IBD: Puts & Calls
Put Buying
A put option gives the holder the right, but not the obligation, to sell the underlying security at the strike price at any time until the expiration date of the option. If an investor wishes to capitalize on an expected drop in a stock’s price he must either sell the stock short or buy a put option on the stock. The put buyer has limited profit potential just like the short seller (as prices cannot drop below zero), but his losses are limited to the amount of his initial investment (premium), something that cannot be said for the short seller.
1) Buying puts to profit from downward price movements:
Buying an XYZ July 50 put option gives you the right to sell 100 shares of XYZ common stock at $50 per share at any time before the option expires in July. The right to sell stock at a fixed price becomes more valuable as the price of the underlying stock decreases. Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was 3 ½ (or $350). If the price of XYZ stock drops to $45 before your option expires and the premium rises to 5 ½, you can sell your option for $550, collecting a $200 profit.
The profitability of similar examples will depend on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date.
If the price of XYZ instead rose to $55 and the option premium fell to 7/8, you could sell your option premium to partially offset the premium you paid. Otherwise, the option would expire worthless and your loss would be the total amount of the premium paid.
This strategy allows you to benefit from a downward price movement while limiting losses to the premium paid.
Selling Calls
As a call writer, you obligate yourself to sell, at the strike price, the underlying shares of stock upon being assigned an exercise notice. For assuming this obligation, you are paid a premium at the time you sell the call.
Covered Call Writing
The most common strategy is writing calls against a long position in the underlying stock, referred to as covered call writing. Investors write covered calls primarily for the following reasons:
- to realize additional return on their underlying stock by earning premium income; and
- to gain some protection (limited to the amount of the premium) from a decline in the stock price.
- Covered call writing is considered to be a more conservative strategy than outright stock ownership because the investor’s downside risk is slightly offset by the premium he receives for selling the call.
As a covered call writer, you own the underlying stock but are willing to forsake price increases in excess of the option strike price in return for the premium. You should be prepared to deliver the necessary shares of the underlying stock (if assigned) at any time during the life of the option. Of course, you may cancel your obligation at any time prior to being assigned an exercise notice by executing a closing transaction, that is, buying a call in the same series.
A covered call writer’s potential profits and losses are influenced by the strike price of the call he chooses to sell. In all cases, the writer’s maximum net gain (i.e., including the gain or loss on the long stock from the date the option was written) will be realized if the stock price is at or above the strike price of the option at expiration or at assignment. Assuming the stock purchase price is equal to the stock’s current price: 1)If he writes an at-the-money call (strike price equal to the current price of the long stock), his maximum net gain is the premium he receives for selling the option; 2) If he writes an in-the-money call (strike price less than the current price of the long stock), his maximum net gain is the premium minus the difference between the stock purchase price and the strike price; 3) If he writes and out-of-the-money call (strike price greater than the current price of the stock), his maximum net gain is the premium plus the difference between the strike price and the stock purchase price should the stock price increase above the strike price.
If the writer is assigned, his profit or loss is determined by the amount of the premium plus the difference, if any, between the strike price and the original stock price. If the stock price rises above the strike price of the option and the writer has his stock called away from him (i.e., is assigned), he forgoes the opportunity to profit from further increases in the stock price. If, however, the stock price decreases, his potential or loss on the stock position may be substantial; the hedging benefit is limited only to the amount of the premium income received.
Assume you write an XYZ July 50 call at a premium of 4 covered by 100 shares of xyz stock which you bought at $50 per share. The premium you receive helps to fulfill one of your objectives as a call writer: additional income from your investments. In this example, a $4 per share premium represents an 8% yield on your $50 per share stock investment.
If the stock price subsequently declines to $40, your long stock position will decrease in value by $1000. This unrealized loss will be partially offset by the $400 in premium you receive for writing the call. In other words, if you actually sell the stock at $40, your loss will be only $600.
On the other hand, if the stock price rises to $60 and you are assigned, you must sell your 100 shares of stock for $5000. By writing a call option, you have forgone the opportunity to profit from an increase in value of your stock position in excess of the strike price of your option. The $400 in premium you keep, however, results in a net selling price of $5400. The $6 per share difference between this net selling price ($54) and the current market value ($60) of the stock represents the “opportunity cost” of writing this call option.
Of course, you are not limited to writing an option with a strike price equal to the price at which you bought the stock. You might choose a strike price that is below the current market price of your stock (and in-the-money option). Since the option buyer is already getting part of the desired benefit, appreciation above the strike price, he will be willing to pay a larger premium, which will provide you with a greater measure of downside protection. However, you will also have assumed a greater chance that the call will be exercised.
On the other hand, you could opt for writing a call option with a strike price that is above the current market price of your stock (an out-of-the-money option). Since this lowers the buyer’s chances of benefiting from the investment, your premium will be lower, as will the chances that your stock will be called away from you.
In short, the writer of a covered call option, in return for the premium he receives, forgoes the opportunity to benefit from an increase in the stock price which exceeds the strike price of his option, but continues to bear the risk of a sharp decline in the value of his stock which will only be partially offset by the premium received for selling the option.
Uncovered Call Writing
A call option writer is uncovered if he does not own the shares of the underlying security represented by the option. As an uncovered call writer, your objective is to realize income from the writing transaction without committing capital to the ownership of the underlying shares of stock. An uncovered option is also referred to as a naked option. An uncovered call writer must deposit and maintain sufficient margin with his broker to assure that the stock can be purchased for delivery if and when he is assigned.
Writing uncovered calls can be profitable during periods of declining or generally stable stock prices, but investors considering this strategy should recognize the significant risks involved:
If the market price of the stock rises sharply, the calls could be exercised. To satisfy your delivery obligation, you may have to acquire stock in the market for more than the option’s strike price. This could result in substantial loss.
The risk of writing uncovered calls is similar to that of selling stock short, although, as an option writer, your risk is cushioned somewhat by the premium received.
As an example, if you write an XYZ July 65 call for a premium of 6, you will receive $600 in premium income. If the stock price remains at or below $65, you will not be assigned on your option and, because you have no stock position, the price decline has no effect on your $600 profit. On the other hand, if the stock price subsequently climbs to $75 per share, you likely will be assigned and will have to cover your position at a loss of $400 ($1000 loss on covering the call assignment offset by $600 in premium income).
As with any option transaction, an uncovered writer may cancel his obligation at any time prior to being assigned by executing a closing purchase transaction. An uncovered call writer also can mitigate his risk at any time during the life of the option by purchasing the underlying shares of stock, thereby becoming a covered writer.
LEAPS
LEAPS are Long-term Equity Anticipation Securities. A LEAP is nothing more than a listed option that is issued with two or more years remaining until expiration.
Many of the strategies involving LEAPS are similar to those used for shorter-term options but special considerations apply. Generally, the longer term the option, the less rapid the decay of option premium. This is a good thing for an investor with an intermediate to longer-term focus. Many shorter-term options favor the seller as their premiums erode making it necessary for the buyer to not only be right, but to be right, now. That coupled with a generally larger spread (percentage between bid and offer) and typically higher commission leave the buyer of short-term options sometimes playing against the odds. The fact that the option premium in LEAPS will tend to erode more slowly, therefore, will tend to favor the buyer and be less advantageous to the seller, for instance, a covered writer.
LEAPS will also be much more responsive to changes in dividends and interest rates than shorter-term options. A well-laid plan can be spoiled by the effect of a meaningful change in interest rates which is certainly conceivable over a two or three year period. Therefore, it is important to recognize that many of the variables used to price options can either be magnified in the case of LEAPS or can change considerably over the course of two or three years, and dramatically change the way the market prices of LEAPS.
LEAPS will become regular option contracts when they become 9-month options.
