Chapter 3
Basic Option
Strategies: Covered
Calls and Protective
Puts
1
© 2004 South-Western Publishing
Using Options as A Hedge
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2
Protective puts
Using calls to hedge a short position
Writing covered calls to protect against
market downturns
Protective Puts
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3
long stock position combined with a long
put position
Microsoft example
Logic behind the protective put
Synthetic options
Microsoft Example

Assume you purchased Microsoft for $28.51
Profit or loss ($)
0
28.51
28.51
4
Stock price at
option expiration
Microsoft Example (cont’d)

Assume you purchased a Microsoft APR 25 put for
$1.10
23.90
23.90
0
1.10
5
25
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
6
0
5
15
25
30
40
Long stock
@ $28.51
-28.51
-23.51
-13.51
-3.51
1.49
11.49
Long $25 put
@ $1.10
23.90
18.90
8.90
-1.10
-1.10
-1.10
Net
-4.61
-4.61
-4.61
-4.61
0.39
10.39
Microsoft Example (cont’d)
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Protective put
25
0
29.61
4.61
7
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
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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–
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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
–
10
A protective put is an example of a synthetic call
Using Calls to Hedge A Short
Position
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Call options are particularly useful in short
sales, providing a hedge against losses
resulting from rising security prices
Short sale, borrowing shares, later covering
the short position
Microsoft example
Short Sale (cont’d)
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A short sale is like buying a put

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

Assume you short sold Microsoft for $28.51
Profit or loss ($)
28.51
Stock price at
option expiration
0
28.51
Maximum loss = unlimited
13
Microsoft Example (cont’d)
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Combining a short stock with a long call
results in a long put
–
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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 (cont’d)

Construct a profit and loss worksheet to form the
long put:
Stock Price at Option Expiration
15
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
Microsoft Example (cont’d)

Long put (short stock plus long call)
28.01
35
0
28.01
Stock price at
option expiration
6.99
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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A JAN 30 covered call on Microsoft @ $1.20; buy
stock @ 28.51
2.69
0
27.31
27.31
18
30
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
Microsoft example
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)

Writing calls may not be appropriate when
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–
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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 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.
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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 $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.
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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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25
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(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
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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)
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A special short put is a fiduciary put
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–
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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)

A short stock position would cushion
losses from a short put:
Short stock + short put  short call
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Put Overwriting
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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 $28.51
Writes an OCT 30 MSFT put for $2
Microsoft Example (cont’d)

Construct a profit and loss worksheet for put
overwriting:
Stock Price at Option Expiration
32
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
Microsoft Example (cont’d)

Writing an OCT 30 put on MSFT @ $2; buy stock @
$28.51
3.49
0
56.51
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Stock price at
option expiration
30
Breakeven point = 28.255