered
Calls and Protective
Puts
10
© 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
11
Using Options as A Hedge



12
Protective puts
Using calls to hedge a short position
Writing covered calls to protect against
market downturns
Options as a Hedge

Hedgers transfer unwanted risk to
speculators who are willing to bear it
–


13
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
Protective Puts

A protective put is a descriptive term given
to a long stock position combined with a
long put position
–
14
Investors may anticipate a decline in the value
of an investment but cannot conveniently sell
the security or choose not to for some reason
Microsoft Example

Assume you purchased Microsoft for $79 7/16
Profit or loss ($)
0
79 7/16
79 7/16
15
Stock price at
option expiration
Microsoft Example (cont’d)

Assume you purchased a Microsoft AUG 75 put for
$1 13/16
73 3/16
73 3/16
0
1 13/16
16
75
Stock price at
option expiration
Microsoft Example (cont’d)

Construct a profit and loss worksheet to form the
protective put:
Stock Price at Option Expiration
17
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
Microsoft Example (cont’d)

The worksheet shows that
–
–
–
–
18
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 but it will always
be reduced by the cost of the ‘insurance’ - this is
what needs to be clearly understood
Microsoft Example (cont’d)

Protective put (vs unhedged position)
unhedged
1 13/16
75
0
81 1/4
79 7/16
- 6 1/4
19
Stock price at
option expiration
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

–
20
Like the deductible in car insurance
The more protection you want, the higher the
premium you are going to pay
Protective Put (cont’d)
Insurance Policy
Put Option
Premium
Value of Asset
Face Value
Deductible
Time Premium
Price of Stock
Strike Price
Stock Price Less
Strike Price
Time Until Expiration
Volatility of Stock
Duration
Likelihood of Loss
21
Synthetic Options

The term synthetic option describes a
collection of financial instruments that are
equivalent to an option position
–
–
22
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
Microsoft - Synthetic Call
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
-71/4
15-71/4
=7 3/4
30-71/4
=22 3/4
Call Option
23
-7 1/4
-71/4
-71/4
Using Calls to Hedge A Short
Position


24
Short sale
Microsoft example
Hedging a Short Position
25

Call options can be used to provide a hedge
against losses resulting from rising
security prices

Call options are particularly useful in short
sales
Short Sale

Investors can make a short sale
–
–


26
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
Short Sale (cont’d)


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
However:
– The put has a limited life or time frame
– The cost of the put needs to be considered
–
27
Hedging a Short Position

Assume you short sold Microsoft for $79 7/16
Profit or loss ($)
79 7/16
Stock price at
option expiration
0
79 7/16
Maximum loss = unlimited
28
Hedging a Short Position

29
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
Hedging a Short Position

Construct a profit and loss worksheet to form the
long put:
Stock Price at Option Expiration
30
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
Hedging a Short Position
Short sale with a long call creates the
equivalent of a long put
76 1/16
90
0
76 1/16
Stock price at
option expiration
13 15/16
The potential for
unlimited loss is gone
31
Hedging a Short Position
Short sale with a long call creates the
equivalent of a long put
76 1/16
unhedged
90
0
Stock price at
option expiration
76 1/16
13 15/16
93 3/8
32
The potential for
unlimited loss is gone
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
–
–
33
The call premium cushions the loss
Useful for investors anticipating a drop in the
market but unwilling to sell the shares now
Writing Covered Calls

An OCT 85 covered call on Microsoft @ $5; buy
unhedged
stock @ 79 7/16
15 9/16
74 7/16
0
90
Stock price at
option expiration
74 7/16
.....not particularly effective as a hedge against losses,
34
consider protective puts instead
Using Options to Generate
Income




35
Writing calls to generate income
Writing naked calls
Naked vs. covered puts
Put overwriting
Writing Covered Calls to
Generate Income




36
Actually quite a conservative approach
An attractive way to generate income for
foundations, pension funds, and other
portfolios
A very popular activity with individual
investors
Attractive when investor expects stock to
trade sideways
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


37
may be able to generate more income by writing a
series of shorter term call options
give away upside opportunity for long term
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.
38
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.
39
Writing Naked Options


40
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
Writing Naked Calls(cont’d)
Writing a Naked Microsoft Call Example
The following information is available:




41
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
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.
42
Naked vs. Covered Puts
43

A naked put means a short put by itself

A covered put means the combination of a
short put and a short stock position
Naked vs. Covered Puts (cont’d)

A short stock position would cushion (only)
losses from a short put:
Short stock + short put  short call
Profit/
Loss
44
Stock Price
@ Expiration
Put Overwriting:

Put overwriting involves owning shares of stock
and simultaneously writing put options against
these shares
–
–
–
45
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
Also a consideration in Corporate Share repurchase
(buyback) situations
Microsoft Example

An investor simultaneously:
–
–
46
Buys shares of MSFT at $79 7/16
Writes an AUG 80 MSFT put for $4
Microsoft Example (cont’d)

Construct a profit and loss worksheet for put
overwriting:
Stock Price at Option Expiration
47
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
Microsoft Example (cont’d)

Writing an AUG 80 put on MSFT @ $4; buy stock @
79 7/16
Unhedged
4 9/16
0
155 7/16
48
Stock price at
option expiration
80
Breakeven point = 77 23/32
Profit and Loss Diagrams With
Seasoned Stock Positions



Adding a put to an existing stock position
Writing a call against an existing stock
position
Other investment considerations:
–
–
–
49
sell stock - realize your profits!
Sell stock and replace it with a call option
Do nothing - continue to hold the stock
expecting further gains
Adding A Put to an Existing
Stock Position

Assume an investor
–
–
Bought MSFT @ $46
Buys an AUG 75 MSFT put @ $1 13/16
Objective .........to lock in existing profit
50
Adding A Put to an Existing
Stock Position (cont’d)
Stock Price at Option Expiration
51
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
Adding A Put to an Existing
Stock Position (cont’d)

Protective put with a seasoned position
unhedged
27 3/16
0
75
52
Stock price at
option expiration
Writing A Call Against an
Existing Stock Position

Assume an investor
–
–
53
Buys MSFT @ $46
Writes an OCT 85 call @ $5
Writing A Call Against an
Existing Stock Position (cont’d)

Covered call with a seasoned equity
position
44
0
41
41
54
85
Stock price at
option expiration
Improving on the Market

Writing calls to improve on the market
–
55
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
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.
56
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.
Writing Calls to Improve on the
Market (cont’d)

There is risk associated with writing deepin-the-money calls
–
–

57
It is possible that Microsoft could fall below the
striking price (option strategy less
advantageous vs outright sale)
Bid/ask and liquidity/depth considerations
Upside is essentially capturing time value
associated with the option
Writing Puts to Improve on the
Market

Writing puts to improve on the market
–

Risks to consider:
–
–

58
An institution could write deep-in-the-money puts when it
wishes to buy stock to reduce the purchase price
If the stock rises above the strike price and the put is not
exercised, the stock has not been acquired
‘opportunity loss’ if the stock price falls ie you would have
done better simply buying the stock outright
Trading range for the stock when this strategy is
advantageous