Chapter 3
Basic Option
Strategies: Covered
Calls and Protective
Puts
1
© 2002 South-Western Publishing
Outline
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2
Using options as a hedge
Using options to generate income
Profit and loss diagrams with seasoned
stock positions
Improving on the market
Using Options as A Hedge
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3
Introduction
Protective puts
Using calls to hedge a short position
Writing covered calls to protect against
market downturns
Introduction
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Hedgers transfer unwanted risk to
speculators who are willing to bear it
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4
E.g., insuring a home
Insurance that expires without a claim does
not constitute a waste of money
Protective Puts
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Definition
Microsoft example
Logic behind the protective put
Synthetic options
Definition
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A protective put is a descriptive term given
to a long stock position combined with a
long put position
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6
Investors may anticipate a decline in the value
of an investment but cannot conveniently sell
Microsoft Example
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Assume you purchased Microsoft for $79 7/16
Profit or loss ($)
0
79 7/16
79 7/16
7
Stock price at
option expiration
Microsoft Example (cont’d)
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Assume you purchased a Microsoft AUG 75 put for
$1 13/16
73 3/16
73 3/16
0
1 13/16
8
75
Stock price at
option expiration
Microsoft Example (cont’d)
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Construct a profit and loss worksheet to form the
protective put:
Stock Price at Option Expiration
9
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)
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The worksheet shows that
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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
Microsoft Example (cont’d)
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Protective put
75
0
81 1/4
6 1/4
11
Stock price at
option expiration
Logic Behind the Protective Put
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A protective put is like an insurance policy
–
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You can choose how much protection you want
Logic Behind the Protective Put
(cont’d)
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The put premium is what you pay to make
large losses impossible
–
The striking price puts a lower limit on your
maximum possible loss
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Like the deductible in car insurance
The more protection you want, the higher the
premium you are going to pay
Logic Behind the 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
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Synthetic Options
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The term synthetic option describes a
collection of financial instruments that are
equivalent to an option position
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A protective put is an example of a synthetic call
Using Calls to Hedge A Short
Position
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Introduction
Short sale
Microsoft example
Introduction
17
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Call options can be used to provide a hedge
against losses resulting from rising
security prices
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Call options are particularly useful in short
sales
Short Sale
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Investors can make a short sale
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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)
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A short sale is like buying a put…
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Many investors prefer the put
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The loss is limited to the option premium
Buying a put requires less capital than margin
requirements
Microsoft Example
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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
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Microsoft Example (cont’d)
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Combining a short stock with a call results
in a long put
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Assume the purchase of an OCT 90 call at $3 3/8
in addition to the short sale
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The potential for unlimited losses is eliminated
Microsoft Example (cont’d)
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Construct a profit and loss worksheet to form the
long put:
Stock Price at Option Expiration
22
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
Microsoft Example (cont’d)
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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
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Writing Covered Calls to Protect
Against Market Downturns
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A call where the investor owns the stock
and writes a call against it is called a
covered call
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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 to Protect
Against Market Downturns
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An OCT 85 covered call on Microsoft @ $5; buy
stock @ 79 7/16
15 9/16
0
74 7/16
74 7/16
25
90 (85)
Stock price at
option expiration
Using Options to Generate
Income
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Writing calls to generate income
Writing naked calls
Naked vs. covered puts
Put overwriting
Writing Calls to Generate
Income
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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 (cont’d)
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Writing calls may not be appropriate when
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Option premiums are very low
The option is very 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.
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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
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Very risky due to the potential for unlimited
losses
Writing Naked Calls(cont’d)
Writing a Naked Microsoft Call Example
The following information is available:
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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.
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Naked vs. Covered Puts
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A naked put means a short put by itself
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A covered put means the combination of a
short put and a short stock position
Naked vs. Covered Puts (cont’d)
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A special short put is a fiduciary put
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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
Naked vs. Covered Puts (cont’d)
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A short stock position would cushion
losses from a short put:
Short stock + short put  short call
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Put Overwriting: Introduction
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Put overwriting involves owning shares of
stock and simultaneously writing put
options against these shares
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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
Microsoft Example
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An investor simultaneously:
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Buys shares of MSFT at $79 7/16
Writes an AUG 80 MSFT put for $4
Microsoft Example (cont’d)
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Construct a profit and loss worksheet for put
overwriting:
Stock Price at Option Expiration
39
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)
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Writing an AUG 80 put on MSFT @ $4; buy stock @
79 7/16
4 9/16
0
155 7/16
40
Stock price at
option expiration
80
Breakeven point = 77 23/32
Profit and Loss Diagrams With
Seasoned Stock Positions
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41
Adding a put to an existing stock position
Writing a call against an existing stock
position
Adding A Put to an Existing
Stock Position
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Assume an investor
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Bought MSFT @ $46
Buys an AUG 75 MSFT put @ $1 13/16
Adding A Put to an Existing
Stock Position (cont’d)
Stock Price at Option Expiration
43
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)
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Protective put with a seasoned position
27 3/16
0
75
44
Stock price at
option expiration
Writing A Call Against an
Existing Stock Position
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Assume an investor
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Buys MSFT @ $46
Writes an OCT 85 call @ $5
Writing A Call Against an
Existing Stock Position (cont’d)
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Covered call with a seasoned equity
position
44
0
41
41
46
85
Stock price at
option expiration
Improving on the Market
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Writing calls to improve on the market
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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.
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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)
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There is risk associated with writing deepin-the-money calls
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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
Writing Puts to Improve on the
Market
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Writing puts to improve on the market
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An institution could write deep-in-the-money
puts when it wishes to buy stock to reduce the
purchase price