Just as with any other type of security, the initial, or opening, option transaction may be a sale rather than a purchase. When you do that with a stock, you must first borrow the shares before you can sell them “short.” However, with options or futures, that is not necessary.
The mere option transaction itself creates a contract, so that the buyer of the option is longthe contract and the seller of the option is short the contract. The common term to describe the sale of an option as an opening transaction is to say the option has been written. This term comes from the old days when a physical contract was issued by the seller and delivered to the buyer. In today’s paperless trading world, there is no longer any physical contract, but the term remains.
Figure 2.6
COMBINATION (STRANGLE) PURCHASE
Covered Call Writing
When you write a covered call, you own the underlying and have sold a call option against it.
Example: Assume that XYZ is trading at 51 and a July 50 call is selling for 4. If you bought 100 shares of XYZ and sold one July 50 call, you would have a covered write with the following profit potential at July expiration:
Stock Option Total
Stock Profit Option Profit Profit
Price ($) Price ($) ($)
40 –1,100 0 +400 –700
45 –600 0 +400 –200
50 –100 0 +400 +300
55 +400 5 –100 +300
60 +900 10 –600 +300
Figure 2.7 shows the same results as in the example profit table.
Covered call writing is considered to be a conservative strategy.
There is limited upside profit potential and rather large downside risk. The profit potential is limited because the trader has written the call and therefore has assumed the obligation to sell his stock at the striking price should he be assigned on the call. The risk of covered writing is less than that of owning the common stock, although that risk can still be considerable if the stock falls by a great distance. It is this reduction in risk that has made covered writing a “conservative”
option strategy not only in the eyes of institutional money managers but in the eyes of the courts as well.
Covered call writers are usually interested in two numbers: (1) the kind of return that would be made if the underlying stock were called away at expiration (called the return if exercised) and (2) the kind of return that would be made if the underlying stock were unchanged at expiration (called the return if unchanged). Of course, opinions of what is an acceptable return would probably differ depending on whether the stock were being bought specifically for the purpose of
writing calls against it or whether an existing stockholder was writing calls against his long stock. The former probably represents the oper- ation of the entire position as a strategy, while the latter may just be looking for a little additional income without really wanting to sell his stock.
There is an inherent attraction in selling options, since an option is a wasting asset and the writer enjoys the benefit of the time decay.
This seems especially true to those who have suffered substantial losses due to time decay from owning options. As we pointed out earlier, option buyers who lose too much due to time decay are prob- ably buying options that are too far out-of-the-money. Unfortunately, writing a deeply out-of-the-money option, while it will probably expire worthless, is not really a very conservative way to approach covered call writing. The minimal amount of premium brought in by such an approach does not provide much in the way of downside protection. As with any strategy, covered writing can be operated in a conservative or an aggressive manner; the writing of deeply out-of- the-money calls is an aggressive approach.
A quite conservative covered write can be constructed by selling an in-the-money call against long stock. In such a case, there is
Figure 2.7
COVERED CALL WRITE
downside protection all the way down to the striking price of the written option, which can be a considerable distance below the cur- rent stock price. Of course, the return from such a strategy is not going to be huge on the upside, but it is sometimes surprisingly large when you consider that the hefty call premium you receive can be used to reduce the cost of buying the stock.
Overall, covered writing is usually employed as a moderately bull- ish strategy, so that one can make money if the stock rises or remains relatively unchanged until expiration. What is sometimes for- gotten is that this is not a very good strategy for bear markets, for stocks will normally fall faster than the protection provided by the limited amount of premium from the written call. Advocates of the strategy will say that even in a bearish scenario, all you have to do is keep writing calls at lower strikes and eventually you will collect enough premium to recoup your losses. However, if after a stock falls quickly, you write a call with a lower strike and then the stock rallies back quickly, you will surely have locked yourself into a loss no matter how large the premium you took in.
In summary, then, covered writing is a strategy designed to do best when stock prices are stable or moderately rising. If the underly- ing stock is, or becomes, volatile, this is not an attractive strategy because you cannot participate in large moves on the upside, but you willsuffer the results of any large move to the downside.
Naked Option Writing
When an option is written without any offsetting position in the underlying stock, or without being hedged by a similar long option, that option is considered to be written naked. In general, naked option writing is considered to be risky because you can make only a limited amount of money, yet could lose large sums if the underlying stock or futures contract moved so far that you were forced to buy the option back for a great deal of money. In general, larger margin and equity requirements are required by most brokerage firms before they will allow a customer to participate in the sale of naked options as a strategy. Yet, in the next few sections, we see that naked option writ- ing may not be all that risky if approached in a reasonable manner.
The “investment” required to write a naked option is somewhat different from that required for buying stock or options. You must have collateral of a sufficient amount to cover your risk in the eyes of your broker. Currently, if you are writing naked stock options, you must have collateral equal to 20 percent of the stock price, plus the premium of the option, less any out-of-the-money amount.
Example: Suppose XYZ were a $100 stock, and you wanted to write one July 110 call naked for a premium of 4 points. You would need to have the following collateral:
$2,000 (20 percent of the value of 100 shares of XYZ) –1,000 (the amount by which the call is out-of-the-money)
+400 (the premium of the option) ________
$1,400
There is a minimum collateral requirement that you must meet, which is 10 percent of the underlying price, no matter how far out- of-the-money the option is when initially written. Since the option premium is credited to your account when you sell the option, you can apply it toward your initial collateral requirement.
What is collateral? It’s any type of equity in your account that is not already borrowed against; it could be cash or any marginable security, such as stock, bonds, or government or municipal debt securities. Note that you are not charged any interest for the naked option collateral requirement, as you would be if you were buying stocks on margin, for you are not borrowing any money from your broker. In fact, if you use government securities as collateral, you are allowed to earn interest on the credit balance that is generated from the sale of the naked options. Thus, in the preceding example, the
$400 call premium could be invested in a money market fund and allowed to earn interest as long as you had $1,400 worth of equity in your T-bills.
The collateral requirement changes as the underlying stock moves up and down, to reflect the risk your broker envisions that you have in the position. For example, if XYZ rose to 120, the July 120 call might then be selling at 13. Your requirement would be $2,400
(20 percent of $12,000) plus $1,300 for the option premium, for a total requirement of $3,700—considerably larger than it was when the option was first written.
For index options, the calculation is similar, except that only 15 percent of the index value is required, as opposed to the 20 percent required for stock options. This is because indices are less volatile than individual stocks.
For futures options, if you are using SPAN margin, the require- ment is based on the volatility of the underlying futures contract. This is a sophisticated and enlightened way of approaching the matter and hopefully one day will be employed for stock options. Thus, SPAN margin might require more collateral for pork belly options than it would for heating oil options, even though both futures might be trading at the same price (most of the time, pork bellies are more volatile than heating oil). If you are notusing SPAN margin, then the requirement for writing a naked futures option is usually equal to the futures margin plus the option premium less one-half the out- of-the-money amount, if the option is out-of-the-money.
As with naked options, naked index or futures options require a minimum amount of margin. This is normally in the neighborhood of $200 to $300 per option, so that even an extremely out-of- the-money option will still require some collateral in order to write it naked.
Naked Put Writing
The sale of a put, without any accompanying position in the underly- ing stock, is termed naked put writing. It is a popular strategy among moderately sophisticated investors. The profit potential is a limited one; if the underlying security rises in price, the put that was sold will expire worthless and you will profit by the amount of the original premium that was collected. The following example and Fig- ure 2.8 define the strategy.
Example: Suppose XYZ is selling for 51 and the July 50 put is selling for 2.
If you sell the July 50 put naked, your profit potential at expirationwould be:
Stock Option Naked Put
Price Price Profit ($)
30 20 –1,800
35 15 –1,300
40 10 –800
45 5 –300
50 0 +200
55 0 +200
60 0 +200
Figure 2.8 shows the shape of the profits and losses associated with naked put writing. The profit is limited to the premium col- lected. On the other hand, if the underlying security falls in price, large risks could materialize. You would be forced to either buy back the put at a much higher price in that case or accept assignment of the stock at expiration. That is, the sale of a put obliges you to buy
Figure 2.8 NAKED PUT WRITE
the stock if you are assigned at some later date. The purchase of this stock could require considerable money.
One of the worst put-writing debacles of all time occurred in the crash of 1987. In the years and particularly the months leading up to the crash, many investors had been writing naked puts on the “stock market.” In this case, the stock market was generally represented by the Standard & Poor’s Index (OEX), although some other broad-based indices were being used as well. One of the great attractions was that you only had to have collateral of 5 percent (!) of the value of the index at that time.
As the stock market inexorably ground its way higher and higher through 1986 and 1987, more and more investors became enamored with the idea of putting up about $3,000 in collateral to collect $100 or $200 in profits every month, month in and month out. Of course, when the crash came, OEX fell almost 100 points in two days. Thus, puts that had been sold for $100 were suddenly worth $8,000 to $10,000. To make matters worse, volatility had increased so dramatically that the puts were even more expensive than they normally should have been.
Needless to say, many investors were wiped out, some brokerage firms were wiped out, and lawsuits flew back and forth. In the aftermath, margin requirements were raised, brokers required more sophistication from their customers who wanted to write naked options, and limits were placed on stock market movement.
It is stories like this that make many traders leery of writing naked options. However, before turning the page to look for the next strat- egy, stop for a minute and look at the preceding profit graph of the naked put write (Figure 2.8) and compare that profit graph with the one of the covered call write in the preceding section (Figure 2.7).
They are the same! The profit and loss potential of a covered call write (which is considered to be a conservative strategy) is exactly the same as the profit and loss potential of a naked put write (which seems, by the previous example, to be a very risky strategy).
What is going on here? Is there some trick? No, there isn’t. In fact, the two strategies do have the same profit and loss potential.
The investmentrequired for the two is slightly different, but the dol- lars of profit and loss are the same. But, you may ask, what about the disaster scenario in the preceding example? Well, owning stocks dur- ing the crash was pretty risky, too, you may remember. In fact, any
time you own stock, you have large risk to the downside—whether or not you take in some call premium as a hedge—just as you have downside risk from selling naked puts. In reality, covered call writing probably isn’t as conservative as some would have you believe, and naked put selling isn’t as dangerous, either.
The conventional wisdom is that covered call writing is the safest form of option trading because it has less risk than owning stock. I’ve always had some trouble with this argument because a stock can fall a long way; and even if you sell calls against it several times on the way down, you can still suffer some rather large losses in bear markets.
Moreover, no matter what kind of market you’re in, the sale of a call against your stock deprives you of the potential for large gains on the upside, since you are obligated to sell your stock at the striking price.
More realistically, it could be said that covered call writing canbe a conservative strategy. As with all option strategies, it depends upon how they’re implemented as to whether they are conservative. If you’re selling “expensive” calls against a stock that is oversold (or cheap by some other measure), then I would agree that that is proba- bly a conservative method of covered call writing. However, if you’re selling out-of-the-money calls against a volatile, overpriced stock, that’s not very conservative because you are taking too much downside risk.
Recall that when two strategies’ profit graphs have the same shape—as do covered call writing and naked put selling—then the two strategies are considered to be equivalent.
I generally prefer the naked put selling strategy for two reasons:
first, you are only dealing with one security’s bid-asked spread rather than two, and second, the margin requirement is considerably smaller. The stock owner receives dividends (if any are paid), but the naked put seller can use T-bills as his collateral and earn interest that way. Moreover, the price of the put has the dividend factored in (i.e., puts are more expensive on high-dividend-paying stocks, all other things being equal).
Put Writing Philosophy. The naked put writing strategy is often approached in this manner: if you sell an out-of-the-money put on a stock that you like—and wouldn’t mind owning—then you are in a
“no-lose” situation. If the stock goes up, you profit by the amount of the premium received from selling the put. On the other hand, if the
stock goes down below the striking price of the put you sold, you buy the stock at a low price, which is theoretically good since you don’t mind owning the stock. At that point, you can just hold the stock or maybe even write some calls against it. This philosophy is quite wide- spread among naked put sellers. That is, they choose the puts they sell by looking at the qualities of the underlying stock. They are not overly concerned with whether the puts are “cheap” or “expensive”
by statistical measures. In this manner, if you do eventually wind up being put the stock, you are buying a stock that you have confidence in and that is fundamentally attractive to you.
Unfortunately, the theory and the practice of it are sometimes at odds. It’s all well and good to say that you wouldn’t mind owning a stock if it dropped to the striking price of the puts you sold. How- ever, what it if dropped to that level and kept on dropping? Then, it’s not so much fun.
When LEAPS options (options with expirations extending out to two years) were introduced, they were generally only listed on some of the biggest and best stocks. One of the reasons this was done, as opposed to listing them on volatile highfliers with big option premiums, was to attract put writers who adhere to the philosophy just described. One of these stocks was IBM, which at the time was selling between 105 and 100. Long-term puts with a striking price of 90 were listed; and many investors sold them naked, figur- ing that if they had a chance to own IBM at 90, they wouldn’t mind. Well, they all got their chance as the stock began to drop rather precipitously and fell all the way to 45. It didn’t recover right away, either. When the puts got so deeply in the money, most of them were assigned, even though there was over a year of life remaining in the puts. Many of those put writers, in the final analysis, were not really ready to buy IBM and hold it through a plunge like that. Some of them didn’t have the money required to take on the debit necessary to buy the stock, so they tried to roll their puts to even longer-term puts, but those too were assigned. The moral is that even the best of stocks can go through its own bear market; and, if it does, it will hurt covered call writers and naked put sellers.
Protecting Your Positions. Regardless of whether you use cov- ered call writing or naked put selling, you have downside risk, as the