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protection.
An investor who would like to be paid for assuming the obligation of selling a particular
This strategy would work equally well for a cash, margin, Keogh account or IRA. Although this strategy may not be suitable for everyone, any of the investors above may benefit from using the covered call.
Definition
Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is "paid" to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.
In either case the investor is at risk of losing the stock if it rises above the strike price. Remember, in exchange for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you will see in the following example, even though he has given up some upside potential there can still be a good return on the investment. Stock ZYX currently is priced at 41.75, and the investor thinks this might be a good purchase. The threemonth 45 calls can be sold for 1.25. Historically, ZYX has paid a quarterly dividend of 25 cents. By selling the three-month 45 call the investor is agreeing to sell ZYX at 45 should the owner of the call decide to exercise his right to buy the stock. Keep in mind that the call owner may exercise the option if the stock is above 45, because he will be able to buy the stock for less than it is currently trading for in the open market. But, as you will see, his return will be greater than if he had held the stock until it reached 45 and then sold it at that price. Lets take a look at what happens to a covered call position as the underlying stock moves up or down. Commissions have not been taken into consideration in these examples; however, they can have a significant effect on your returns.
II. ZYX rises above 45 between now and expiration--call assigned. The call buyer can exercise his right to buy the stock and the call seller will have to sell ZYX at 45, even though ZYX has risen above 45. But remember the call seller has taken in the premium of the call and has been earning dividends (if any) on the stock. If ZYX stock is called away at expiration: Receive: Less: $45 for Stock $4,500.00
Return: 11.11% $450* *In three months plus dividends (if any) received. III. ZYX is right at 45 at expiration. The seller of a call may be in situation I or II. The stock may be called away and the call writer will be obligated to sell ZYX at 45. Alternatively, the stock may not be called away. A call could then be sold going further out in time, bringing in additional premium and further reducing the breakeven point.
Summary
The covered call write is a strategy that has the ability to meet the needs of a wide range of investors. It can be used in your Keogh, margin, cash account or IRA against stock you already own or are planning on buying. Currently, there are short-term options listed on more than 1,400 stocks and more than 350 of those stocks also have LEAPS, Long-term Equity AnticiPation SecuritiesTM, which are simply long-term stock and index options. Todays investor has a choice of short-term and long-term expirations, as well as multiple strike prices. This strategy is actually more conservative than just buying stock, due to the fact that you have taken in premium and lowered your breakeven price on the stock position. The covered write allows you to be paid for assuming the obligation of selling a particular stock at a specified price.
The goal of the strategy is to reduce the investors break-even price, without having to assume any additional downside risk.
Definition
The Repair Strategy is built around an existing stock position, usually a stock that is now trading at a lower price than the investors original cost. For every 100 shares held, 1 call option is purchased, and 2 call options with a higher strike price are sold; these purchases and sales are structured in such a fashion that the investors cash outlay is minimal or none.
investors break-even point, but it requires that additional funds be committed to the strategy, and it increases the downside risk of the position. An investor who finds himself with an unrealized loss on an optionable stock, has a third alternative: the Repair Strategy. For example, an investor could have purchased 500 shares of YZYZ stock at $50 and seen the value of these shares fall to the current price of $40. To establish the Repair Strategy, this investor could purchase 5 60-day 40 calls at $3 and simultaneously sell 10 60-day 45 calls at $1.50. Note that the cost of the purchased calls ($3 x 5 x 100 = $1,500) is fully offset by premium received from the sale of the written calls ($1.50 x 10 x 100 = $1,500). The 5 purchased calls give the investor the right to purchase an additional 500 shares at a cost of $40 per share. The 10 written calls means that the investor could be obligated to sell 1,000 shares of YZYZ at $45. He currently holds only 500 shares, but, if needed, could exercise his long calls and purchase another 500 shares at $40.
Establishing the Repair Strategy: Long 5 60-day 40 Calls, Short 10 60-day 45 Calls
I. YZYZ falls to $35 at option expiration in 60 days If at expiration in 60-days, the price of YZYZ has continued to decline and is now at $35, both the long 40 calls will expire worthless, and the short 45 calls will expire worthless. Since the investor initiated the option position at no cost and all of these options have expired worthless, the option strategy has had no impact on the overall position. The investor has seen an additional $5 loss accrue on the original shares, the same as would have resulted had he simply held on to his shares. It should be noted that if the Repair Strategy is utilized on a stock that continues to decline, it will not protect the investor from any further decrease in the price of the underlying stock. If the investor is expecting the price of YZYZ to continue to fall, a strategy other than the Repair Strategy should be considered. II. YZYZ is unchanged at $40 at option expiration in 60 days If at expiration in 60-days, the price of YZYZ is unchanged at $40, the situation is very similar to the above: all of the call options expire worthless, and the investor is left with his stock position. Once again the Repair Strategy has neither helped, nor made things any worse.
III. YZYZ is up to $45 at expiration in 60 days If YZYZ has rallied to $45 at expiration, the investors long calls will then be worth $5. The short $45 calls will expire worthless. The investor will have a $5 profit on the options, keeping in mind that the position was initiated for no cost. On the long stock position, at $45, the unrealized loss will be reduced to $5. Taking this $5 loss on the stock, and the $5 profit on the option position, the investor breaks-even on the overall position. Notice that what the investor has succeeded in doing is lowering his break-even point from a stock cost of $50, to $45. Also note that the Repair Strategy does need the underlying to at least partially recover in order to obtain the desired result. IV. YZYZ is up to $50 at expiration in 60 days Should YZYZ rally back to $50 by option expiration, the investors position will be as follows: Long stock will break-even Long 5 of the 40 calls, each now worth $10 Short 10 of the 45 calls, each now worth $5. The net value of the options equals zero: (5 x 10 x 100) (10 x 5 x 100) = $0. The value of the options cancel out, the stock is at break-even, and so the overall position breaks-even. This is the downside of the Repair Strategy: the best the investor can do is to break even.
The following table summarizes the investors overall position for various stock prices at expiration. Note that the cost of the options is not taken into account since the option position was initiated for no net cost. Stock at Gain (Loss) Value of 40 Value of 45 Net Gain Expiration on Stock Calls Calls* (Loss) 35 (15) 0 0 (15) 40 (10) 0 0 (10) 45 (5) 5 0 0 0 50 0 10 (2 X -5) 55 5 15 (2 X -10) 0 * The value of the short calls is multiplied by 2 since the investor sold 10 calls, versus a long position of 500 shares, and a long position of 5 calls.
Can the Repair Strategy be implemented for all stocks that are trading below the purchase price? Unfortunately not. The strategy will work for most stocks that are down 20% from their entry point (using options that may have 60 to 90 days to expiration), but will prove inadequate for stocks down 40% or 50%. In the later cases, investors will find that selling two out-of-the-money calls will not generate enough premium to finance the one atthe-money call purchased. Finally, very often, the strategy can be initiated for a small credit or a small debit. Investors should still consider the strategy in those cases were they may have to pay $0.25 or $0.50 for initiating the position. They may find that the overall benefits of the strategy are worth a minimal outlay.
Summary Table
Use per share amounts Stock Price at Expiration LS* US** (2 x Net Gain (Loss) = 1 + 2 + 3 + 4 * LS = Lower Strike (Calls Purchased) ** US = Upper Strike (Calls Sold) (1) Gain (Loss) on Stock (2) Expiration Value of Lower Strike Calls 0 0 (3) Expiration Value Upper Strike Calls 0 0 0 ) (4) Per share Cost of Initiating Position (5) Net Gain (Loss)
Definition
Selling a cash-secured put involves selling a put and depositing the money for the purchase of stock at the brokerage firm (generally, this money is invested in short-term instruments). The purpose of having the money in the account is to assure that funds are available to purchase the stock should the put be assigned to the account. Generally, the buyer of the put will exercise the option should the underlying
Lets compare these two strategies. Commissions and taxes have not been taken into consideration in these examples, although they can have a significant affect on your returns.
Placing a Limit Buy Order on 500 ZYX at 45 vs. Selling 5 ZYX 2-Month 45 Puts at 1.25 When the Stock is Trading at 47.
At expiration, the stock will either be above 45, in which case the investor will not buy the stock, or below 45, in which case he can expect to buy the stock at 45. The outcome of each scenario is explained below. I. ZYX remains above 45 between now and expiration--option not assigned. Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25 no stock is bought no stock is bought limit order still open keep premium of 1.25 x 5 contracts = $625 By selling a cash-secured put or entering a limit order to purchase the stock, the investor will not be able to participate in a rise in the price of the underlying. If the puts that were sold expired without being assigned, the investor could sell another 5 puts if he were still interested in owning 500 shares of ZYX. II. ZYX is below 45 at expiration--option assigned. Limit Order to Buy 500 ZYX @ 45 Sell 5 ZYX 2-month 45 Puts @ 1.25 Own (long) 500 shares ZYX @ 45 Own (long) 500 shares ZYX @ 45 1.25 less premium for put net cost = 43.75 Using a limit order to buy ZYX, the breakeven would be what he paid for the stock. Selling the put lowers the breakeven which is the strike price less the premium, 45 - 1.25 = 43.75. Having sold the puts with a 45 strike, should ZYX decline considerably the investor still has the obligation to buy the stock at 45. However, he does have the cost reduction of the 1.25 premium received for the sale. If a limit order had been used to purchase the stock at 45, he would begin losing money as soon as ZYX dropped below 45 (the breakeven). III. ZYX is at 45 at expiration. The investor may be in either situation I or II. With a limit order at 45, he may or may not buy the stock. There is no guarantee that he has bought ZYX at 45 until it trades below his limit price. If puts were sold, he has the obligation to buy 500 shares of ZYX, and he may be assigned (have the stock put to him) or the puts may expire worthless. Either way he retains the premium.
Placing a Limit Buy Order on 500 ZYX at 60 vs. Selling 5 ZYX 2-Month 65 Puts at 5.50 When the Stock is Trading at 65
There is another way to use the cash-secured put. For this example we will assume ZYX is trading at 65. Once again, an investor would like to own ZYX, but not at this level. He thinks that ZYX would be a good buy at 60. The previous example showed the sale of an out-of-the-money put (put strike price below current stock price) which required the stock dropping to the strike price of the put before the stock would be purchased. An alternative approach is to sell an at-the-money put (put strike price and current stock price are equal) or an in-the-money put (put strike price above current stock price) in which the premium from the put assures a target net purchase price
for the stock. By selling an in-the-money put it is more likely that the put will be assigned and the stock will be purchased. The owner of an in-the-money put is likely to exercise his right to sell the stock above its current value, therefore, the seller of the put will be obligated to buy the stock. Lets compare the limit order to the at-the-money put sale. I. ZYX rises above 65 between now and expiration, and there is no assignment. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50 no stock bought no stock bought limit order still open keep premium of 5.50 x 5 contracts = $2,750 II. ZYX drops below 65, but remains above 60 by expiration--option assigned. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5.50 no stock bought own (long) 500 shares ZYX @ 65 less premium for put 5.50 limit order still open net cost = 59.50 Selling the cash-secured put at a strike price of 65 for 5-5/8 allowed the investor to buy ZYX below the 60 limit at a net cost of 59.50, even though ZYX never traded there. If he had used a buy order at 60, he would not own any stock. III. ZYX drops below 60 by expiration--option assigned. Limit Order to Buy 500 ZYX @ 60 Sell 5 ZYX 2-month 65 puts @ 5-5/8 own (long) 500 shares @ 60 own (long) 500 shares @ 65 less premium for put 5-5/8 net cost = 59-3/8 Even if ZYX dropped through his 60 limit, the cash-secured puts supplied some downside protection. Since the net cost is 59-3/8, so is the breakeven. Had ZYX been purchased with a limit order at 60, the investor would not have any downside protection, and would begin to lose as soon as it dropped below the limit order cost. IV. ZYX at 60 at expiration. If a limit order was used to buy the stock, he may or may not own it. However, had the put been sold he might be put the stock and own ZYX at a price of 59.50 (65 strike price - 5.50 premium).
Summary
Selling a cash-secured put is a strategy that allows you to be paid a premium for the obligation to buy a particular stock. Currently, there are short-term options listed on more than 1400 stocks and more than 350 of those stocks also have LEAPS, Long-term Equity AnticiPation SecuritiesTM, which are simply long-term stock and index options. The premium received for selling a put gives you some downside protection by lowering your breakeven while placing no limit on how high the stock can be subsequently sold. This strategy may also give you the opportunity to purchase a security for a lower cost than it is currently trading. In other words, someone interested in investing in stock may want to consider selling a cash-secured put as a means of buying that stock.
downside protection.
Equity collars are used by investors whose primary concern is the downside risk of a stock position. They are willing to place a cap on upside potential in order to limit their down side risk at little, and sometimes no cost. Collars may be of special interest to those investors who have one equity position that accounts for a large proportion of their net worth, and who may not be able to reduce the size of this position. For these investors, low cost protection may take a precedence over maintaining upside potential.
Definition
An equity collar consists of the simultaneous purchase of a put option, and the writing of a call option. Both options are out-of-the-money, and usually have the same expiration date. Most often a collar is established against an existing equity position, with one put purchased and one call written for every 100 shares held. It is also possible to establish a collar at the same time that an equity position is purchased.
reasons: the tax liability could be substantial, or selling your employers stock may be sending the wrong kind of signal to management or other shareholders. These investors are also willing to give up some of the stocks upside potential in order to obtain the desired downside protection at little or no cost. As an example, consider an investor who has accumulated 1,000 shares of XYX stock, now trading at $44.75 This investor may be familiar with the purchase of protective puts but may also be reluctant to spend the amount necessary to buy put options. This could be especially true if the desired protection is for a relatively long period of time. If a 10-month 40 put option on XYX could be purchased for $4.75, for example, the investor might be unwilling to pay such a high premium.
In order to lower the net cost of the protection, the investor could purchase 10 of the 10-month 40 puts, and, at the same time, sell 10 of the 10month 55 calls for $4.50. The cost of the put options is offset, for the most part, by the premium received from writing the call options. If the collar could be established for no net premium, then it would be what is commonly known as a zero-cost collar. Commissions are not taken into consideration in the analysis that follows, however, commissions can have a significant effect on expected returns.
II. XYX is above $55 at expiration If XYX is trading above $55 at expiration, it is likely that the written 55 calls will be assigned. Consequently, the investor will be forced to sell the XYX shares at the strike price of $55. Remember that when call options are written against a long stock position, an obligation to deliver those shares at the options strike price is being assumed. If the buyer of these calls decides to exercise, then the writer must deliver the shares. In establishing a collar, the obligation to deliver shares was assumed so that the call premium could be used to partially offset the cost of the put option. The stock being called away at $55, in this example, represents the investors best case scenario. A $10.25 gain (the exercise price of $55 minus the original price of the stock, $44.75) will be realized less the $0.25 cost of the collar. The upside, therefore, is limited to $10 per share. III. XYX is trading between $40 and $55 at expiration If the price of XYX is anywhere between $40 and $55 at expiration, both the put and call options will be out-of-the-money and will expire worthless. The investor will keep the XYX shares, and the only cost will have been that of establishing the collar, $0.25 per share in this example. During this period, the investor will have retained ownership of the shares, with the ability to vote and to receive dividends, if either applied.
Purchasing the 10-month 40-55 Collar for a Net Premium of $0.25 per Share
I. XYX is below $40 at expiration If XYX is trading below $40 at expiration, the investor will have the right to exercise the put options and sell the shares at the strike price of $40. This represents the worst case scenario, and the investor will have to absorb a loss of $4.75 per share (the difference between the stock price of $44.75 when the position initiated and the selling price of $40) and a loss of $0.25 per share which represents the cost of the collar. The total downside risk, therefore, is $5.00 per share. Note: If, prior to expiration, the investor decides to keep the shares, the put could be sold. The proceeds from the sale of the put would partially offset the accrued loss on the stock.