Example: Suppose that you bought 10 XYZ June 20 calls for 2 each when the stock was 21. This costs $2,000 before commissions. XYZ subse- quently rallies to 25, and your calls are now worth 5 (at least). Upon investi- gation, you see that the July 25s are selling for 11⁄2. You could therefore do the following:
Sell 10 June 20 calls at 5: $5,000 credit Buy 10 July 25 calls at 11⁄2: $1,500 debit
You therefore take a nice healthy $3,500 credit out of the position, less commissions—which more than covers your $2,000 initial cost—and you still have 10 long calls in case the stock explodes on the upside. The worst that can now happen is that the July 25s expire worthless, if the stock takes a dive. However, you have locked in a profit already, so that needn’t overly concern you.
USING LONG OPTIONS
in the profit graph in Figure 2.3. Note that the position has limited risk, equal to the initial cost of the put (2 points) plus the amount by which the put was out-of-the-money (1 point). Moreover, it has unlimited upside profit potential, which is almost as large as that of owning the stock itself.
Table 2.1
LONG STOCK/LONG PUT PROFIT POTENTIAL
Stock Long Stock Option Long Put Net Profit
Price Profit ($) Price Profit ($) ($)
30 –2,100 20 +1800 –300
35 –1,600 15 +1300 –300
40 –1,100 10 +800 –300
45 –600 5 +300 –300
50 –100 0 –200 –300
55 +400 0 –200 +200
60 +900 0 –200 +700
70 +1,900 0 –200 +1,700
Figure 2.3
LONG STOCK/LONG PUT
One other item is important: note that the shape of the profit graph of this position is exactly the same as the shape of the profit graph for owning a call. When two strategies’ profit graphs have the same shape—as do call buying and this strategy of protecting long stock with a long put—then the two strategies are considered to be equivalent, which means they have the same profit and loss poten- tial. We discuss equivalences repeatedly in this chapter. Note that just because two strategies are equivalent doesn’t mean they have the same rates of return. For example, the cost of buying a call is far less than the cost of buying both 100 shares of stock and buying a put.
When you consider buying a put to protect a holding in your stock, you have several things to consider, just as you do with another form of “insurance.” How much coverage do you want, how long a time period does the insurance cover, and how much are you willing to pay? Since options have varying expirations—even going out to two years or more with LEAPS options—as well as several striking prices, usually there are many choices. You might consider the amount by which the put is out-of-the-money as the “deductible”
portion of your insurance policy.
A very short-term insurance policy that has a large deductible is not very expensive. Thus, if XYZ were at 51 in April, then the pur- chase of a July 45 put would represent a rather short-term, large- deductible insurance policy. However, a two-year LEAPS put with a striking price of 50 would be a much more expensive form of insur- ance because (1) it is long-term and (2) there isn’t much of a deductible (only one point).
This strategy was employed, but rather rarely, back in the days of over-the-counter options, prior to the 1973 introduction of listed options. The first listed options were only calls (puts weren’t listed until 1976, and then only on 25 stocks). Thus, in the early days of listed options, investors were forced to use covered calls as their only real means of lessening the downside risk of stock ownership.
The introduction of listed options coincided fairly closely with the 1973–
1974 bear market that saw the Dow Jones Industrials decline from 1,000 to about 580 in a matter of approximately one year. The havoc wreaked on some of the “high-flying” stocks was even worse than the more than 40 percent loss suffered by the averages. The “nifty 50” stocks were supposed
to be a group that would outperform the regular market, regardless of bull or bear markets. These stocks were very overpriced and eventually suffered some of the worst declines of that bear market.
One trader owned Polaroid at about 150 a share at the beginning of that market and wrote covered calls against it all the way down to its even- tual low of 15! He claimed that he was able to protect nearly 75 percent of the loss with covered calls, a figure that may be a slightexaggeration—all trading stories grow in stature as the years pass—but is probably not a gross exaggeration. This shows just how expensive call options were in those early years (recall, there were no listed puts). It also reflects how large the volatility of that 1973–1974 market became as the months wore on.
In today’s market, of course, option premiums are much smaller, and investors do not view covered call writing as providing much more than a modicum of downside protection. Today’s strategy of insuring your stock holding by buying puts has become more and more popular since the crash of 1987. The main problem is that the protection is static; that is, if the underlying stock were to rally by a substantial amount after the insurance was purchased, the
“deductible” portion of the policy becomes huge. For example, with XYZ at 51, if the stockholder initially bought the LEAPS put with a striking price of 50, his deductible was one point. If the stock then proceeds to rally 20 points to 71 over the next year, his policy is still in force, except that the deductible is now 21 points since the put still has a striking price of 50. The only way to “upgrade” the insur- ance would be to sell the original put and then to buy another put with a striking price closer to the current stock price.
Some money managers and individuals with large holdings have found that it is easier to buy index puts on a sector or broad-based index whose characteristics more or less match those of their stock portfolios. Then, they can buy all of their insurance at once—puts don’t have to be bought individually for each stock in the portfolio.
This subject is covered in more detail in the next chapter.
Buying Calls to Protect Short Stock
Selling stock short is often considered a somewhat sophisticated strategy because theoretically there are unlimited risks involved. The
stock could soar in price and cause large losses. While it is usually the case that a trader can limit his risk with stop-loss orders or by paying attention to the market on a constant basis, it is sometimes easier for the short seller to know for certain that he has a limited loss even if the stock soars mightily. He can accomplish the task of limiting his loss by merely buying a call—probably an out-of-the-money one—
against his short stock. Then, even if there were a high-priced takeover bid for the company, his loss would be limited on the upside. Thus, a long call acts as insurance against large loss for a short seller, much in the same way that the stockholder’s loss was limited by the ownership of a put in the previous section.
The profit graph of the long call/short stock position is presented in Figure 2.4. Note that its shape is the same as that of merely own- ing a put. Thus, long put is equivalent to long call/short stock. As a result, the strategy is also known as a synthetic put.
In fact, when options were first listed—and for the ensuing three years—there were only listed calls. Thus, the only way that you could have large downside profit potential with limited risk was to utilize this long call/short stock strategy. Even when puts first were listed in
Figure 2.4
LONG CALL/SHORT STOCK
1976, there were only 25 stocks that had listed puts trading. If you wanted a position that was similar to owning a long put in any of the other optionable stocks, you still had to short the stock and buy a call.
The strategy was widely used, especially by professionals and arbitrageurs, and its name was shortened merely to “synthetic.” If you were “doing synthetics,” you were setting up a sizable position of short stock and long calls, for the purpose of making an arbitrage profit via the interest earned on the short sale, and/or for the pur- pose of capitalizing on the collapse of the stock price. Today, since all stocks with listed options have both a listed put and a listed call, this strategy is no longer as widely used as it once was.