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Chapter 18

Option Overwriting

Whats 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

Introduction Using options to generate income Combined hedging/income generation strategies Multiple portfolio managers

Option overwriting refers to creating and selling stock options in conjunction with a stock portfolio Motives for overwriting:
To generate additional portfolio income To purchase or sell stock at a better-thanmarket price

Using Options to Generate Income

Writing calls to generate income Writing puts to generate income Writing index options A comparative example

Writing Calls to Generate Income

Writing covered calls Writing naked calls

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

Writing Covered Calls (contd)

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

Writing Covered Calls (contd)

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.

Writing Covered Calls (contd)

Example (contd)
Solution: A possible worksheet is shown below: Stock Price at Option Expiration 0 50 100 116 120 -116 -66 -16 0 +4 +6 -110 +6 -60 +6 -10 +6 +6 +6 +10 125 +9 +1 +10 150 +34 -24 +10

Long stock Short call Total

Writing Covered Calls (contd)

Example (contd)
Maximum gain

$10 $0 $120


Maximum loss


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


Writing Naked Calls (contd)

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

Writing Puts to Generate Income

Fiduciary puts Put overwriting


Fiduciary Puts
A fiduciary put is a covered (short) put
The writer of a fiduciary put must depot 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

Fiduciary Puts (contd)

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.


Fiduciary Puts (contd)

Example (contd)
Maximum gain

$7.25 $0 $120


Maximum loss


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 dont want to write calls for fear of opportunity losses

Put Overwriting (contd)

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.

Put Overwriting (contd)

Example (contd)
Solution: A possible worksheet is shown below: Stock Price at Option Expiration 0 75 115 116 Long stock -116 -41 -1 0 Short put Total -110.75 -35.75 +4.25 -226.75 -76.75 +3.25 +4.25 +4.25 150 +34 +4.25 +38.35

Put Overwriting (contd)

Example (contd)
Maximum gain is unlimited

$0 $115


Maximum loss


Writing Index Options

Introduction Margin considerations in writing index call options Using a cash account Using a margin account The risk of index calls What is best?

Index options:
Are one of the most successful innovations of all time Include the S&P 100 and S&P 500 index options Have little unsystematic risk

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


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 and If the writer can provide the necessary collateral by the deposit of cash, cash equivalents, marginable stock, or any combination of these

Using A Margin Account

The required funds in a margin account to write index calls:
Equal the market value of the options plus 15% of the index value times the index multiplier less any out-ofthe-money amount and Are subject to a minimum amount equal to the market value of the options plus 10% of the market value of the index times the index multiplier

Forms of Margin (Margin Equivalents)


The Risk of Index Calls

The risk of writing index calls is that the index will rise above the chosen exercise 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

The Risk of Index Calls (contd)

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

The Risk of Index Calls (contd)

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?


The Risk of Index Calls (contd)

Solution: The manager must pay $27,000: (693.00 690.00) x $100 x 90 contracts = $27,000


What Is Best?
Advantages of writing index options over writing calls on portfolio components:
They require only a single option position 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

A Comparative Example
Setup Covered equity call writing Covered index call writing Writing fiduciary puts Put overwriting Risk/return comparisons

Consider three market scenarios:
An advance of 5% No change A decline of 5%

We are managing a portfolio of five stocks (see next slide)



Covered Equity Call Writing

Individual call options are written against each of the five securities in the portfolio The following slide shows the managers selection of options and the resulting performance



Covered Equity Call Writing (contd)

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

ARC and IP are called away when the market remains unchanged

Covered Index Call Writing

Covered index calls are written The following slide shows the managers selection and performance



Covered Index Call Writing (contd)

The greatest gain occurs when the market advances 5% The manager does not have to sell any stocks because of cash settlement


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



Put Overwriting
Put overwriting is the most aggressive strategy The following slide shows the selection of puts and the resulting performance



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


Risk/Return Comparisons (contd)


Combined Hedging/Income Generation Strategies

Writing calls to improve on the market Writing puts to acquire stock Writing covered calls for downside protection


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

Writing Calls to Improve on the Market (contd)

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?

Writing Calls to Improve on the Market (contd)

Example (contd)
Solution: If the institution sells the shares immediately, it would receive $116,000 (1,000 shares x $116). If it wrote 10 calls, it would receive $118,000 in January: Option premium: $18 x 100 x 10 = $18,000 Stock sale when options are exercised: $100 x 1,000 shares = $100,000


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


Writing Puts to Acquire Stock (contd)

You want to buy 500 shares of Western Oil, which currently trades at $66.75 per share. January 70 puts sells 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?

Writing Puts to Acquire Stock (contd)

Solution: Outright purchase of the shares now would cost $33,375 (500 shares x $66.75). If you write 5 puts, you would pay $32,500 for the shares: Option premium received: 5 x 100 x $5 = $2,500 Amount paid for shares when options are exercised: 5 x 100 x $70 = $35,000

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 Does not want to sell the shares at the moment

Provides some downside protection, but alternatives are:

Buying puts Using portfolio insurance

Multiple Portfolio Managers

Separate responsibilities Distinction between option overwriting and portfolio splitting Integrating options and equity management


Separate Responsibilities
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


Option Overwriting Versus 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

Integrating Options and Equity Management

Hedging company-specific risk Unity of command


Hedging Company-Specific Risk

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

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