dr. hassan mounir el-sady 1 chapter 3 basic option strategies: covered calls & protective puts

Dr. Hassan Mounir El-Sady 1

Chapter 3

Basic Option Strategies: Covered Calls &Protective Puts

Dr. Hassan Mounir El-Sady2

Outline

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

Introduction Protective puts Using calls to hedge a short position Writing covered calls to protect

against market downturns


Introduction

Hedgers transfer unwanted risk to speculators who are willing to bear it– 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.

Insurance that expires without a claim does not constitute a waste of money– Money spent on reducing risk is not wasted, it

provides peace of mind to the insurer.


Protective Puts

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– 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.


Microsoft Example

Assume you purchased Microsoft for $28.51

Stock price at option expiration

Profit or loss ($)

0

28.51

28.51


Microsoft Example (cont’d)

Assume you purchased a Microsoft APR 25 put for $1.10


0

1.10

23.90

23.90 25



Construct a profit and loss worksheet to form the protective put:

Stock Price at Option Expiration

0 5 15 25 30 40

Long stock @ $28.51

= 0 – 28.51

= - 28.51

= 5 – 28.51

= - 23.51

= 15 – 28.51

= - 13.51

= 25 – 28.51

= - 3.51

= 30 – 28.51

= 1.49

=30– 28.51

= 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

Net - 4.61 - 4.61 - 4.61 - 4.61 0.39 10.39



The worksheet shows that– 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



Protective put


0

- 4.61

25

29.62


Logic Behind the Protective Put

A protective put is like an insurance policy– 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 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

Insurance Policy Put Option

Premium Time PremiumValue of Asset Price of StockFace Value Strike PriceDeductible Stock Price Less

Strike PriceDuration Time Until ExpirationLikelihood of Loss Volatility of

Stock


Using Calls to Hedge A Short Position

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– 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

A short sale is like buying a put

Many investors prefer the put – 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 ($)

0

28.51

28.51

Maximum loss = unlimited



Combining a short stock with a long call results in a long put– Assume the purchase of an APR 35 call

at $0.50 in addition to the short sale– The potential for unlimited losses is

eliminated



Construct a profit and loss worksheet to form the long put:


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



Long put (short stock plus long call)


0

6.99

35

28.01

28.01

The potential forunlimited 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– 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

A JAN 30 covered call on Microsoft @ $1.20; buy stock @ 28.51


0

27.31

30

2.69

27.31


Using Options to Generate Income

Writing calls to generate income Writing naked calls Naked vs. covered puts Put overwriting Microsoft example


Writing Calls to Generate Income

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 may not be appropriate when– Option premiums are very low– The option is very long-term


Writing Calls to Generate Income (cont’d)

Writing a Microsoft Call ExampleIt 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.


Writing Naked Calls

Very risky due to the potential for unlimited losses

Writing a Naked Microsoft Call Example

The following information is available:

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.


Naked vs. Covered Puts

A naked put means a short put by itself

A covered put means the combination of a short put and a short stock position

A special short put is a fiduciary put– 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


Put Overwriting

Put overwriting involves owning shares of stock and simultaneously writing put options against these shares– 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

An investor simultaneously:– Buys shares of MSFT at $28.51– Writes an OCT 30 MSFT put for $2

Construct a profit and loss worksheet for put overwriting:


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



Writing an OCT 30 put on MSFT @ $2; buy stock @ $28.51


0

56.51

30

3.49

Breakeven point = 28.255


Profit and Loss Diagrams With Seasoned Stock Positions

1. Adding a put to an existing stock position

2. Writing a call against an existing stock position


1. Adding A Put to an Existing Stock Position

Assume an investor– Bought MSFT @ $22– Buys an APR 25 MSFT put @ $1.10

The stock price is currently $28.51


0 10 25 30 35 40

Long stock @ $22 -22 -12 +3 +8 +13 +18

Long 25 put @ $1.10

+23.90

+13.90

-1.10 -1.10 -1.10 -1.10

Net 1.90 1.90 1.90 6.90 11.90 16.90


Adding A Put to an Existing Stock Position (cont’d)

Protective put with a seasoned position


025

1.90


2. Writing A Call Against an Existing Stock Position

Assume an investor– Bought MSFT @ $22– Writes a JAN 30 call @ $1.20

The stock price is currently $28.51


Writing A Call Against an Existing Stock Position (cont’d)

Covered call with a seasoned equity position


0

20.80

30

9.20

20.80


Improving on the Market

Writing calls to improve on the market– 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 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.

Writing Calls to Improve on the Market (cont’d)


Writing Calls to Improve on the Market (cont’d)

There is risk associated with writing deep-in-the-money calls– 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

Writing puts to improve on the market– 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 1 chapter 3 basic option strategies: covered calls & protective puts

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