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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
Outline
Introduction Using options to generate income Combined hedging/income generation strategies Multiple portfolio managers
Introduction
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
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$10 $0 $120
-$110
Maximum loss
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Fiduciaries should be extremely careful about writing naked calls for a client
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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
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$7.25 $0 $120
-$112.75
Maximum loss
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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
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$0 $115
-$226.75
Maximum loss
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Introduction
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
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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
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A Comparative Example
Setup Covered equity call writing Covered index call writing Writing fiduciary puts Put overwriting Risk/return comparisons
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Setup
Consider three market scenarios:
An advance of 5% No change A decline of 5%
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ARC and IP are called away when the market remains unchanged
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Put Overwriting
Put overwriting is the most aggressive strategy The following slide shows the selection of puts and the resulting performance
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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
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Separate Responsibilities
Assume:
A stock portfolio is assembled by a manager for a client The stock portfolio is used by a different manager for writing covered options
Option overwriting seeks to generate additional profits for the fund through the receipt of option premiums
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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
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