Chapter 18
Option Overwriting
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
1
What’s a good way to raise the blood pressure of an
Investor Relations Manager? Answer: Talk about
the pros and cons of stock options.
Eilene H. Kirrane, Boston
chapter of the National
Investor Relations Institute
2
Introduction

Option overwriting refers to creating and selling
stock options in conjunction with a stock portfolio
 Motives
for overwriting:
• To generate additional portfolio income
– Writing calls and/or puts
– Can also arise using index option
• To purchase or sell stock at a better-than-market price
3
Writing Covered Calls
 Writing
covered calls:
• Occurs when the investor writes options against
stock he already owns
• Is the most common use of stock options by
both individual and institutional investors
• Has a profit or loss determined by the long
position and the short position
4
Writing Covered Calls (cont’d)
Example
Nile.com stock currently trades for $116 per share. Call
options with a striking price of $120 and a $6 premium
are available for Nile.com.
Construct a worksheet and a profit and loss diagram to
determine the profit or loss associated with writing a
covered call for Nile.com. Assume the investor purchases
the stock for $116. Use a range for the stock price at
option expiration from $0 to $150.
5
Writing Covered Calls (cont’d)
Example (cont’d)
Solution: A possible worksheet is shown below:
Long stock
Short call
Total
Stock Price at Option Expiration
0
50
100 116
120
–116 –66 –16
0
+4
125
+9
150
+34
+6
+6
+6
+6
+6
+1
–24
–110
–60
–10
+6
+10
+10
+10
Stock price = $116; FEB 120 call = $6
6
Writing Covered Calls (cont’d)
Maximum gain
Example (cont’d)
$10
$0
$120
–$110
Maximum loss
Stock price = $116; $120 call = $6
7
Writing Covered Calls (cont’d)
 Covered
call writing is very popular with
foundations, pension funds, and other
portfolios that need to produce periodic
cash flows
 In
relatively stable or slightly declining
markets, covered call writing can enhance
investment returns
8
Writing Naked Calls
 Writing
naked calls:
• Involves writing an option without owning the
underlying stock
• Has a potentially unlimited loss
– Especially if the writer must buy the shares in the
market
• Is used by institutional heavyweights to make
money for their firm
9
Writing Naked Calls (cont’d)
 Naked
call writing is not often used by
individual investors
• Brokerage houses may enforce high minimum
account balances
 Fiduciaries
should be extremely careful
about writing naked calls for a client
10
Writing Puts to
Generate Income
 Fiduciary
Puts
• A fiduciary put is a covered (short) put
• The writer of a fiduciary put must deposit the
striking price of the option in an interestbearing account or hold the necessary cash
equivalents
• The commission costs of fiduciary puts may be
lower than writing covered calls
 Put
Overwriting
11
Fiduciary Puts (cont’d)
Example
February put options on Nile.com are available with an
exercise price of $120 and an option premium of $7.25.
Construct a profit and loss diagram for a fiduciary put,
showing the maximum gain and maximum loss.
12
Fiduciary Puts (cont’d)
Example (cont’d)
Maximum gain
$7.25
$0
$120
–$112.75
Maximum loss
Strike price = $120
13
Put Overwriting
 Put
overwriting:
• Involves owning shares of stock and writing put
options against them
• Is a bullish strategy
– Both owning shares and writing puts are bullish
strategies
• May be appropriate for portfolio managers who
don’t want to write calls for fear of opportunity
losses
14
Put Overwriting (cont’d)
Example
An investor buys Nile.com stock for $116 per share.
Simultaneously, the investor writes a Nile.com FEB 115
put with an option premium of $4.25 per share.
Construct a worksheet and a profit and loss diagram to
determine the profit or loss associated with put
overwriting. Use a range for the stock price at option
expiration from $0 to $150.
15
Put Overwriting (cont’d)
Example (cont’d)
Solution: A possible worksheet is shown below:
Stock Price at Option Expiration
0
75
115
116
Long stock
–116
–41
–1
0
150
+34
Short put
–110.75 –35.75 +4.25
+4.25
+4.25
Total
–226.75 –76.75 +3.25
+4.25
+38.25
Buy stock at $116; write $115 put at $4.25.
16
Put Overwriting (cont’d)
Example (cont’d)
Maximum gain
is unlimited
$0
$115
–$226.75
Maximum loss
Buy stock at $116; write 115 put at $4.25.
17
Writing Index Options
 Index
options:
• Are one of the most successful financial
innovations of all time
• Include the S&P 100 and S&P 500 index
options
• Have little unsystematic risk
18
Margin Considerations in
Writing Index Call Options
 Using
a margin account does not necessarily
involve borrowing
 Charitable
funds or fiduciary accounts use
margin accounts to provide the fund
manager with added flexibility
19
Using a Cash Account

A portfolio manager can use a cash account to
write index options:
• If a custodian bank issues an OCC index option escrow
receipt to the broker
• If the bank certifies that it holds collateral sufficient to
cover the writing of index calls
• If the writer can provide the necessary collateral by the
deposit of cash, cash equivalents, marginable stock, or
any combination of these
20
Using a Margin Account

The required funds in a margin account to write
index calls:
• Equal the market value of the options plus 15 percent of
the index value times the index multiplier less any outof-the-money amount
• Are subject to a minimum amount equal to the market
value of the options plus 10 percent of the market value
of the index times the index multiplier
21
Forms of Margin
(Margin Equivalents)
22
The Risk of Index Calls
 The
risk of writing index calls is that the
index will rise above the chosen striking
price
 The
lower the striking price:
• The more income the portfolio receives
• The higher is the likelihood that the option ends
up in the money
23
The Risk of
Index Calls (cont’d)
 Cash
settlement procedures for in-themoney index options:
• Involve the transfer of cash rather than
securities
• The writer owes the call holder the intrinsic
value of the call at option expiration
24
The Risk of
Index Calls (cont’d)
Example
A portfolio manager wrote 90 FEB 690 OEX calls. On the
expiration date, the S&P 100 index is at 693.00.
What is the amount the portfolio manager must pay to the
holder of the OEX options?
25
The Risk of
Index Calls (cont’d)
Example
Solution: The manager must pay $27,000:
(693.00 – 690.00) × $100 × 90 contracts = $27,000
26
What Is Best?
 Advantages
of writing index options over
writing calls on portfolio components:
• They require only a single option position
instead of many
• They vastly reduce aggregate commission costs
• They carry much less unsystematic risk
• There is less disruption of the portfolio when
calls expire in-the-money and are exercised
27
A Comparative Example
 Consider
three market scenarios:
• An advance of 5 percent
• No change
• A decline of 5 percent
 We
are managing a portfolio of five stocks
(see next slide)
28
29
Covered Equity Call Writing
 Individual
call options are written against
each of the five securities in the portfolio
 The
following slide shows the manager’s
selection of options and the resulting
performance
30
31
Covered Equity
Call Writing (cont’d)
 Observations:
• The portfolio makes money in each of the
scenarios
• The portfolio makes the most money when the
market advances
– The portfolio would lose all five securities
– The owner may prefer to have still own them
• ARC and IP are called away when the market
remains unchanged
32
Covered Index Call Writing
 Covered
index calls are written
 The
following slide shows the manager’s
selection and performance
33
34
Covered Index
Call Writing (cont’d)
 Observations:
• The greatest gain occurs when the market
advances 5 percent
• When the market drops, the index income is
insufficient to offset the stock loss
• The manager does not have to sell any stocks
because of cash settlement
35
Writing Fiduciary Puts
 Index
put options are written in anticipation
of the underlying stock rising in value
 The
following slide shows the selection of
puts and the resulting performance
36
37
Put Overwriting
 Put
overwriting is the most aggressive
strategy
 The
following slide shows the selection of
puts and the resulting performance
38
39
Risk/Return Comparisons

Put overwriting has the largest potential losses and
gains
 Writing
covered equity calls is not always superior
to writing covered index calls
 The
following slide shows the relative profits and
losses resulting from the four strategies
40
Risk/Return
Comparisons (cont’d)
41
Combined Hedging/Income
Generation Strategies
 Writing
Calls to Improve on the Market
 Writing Puts to Acquire Stock
 Writing Covered Calls for Downside
Protection
42
Writing Calls to
Improve on the Market
 Appropriate
for someone who wants to sell
shares of a stock but has no immediate need
for the money
 Income can be increased by writing deepin-the money calls
• The writer attempts to improve on the market
• The expectation is that the calls will be
exercised
43
Writing Calls to Improve on
the Market (cont’d)
Example
Nile.com stock currently sells for $116 per share. An
institution holds 1,000 shares and would like to sell the
stock. JAN 100 calls on Nile.com are available for $18 per
share.
If the stock price on the expiration is $120, what would be
the cash receipts to the institution if it writes 10 calls and
sells the stock in January? What would be the cash
receipts if it sold the stock today?
44
Writing Calls to Improve on
the Market (cont’d)
Example (cont’d)
Solution: If the institution sells the shares immediately, it
would receive $116,000 (1,000 shares × $116).
If it wrote 10 calls, it would receive $118,000:
Option premium received now:
$18 × 100 × 10 = $18,000
Stock sale when options are exercised in January:
$100 × 1,000 shares = $100,000
45
Writing Puts to Acquire Stock
 Involves
writing in-the-money put options
 A manager
can improve on the market by
purchasing the stock when the put options
are exercised
46
Writing Puts to
Acquire Stock (cont’d)
Example
You want to buy 500 shares of Western Oil, which
currently trades at $66.75 per share. January 70 puts sell
for $5.
What is the cost of acquiring the shares now? What is the
cost of acquiring the shares if you write 5 WO JAN 70
puts and the options are in-the-money on the expiration
day?
47
Writing Puts to
Acquire Stock (cont’d)
Example
Solution: Outright purchase of the shares now would cost
$33,375 (500 shares × $66.75).
If you write 5 puts, you would pay $32,500 for the shares:
Option premium received:
5 × 100 × $5 = $2,500
Amount paid for shares when options are exercised:
5 × 100 × $70 = $35,000
48
Writing Covered Calls
for Downside Protection
 Appropriate
for an investor who:
• Owns shares of stock, suspects the market will
turn down in the near future but does not want
to sell the shares at the moment
 Provides
some downside protection; other
alternatives are:
• Buying puts
• Using portfolio insurance
49
Distinction Between Option
Overwriting and Portfolio Splitting
 Portfolio
splitting means managing a
portfolio in accordance with more than one
objective
• e.g., half is growth of income, half is capital
appreciation
 Option
overwriting seeks to generate
additional profits for the fund through the
receipt of option premiums
50
Management of
Multiple Portfolio Managers
 Assume:
• A stock portfolio is assembled by a manager for
a client
• The stock portfolio is used by a different
manager for writing covered options
 Management
of the stock portfolio is the
most important concern
51
Integrating Options
and Equity Management
 To
hedge a company-specific risk of a
particular firm in a portfolio, use individual
equity options
 To hedge industry risk, employ options on
an industry index
 To hedge the entire portfolio, use index
options
52
Unity of Command
 Index
options increase the feasibility of
using a single portfolio manager for both
equity and option positions
• Index options do not require the transfer of
securities
• The time requirement to overwrite with index
options is minimal
• The manager who has the flexibility of index
options can exercise more creativity
53