Chapter 3
Basic Option Strategies:
Covered Calls &
Protective Puts
1
Dr. Hassan Mounir El-Sady
Outline
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Using options as a hedge
Using options to generate income
Profit and loss diagrams with seasoned stock
positions
Improving on the market
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
Introduction
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Hedgers transfer unwanted risk to speculators who are
willing to bear it
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Insurance that expires without a claim does not constitute
a waste of money
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E.g., insuring a home
Home owner Hedges by buying the insurance, the insurance
company Speculates that the house will not burn.
It is important to note that neither party wants the house to catch
fire.
Money spent on reducing risk is not wasted, it provides peace of
mind to the insurer.
Dr. Hassan Mounir El-Sady
Protective Puts
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It is not special type of put options, a protective
put is a descriptive term given to a long stock
position combined with a long put position
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Investors may anticipate a decline in the value of an
investment but cannot conveniently sell, mainly
because of the tax preference of the stock owner.
Notice that the term “Long” has nothing to do with
the time span, it means that you own something.
Dr. Hassan Mounir El-Sady
Microsoft Example
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Assume you purchased Microsoft for $28.51
Profit or loss ($)
0
28.51
28.51
6
Dr. Hassan Mounir El-Sady
Stock price at
option expiration
Microsoft Example (cont’d)
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Assume you purchased a Microsoft APR 25 put for $1.10
23.90
23.90
25
0
Stock price at
option expiration
1.10
7
Dr. Hassan Mounir El-Sady
Microsoft Example (cont’d)
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Construct a profit and loss worksheet to form the
protective put:
Stock Price at Option Expiration
0
15
25
30
40
Long stock
@ $28.51
= 0 – 28.51
= 5 – 28.51
= 15 – 28.51
= 25 – 28.51
= 30 – 28.51
=30– 28.51
= - 28.51
= - 23.51
= - 13.51
= - 3.51
= 1.49
= 11.49
Long $25
put @ $1.10
= 25 - 0 - 1.1
= 23.90
= 25 - 5 - 1.1
= 18.90
= 25 - 15 - 1.1
= 8.90
= 25 - 25 - 1.1
= - 1.10
-1.10
-1.10
- 4.61
- 4.61
- 4.61
- 4.61
Net
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5
Dr. Hassan Mounir El-Sady
0.39
10.39
Microsoft Example (cont’d)
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The worksheet shows that
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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 $29.62 = $28.51 + $1.1)
The maximum gain is unlimited
Dr. Hassan Mounir El-Sady
Microsoft Example (cont’d)
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Protective put
25
0
29.62
- 4.61
10
Dr. Hassan Mounir El-Sady
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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Like the deductible in car insurance
The more protection you want, the higher the
premium you are going to pay
Dr. Hassan Mounir El-Sady
Logic Behind the Protective Put
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
12
Dr. Hassan Mounir El-Sady
Using Calls to Hedge A Short Position
13
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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
Dr. Hassan Mounir El-Sady
Short Sale
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Investors can make a short sale
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Short sellers borrow shares from their brokers
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Closing out a short position is called covering the short
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A short sale is like buying a put
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Many investors prefer the put
position
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The opening transaction is a sale
The closing transaction is a purchase
The loss is limited to the option premium
Buying a put requires less capital than margin requirements
Dr. Hassan Mounir El-Sady
Microsoft Example
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Assume you short sold Microsoft for $28.51
Profit or loss ($)
28.51
Stock price at
option expiration
0
28.51
Maximum loss = unlimited
15
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
Microsoft Example (cont’d)

Construct a profit and loss worksheet to form the long
put:
Stock Price at Option Expiration
17
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
Dr. Hassan Mounir El-Sady
Microsoft Example (cont’d)
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Long put (short stock plus long call)
28.01
35
0
Stock price at
option expiration
28.01
6.99
The potential for
unlimited loss is gone
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Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
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
30
27.31
20
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
Writing Calls to Generate Income
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Can be very conservative or very risky, depending
on the remainder of the portfolio
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An attractive way to generate income with
foundations, pension funds, and other portfolios
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A very popular activity with individual investors
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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
Dr. Hassan Mounir El-Sady
Writing Calls to Generate Income (cont’d)
Writing a Microsoft Call Example
It is now September 15, 2005. 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.
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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Dr. Hassan Mounir El-Sady
Writing Naked Calls
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Very risky due to the potential for unlimited
losses
Writing a Naked Microsoft Call Example
The following information is available:
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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
Dr. Hassan Mounir El-Sady
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.
25
Dr. Hassan Mounir El-Sady
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
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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
A short stock position would cushion losses from a short
put:
Short stock + short put = short call
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
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
Construct a profit and loss worksheet for put overwriting:
Stock Price at Option Expiration
28
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
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
Profit and Loss Diagrams With
Seasoned Stock Positions
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1.
Adding a put to an existing stock position
2.
Writing a call against an existing stock position
Dr. Hassan Mounir El-Sady
1. Adding A Put to an Existing Stock Position
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Assume an investor
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Bought MSFT @ $22
Buys an APR 25 MSFT put @ $1.10
The stock price is currently $28.51
Stock Price at Option Expiration
Long stock @ $22
Long 25 put @ $1.10
Net
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0
10
25
30
35
40
-22
-12
+3
+8
+13
+18
+23.90
+13.90
-1.10
-1.10
-1.10
-1.10
1.90
1.90
1.90
6.90
11.90
16.90
Dr. Hassan Mounir El-Sady
Adding A Put to an Existing Stock Position
(cont’d)
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Protective put with a seasoned position
1.90
0
25
32
Dr. Hassan Mounir El-Sady
Stock price at
option expiration
2. Writing A Call Against an
Existing Stock Position
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Assume an investor
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Bought MSFT @ $22
Writes a JAN 30 call @ $1.20
The stock price is currently $28.51
Dr. Hassan Mounir El-Sady
Writing A Call Against an
Existing Stock Position (cont’d)
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Covered call with a seasoned equity position
9.20
0
20.80
30
20.80
34
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady
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 $28.51. OCT 20 call options are available @ $8.62.
The institution could sell the stock outright for a total of $285,100.
Alternatively, the portfolio manager could write 100 OCT 20 calls on
MSFT, resulting in total premium of $86,200. If the calls are
exercised on expiration Friday, the institution would have to sell
MSFT stock for a total of $200,000. Thus, the total received by
writing the calls is $286,200, $1,100 more than selling the stock
outright.
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Dr. Hassan Mounir El-Sady
Writing Calls to Improve on the Market (cont’d)
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There is risk associated with writing deep-in-themoney 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
Dr. Hassan Mounir El-Sady
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
Dr. Hassan Mounir El-Sady